The recent bout of market volatility might not have surprised anyone who looks at asset price movements on a daily basis, but the melt-up-down was disorderly and violent. As well as captivating millions of casual investors it also gave pause for thought: could the long, smooth ride be over?
We find it unlikely that this market episode will be associated with a sustained economic downturn. The ingredients are inconsistent with that most fearsome of scenarios in which inflation picks up sharply while the economy stagnates. In the unlikely event of a sustained market slump, the Oxford Economics model suggests a 10% change in stock prices reduces the level of G7 GDP by around 0.3% on average after two years.
This market reversal is quite a severe one – of a similar magnitude to other tantrums and episodes since mid-2013. Nevertheless, our view is that the worst-case scenario of a sustained market rout with major global macro consequences is quite unlikely. All the tantrums and market episodes of recent years have petered out quite quickly, and it is our view that this one will probably take a similar turn.
The key common theme for such an episode to turn into a sustained bear market with strong macro consequences is the realisation of a fundamental economic weakness and/or balance sheet vulnerabilities.
What might make this period of weakness infect the global economy? The current episode brings to the fore a tail risk that has haunted markets and the global economy for several years. What if central banks have to respond to higher inflationary pressures, with limited offsetting good news on output? Indeed, our forthcoming note will argue that the movement in bond prices is about changed expectations of policy, since implied inflation expectations from swaps have moved less than real rates.
But we do not see this current reversal as consistent with such a fearsome scenario. Rather, we see markets, especially in the US and parts of Asia, as having entered the stage of euphoria often seen during extended late-cycle rallies driven in part by speculation about the impact of tax reforms in the US.
There are several reasons why the length and impact of this reversal will be limited. Even after recent falls, global equities are just 1% down, year-to-date. The strong upward momentum in the global earnings cycle is not a backdrop for a large bear market in global equities. And the latest earnings season in the US shows signs of earnings per share (EPS) growth acceleration, with 261 S&P500 corporations having reported earnings growth of around 15%. We are not seeing a rout in USTs (United States Treasury). Yields increased from 2.4% at end-2017 to a peak of 2.84% on
2 February, but have currently dropped back to 2.7%. Notwithstanding strong US earnings data, we see inflation risks, if anything as balanced or even skewed to the downside.
Global macro indicators suggest advanced economy expansions can mature further. If the stock price slump risks putting a major dent in growth there is scope for Fed action to support the economy by slowing down the pace of policy tightening. Our assessment of pockets of credit risk suggests contagious vulnerabilities are nothing like as severe as in the mid-2000s.
What could happen in an (albeit unlikely) negative scenario is this: consumption-wealth effects. Our recent analysis suggests a 10% change in stock prices alters the level of GDP in the G7 countries by around 0.3% on average after two years. Investment and productivity recovery would be choked off. The low levels of uncertainty that have been boosting the global economy would disappear. The dollar could be driven higher by safe-haven flows, limiting growth in world trade. And in the worst-case scenario, balance sheet weaknesses could be exposed, for example, the weak debt and fiscal positions in governments including Italy and some emerging markets.
We have previously run a model-based global scenario in which financial market turmoil leads to world GDP declining by 0.4% in the first year after a shock and 0.7% in the subsequent year. In that scenario US equities declined 18%, and UST yields declined 1.1% from the peak.
Gabriel Sterne is head of global macro research