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| David Simmonds, Head of Currency and Emerging Markets at RBS |
Although the causes of a renewed bout of volatility are difficult to predict, there are enough potential triggers, from China’s efforts to rebalance its economy to the West’s need to get a grip on its debt, to suggest markets and companies should not be lulled into a false sense of security. The current stability has largely been created by policymakers, led by the US Federal Reserve. Their determination to apply highly energetic liquidity ‘therapy’ to the financial crisis is a persistent, recurring cause for optimism among those who believe policymakers have learned from past crises, notably the Great Depression of the 1930s.
For risk-bearing markets the high and regular liquidity injections favoured by modern central banks are the very oxygen of growth.
But history has shown that years of relative calm are shaken by periods of violent volatility when the global economy is forced to change. Periods of low volatility have happened before and they can last for some time. They always end, however.
It was only a few years ago that there was widespread hubris around what can be termed the great moderation. This was the idea that policymakers had learned so much that they knew how to smooth business and economic cycles. This was the long, stable period following the bursting of the dotcom bubble, from about 2001 to 2007.
This so-called Goldilocks economy, one that was neither too hot nor too cold, ended up being devoured by the bears when the financial crisis hit in 2008.
When, why and how the current period of low volatility will come to an end is difficult to pinpoint. But there are some likely breeding grounds.
One involves economies whose levels of total debt – and not just government debt – look high relative to their likely rates of growth. In many parts of the world, including large parts of the eurozone, the job of deleveraging is still in its infancy.
Another possible catalyst is that a wedge is driven between what monetary policymakers want to do and what they’re actually able to do. They would have less flexibility to act.
For example, injecting further liquidity has diminishing returns in terms of boosting growth. It could also have highly damaging costs. The world’s erstwhile deepest and most liquid asset markets, such as the US Treasury market, are now much less deep and much less liquid because of the effects of quantitative easing.
Because much of the extra liquidity from the Federal Reserve, for example, has been used by US Treasuries, it is hard to envisage that any eventual exit route is smooth when the market ‘free float’ is now so much smaller. Weaning addicted markets off the cheap or free liquidity habit will be hard.
Alternatively, renewed volatility might be more closely linked to China as it seeks to rebalance its economy away from savings and exports, concentrating instead on stimulating domestic consumption and forging further trade links to Asia. That could result in the end of the multi-year commodity supercycle, fuelled by strong Chinese demand for manufacturing and infrastructure development.
Another area of risk is the huge level of foreign currency reserves built up by countries in Asia and other emerging markets. Much of the money is reinvested back into the US and eurozone, suppressing yields and therefore volatility. Any geopolitical event that could spark a sudden sale of US or eurozone debt will spark renewed volatility.
There is no way of telling what might spark a new period of volatility or when it might happen, but it will come.
Companies need to be aware of this. When it comes to managing FX needs, it is important to consider taking advantage of the higher liquidity available in times of lower volatility. Acting reactively is to risk trying to tap the markets at the time when liquidity is evaporating because everyone else is trying to do the same thing. And of course, this is usually the time when liquidity is most needed.
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