Get used to market volatility, it’s not going anywhere

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Hindsight often offers 20/20 vision. Perhaps the mad equity volatility in the waning weeks of 2018 and early days of 2019 should have been expected. But there are many reasons behind the market’s jitters — and many reasons that suggest they may not be calming soon. 

December is seasonally the lowest liquidity month of the year due to the holidays and because many hedge funds, which trade frequently and thus supply liquidity to the markets, have already closed their year.

{mosads}The liquidity situation has been exacerbated this time around as the Federal Reserve, the largest buyer of fixed income assets, is reversing its quantitative easing and gradually withdrawing from the market.

In addition, as a result of the Volcker Rule, securities dealers are restricted from carrying the securities inventory to facilitate trades that they would have prior to the financial crisis.

A vicious cycle is thus created where low liquidity creates volatility, which quickly depresses asset values, in turn causing further price swings.

Adding even more fuel to the fire was news about the partial U.S. government shutdown and the back-and-forth over the Italian fiscal deficit. But equity markets have considered these to be temporary risks and hence have relegated them as background noise.

In this febrile environment, three fundamental questions have pitted investors against each other:

  • whether the Fed is on “autopilot” in tightening financial conditions;
  • whether the trade dispute between the U.S. and China will develop into a framework for a resolution given the short 90-day window for negotiations; and
  • whether China has the fiscal and monetary tools to manage the apparent economic slowdown.

Unconventional monetary policy provides little or no history. The waves of coordinated large scale asset purchases by the world’s largest central banks caused volatility in asset prices to fall sharply, which lowered the risk premium over risk-free rates, increasing the price of financial assets. 

The reverse may now be at play as liquidity is being withdrawn. Last year was supposed to have been the handover year for equities from being driven for almost a decade by central bank liquidity to being driven by improving economic fundamentals resulting in positive revisions to earnings expectations for companies — the best kind of support for stocks.

Indeed, current data for the U.S. economy, including early readings for holiday season retail spending, remain healthy. However, manufacturing data have weakened considerably, as seen in the most recent ISM survey, which still remains in expansion territory.

Contributing to this weakness are the economic slowdown in China, which accounts for approximately a third of global growth, and the dent to business sentiment caused by trade uncertainty, which has resulted in the rise in the number of stocks seeing downward revisions to 2019 earnings estimates. 

Given this backdrop, it is positive for markets (and a negative for further volatility) that the Fed has confirmed that it will continue to “monitor global economic and financial developments” and be data dependent.

While we believe China will be able to manage its liquidity squeeze and the negative consequences on growth, as a result of its policy to curtail shadow-banking and other loosely regulated credit, a further slowdown in China could spur the biggest of debates on the Fed’s likely response, not just on future rate rises but also on the pace of its balance sheet reduction. 

Welcome to 2019, and welcome to volatility and all its opportunities!

Anik Sen is global head of equities at PineBridge Investments, a private, global asset manager.

Tags Asset and liability management economy Finance Financial crisis of 2007–2008 Financial markets financial risk Hedge fund Market liquidity Money Quantitative easing Security Volatility

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