Downgraded global growth forecasts, an end to U.S. quantitative easing, and rising geopolitical tensions have created a near “perfect storm” of financial volatility. But according to the experts, global markets are far from ready for the consequences.
On Tuesday, the Reserve Bank of Australia’s assistant governor, Guy Debelle, warned investors of a “dangerous” complacency to potential disruptions, amid the highest level of market volatility since February, as measured by the VIX index.
“Financial markets have been quiet, maybe too quiet, for much of this year…If I had told you that there were heightened tensions in the Middle East and Eastern Europe, uncertainty about the turning point in U.S. monetary policy, a succession of strong U.S. job numbers, uncertainty about the future direction of policy in Europe and Japan, as well as increased concern about the strength of the Chinese economy, you would not be expecting that to make for a benign time in financial markets,” he told a Citi investment conference in Sydney.
Pointing to “high volatility” in growth in the United States and Japan during the first half of 2014, together with uncertainty over the direction of interest rates, Debelle said markets were underestimating the possibility of a “violent” sell-off, similar to the 1994 U.S. bond market crash.
“One thing which is certain is that the low volatility will not persist,” he said, adding “there are probably a sizeable number of investors who are presuming they can exit their positions ahead of any sell-off. History tells us that this is generally not a successful strategy. The exits tend to get jammed unexpectedly and rapidly.”
He said monetary policy settings in China, Europe, Japan and the United States were in an “extreme environment” and moving in divergent directions, with China’s renminbi moving in “lock step” higher with the dollar even as the yen and euro depreciated.
Pimco: Prices, Fed Key Risks
The central banker’s warning to investors followed a report from U.S. bond fund manager Pimco listing 38 key events that could trigger increased volatility in global financial markets, topped by an economic surprise over inflation or deflation (25 percent probability) and U.S. Federal Reserve tapering or stockmarket “derating” (both 20 percent) .
Next was a “geopolitical surprise” in the Middle East (15 percent), an economic crash in China (15 percent), and short covering on equity markets due to an extended market rally (15 percent). Pimco assigned a 10 percent probability of a Japan-China territorial dispute disrupting markets, with the same risk assigned to a failed major bond auction, large municipal credit default, and problems in Europe and Japanese monetary policy, as well as a “Washington surprise.”
Other risks cited by the leading bond investor included “North Korea going fully rogue,” China selling U.S. treasuries or rebalancing its foreign exchange holdings, and another major housing market crash, all rated 5 percent probability.
Somewhat surprisingly given recent news coverage, Ebola failed to rate a mention, although a bird flu outbreak was assigned a 1 percent probability along with another nuclear reactor meltdown, followed last by a meteor strike or super natural catastrophe, both at 0.5 percent.
Yet despite the extensive list, the report’s author, Vineer Bhansali, said markets were still blithely ignoring growing risks.
“I think the markets are expecting a lot more peace and quiet,” he was quoted as saying by the Sydney Morning Herald.
“And I think that’s a mistake – because even though you can’t identify the probabilities, the fact that something bad can happen can really hurt you.”
Like Debelle, Bhansali cited a sudden withdrawal of liquidity from the Fed or other major central bank as the biggest threat to complacency.
“The biggest issue right now is a surprisingly strong print in terms of economic data and withdrawal of liquidity or expectations of liquidity from global central banks that is ahead of schedule,” he said.
“I don’t think the market is prepared for an implied tightening in global financial conditions.”
IMF: World Economy ‘Mediocre’
The heightened warnings have followed a recent downgrading of global economic growth forecasts by the International Monetary Fund (IMF). The Washington-based lender cut its 2014 forecast for the world economy to a 3.3 percent expansion compared to its April prediction of 3.7 percent, citing “mediocre” growth in the first half of the year.
In 2015, the global economy is expected to pick up speed, expanding by 3.8 percent compared with the IMF’s previous forecast of 3.6 percent growth.
The prognosis was mixed for Asia’s biggest two economies. China’s growth forecasts were left unchanged at 7.4 percent this year and 7.1 percent in 2015, but Japan saw its expansion projections revised downward to just 0.9 percent and 0.8 percent, respectively.
The IMF cited a long list of downside risks to its growth forecasts, including a rise in interest rates, geopolitical turmoil, and a stalled recovery in the Eurozone.
“The pace of the global recovery has disappointed in recent years. With weaker-than-expected global growth for the first half of 2014 and increased downside risks, the projected pickup in growth may again fail to materialize or fall short of expectations,” the fund said.
While markets “can stay irrational longer than you can stay solvent,” as the RBA’s Debelle said quoting Keynes, the warnings are growing increasingly loud. Slamming on the brakes suddenly could cause jittery investors to quickly head for the exits.