The past few months have seen significant volatility in financial markets: global equities endured a double-digit sell-off in the third quarter, high-yield credit spreads have widened sharply, and commodity markets have continued to tumble.
Markets have been unsettled by a combination of issues: the anticipation of the first rate hike from the US Federal Reserve, Chinese growth concerns, and a potential flare up in European political risks. Is the recent bout of volatility a blip or is it the beginning of the end of the upward cycle?
With emerging markets now accounting for around a third of global output, a substantial slowdown among these markets would have a material impact on the global economy. On official data, China is still growing at a much faster pace than the rest of the world and its positive contribution to global economic growth is considerable.
Sceptics argue China is grossly over-reporting its rate of economic growth. However, that would imply that the world economy has already weathered a sharp slowdown in Chinese demand without much obvious damage to western labour markets or consumer demand.
The impact of any slowing in emerging markets therefore seems manageable for the rest of the world. Moreover, western economies would be net beneficiaries of the weakness in oil and other commodity prices that would result from an emerging market slowdown.
Weaker commodity prices are bad news for the principal exporters in emerging markets, and also signals trouble for debt that is secured against commodity earnings. This is of particular concern for US high yield, where there is likely to be materially higher default rates in 2016.
However, a cheapening in oil prices represents a boost to the real income of western consumers and a fall in an important input cost for most industrial producers. On balance, the commodity price fall is a positive development for the sustainability of the global recovery.
In economies where economic slack is limited, such as in the UK and US, the policy response is likely to be relatively muted. Central banks in both countries are preparing to raise interest rates to prevent their economies from overheating in the future. Lower commodity prices and concerns about China’s growth will encourage them to delay hiking interest rates and soften the pace of rate rises.
But lower commodity prices can trigger deflationary risks if low inflation starts to affect wage- and price-setting behaviour. That is a more material concern in continental Europe, due to extremely high unemployment and Japan, because of its long history of near-zero inflation. In these regions, a more aggressive response is likely to be forthcoming, with further interest rate cuts and more asset purchases.
At the global level, monetary policy will therefore remain loose. The quantitative easing baton has simply been passed from the Federal Reserve and Bank of England to the European Central Bank and Bank of Japan.
Overall, there are a number of reasons why the recent market volatility represents a correction, rather than the start of a new bear market.
