Making sense of the global rout
The global equity markets have behaved like a petulant drug addict who has been denied his daily fix of easy money. The prospect of monetary policy normalization in the US has pulled down share prices at a time when the global economy is in the early stages of the strongest synchronized expansion since the financial crisis. This paradox of a sharp market correction in the midst of an economic expansion underlines the influence that extraordinary monetary policy has had on asset prices over the past decade.
It is too early to either say why global markets have suddenly reversed course or whether the recent tumble is just a bull market correction rather than something deeper. What is known is this. Global monetary policy is tightening. The US Federal Reserve seems to be on course for three rate hikes this year, and it remains to be seen when Europe and Japan begin to withdraw from their versions of quantitative easing. Bond yields have spiked. Wage growth in the US is perhaps rising at the fastest pace since 2008—and economists have yet to figure out whether the effect will be inflation or a profit squeeze.
The best policy response will depend on which of the two effects are more likely. Advanced economy central banks will have to accelerate rate hikes in case higher wage costs quickly feed inflation while they will have good reason to moderate the pace of monetary tightening in case more expensive labour eats into corporate profits.
There is a Goldilocks alternative as well. The spike in wage costs gets absorbed through higher labour productivity. Yet, despite these analytical tangles, there is now enough reason to believe that the global interest rate cycle has turned. It is also quite possible that central banks that received reputational knocks because of their failure to deal with the asset bubbles in the first decade of this century will institutionally be more likely to move this time around.
There are more serious fears in the air as well. Some investors have begun to talk about outlier events such as a major bank failure or an emerging-markets blowout. It is in the nature of outliers that they cannot be predicted with any confidence, but the nature of the chatter does show that what has happened in the past few days has shaken the markets. Policymakers in the developed world will have to walk the fine line between preventing markets from tumbling further and ensuring that the underlying economic recovery is not halted in its tracks because of a financial shock.
India has naturally not been spared. The broad share indices have given up most of their gains since the beginning of the calendar year. The more volatile mid-cap shares have taken an even more severe beating. A prolonged wave of selling in the global markets could also have serious repercussions on Indian macroeconomic stability, though the fall in Brent crude to its lowest level in a month could offer some respite to a large energy importer such as India.
Many investors could be wondering whether the ongoing market turmoil is the opening sequence of a 2008-style meltdown. The feedback loops in financial markets mean that fear psychosis can create a self-fulfilling prophecy. A lot depends on the similarities and differences from that gut-wrenching episode. The most important similarity is that leverage is still dangerously high, though it is more on government rather than private sector balance sheets right now, thanks to the record fiscal expansions to deal with the after-effects of the 2008 crash. The most important difference is that the global economy is in the early stages of a strong recovery rather than in the last stages of an expansion, though potential growth in many countries continues to be below what it was a decade ago.
Predicting markets is usually a perilous task. What can be said for now is that the tightening of global liquidity is bound to make equities unattractive on a relative basis, and so a lot will depend on how the underlying macro and corporate fundamentals move in the quarters ahead. There is a lot of positive news on that front, especially in India.
Financial markets had run ahead of fundamentals thanks to easy liquidity. That has now changed.
What should be the policy response to the market correction? Tell us at firstname.lastname@example.org
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