11 December 2018
Could investors have nothing to fear but fear itself?Photo:
Could investors have nothing to fear but fear itself?Photo:

World markets in crisis? It’s all in your head

Since the beginning of the year, sharp volatility and declines in the global markets have made investors confused.

Are we heading into a global crisis?

What has gone wrong?

Is the market telling us something really bad that we do not know?

The strange thing is that there seem to be no dominant factors that can explain the panicky behavior so far.

Consider the following.

In the first few days of January, China seemed to be devaluing the renminbi.

Global investors panicked, and the markets went into meltdown.

A few days later, China did not devalue, but instead the oil price seemed to be headed below US$10 per barrel.

The markets panicked and plunged.

A few days later, the oil price stabilized at below US$30, but the US economy seemed to be sliding into recession, and the global central banks seemed to be running of ammunition.

The markets went into a tailspin.

A few days later, central banks proved that they still had ammunition to save the day, but European banks seemed to be collapsing.

The markets tanked.

A few days later, banks in Europe stopped collapsing, but the US Federal Reserve seemed on the edge of a policy reversal.

The markets went into meltdown.

Then the Fed said it was not about to change its policy course …

The point is that whatever happens, or does not happen, investors panic.

Such a default panic reaction may reflect the worry that something might be seriously wrong with the world economy.

Thus, global financial markets plunge, reflecting a collapse in confidence.

The trouble with this is that the problems that investors seem to be envisaging are not at all that fatal, and that they do not seem to have a good grasp of what is going wrong.

Hence, the story about what is driving equity prices lower keeps shifting.

For example, until recently, the biggest systemic risk to the world economy was perceived to be a strengthening US dollar.

But when the US dollar started weakening after the Fed’s interest rate hike in December, the weakness of the dollar was suddenly seen as the new systemic risk.

This fickle sentiment may suggest that the market panic might not be a sign of it knowing something terribly wrong about the global economy that the public does not.

Maybe it is just that when investors see stock prices falling, they lead themselves to believe that something must be terribly wrong with the world, even though no one can quite identify the precise problem.

There are times when the beliefs of financial markets, be they true or false, could turn into a self-fulfilling prophecy, which is a big factor in market boom-bust cycles.

However, there is an asymmetric behavior in this self-fulfilling prophecy.

When markets go up for no good reason, as with the US tech stock bubble in the late 1990s or the A-share bubble last year, people attribute it to irrational behavior driven by herd instinct.

But when markets collapse for no good reason, everyone assumes that the markets must be aware of some hidden trouble, even though no one can figure out what is exactly wrong.

Suppose the truth is that China will not devalue the renminbi; low oil prices will not kill the global economy; the US will not slide into recession but just remain stuck in slow growth; the global banks will not collapse under negative interest rates … and so on.

Even then, investors relying on their false beliefs could still force equity prices sharply lower, as the financial panic could become self-fulfilling.

The point is that expectations can create their own reality, and this outcome is always the risk in today’s integrated global markets.

And this seems to be the situation that we have been facing since the beginning of the year.

The world markets in crisis? It’s all in your head.

Does this mean that a grumpy bear market, not just in China but also globally, is coming to town?

Maybe not. This is because extreme cases of self-justifying expectations are the exception rather than the rule in financial history.

When stock prices fall far enough, value-oriented investors will come into the markets to buy and, eventually, overwhelm momentum traders who are motivated by the self-fulfilling prophecy of panic selling.

The situations of self-justifying expectations beating value investing are usually ones when economic or political conditions are unstable, when liquidity is drying up, when stock valuations are soaring to extreme levels and when governments are making serious policy mistakes.

The most recent example is the US subprime crisis and the ensuing market crash in 2007-08.

The global environment today is indeed confusing. But it is far from dire.

Global monetary policy remains loose, ensuring ample liquidity.

Governments do not seem to be making serious policy mistakes.

Stock valuations are not stretched to extreme levels.

When the dust settles, there may still be light at the end of the tunnel.

Opinions here are of the author’sand do not necessarily reflect his employer’s.

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Senior economist of BNP Paribas Investment Partners (Asia) Ltd. and author of “China’s Impossible Trinity – The Structural Challenges to the Chinese Dream”

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