Fear and the market volatility that goes with it are back, big time.
The Dow this week mimicked a roller coaster, with rises and falls of close to 300 points for three days on the trot. Oil went into near free fall and has officially embraced bear market status. Currencies everywhere are plunging against the U.S. dollar and their volatility is back to 2011's levels.
The VIX – the Chicago Board Options Exchange's volatility index, also known as the fear index – has jumped to its highest level since February, putting it 70-per-cent above its lowest reading in July.
How to explain this eruption of uncertainty in the markets? There is no doubt the global markets DJ has changed the mood music, mid-dance.
What was the motivation? Any 10 market strategists will have 20 different reasons, none of them provable, some credible, as many not. My view from the dreamscape of Rome, where papal pronouncements carry more weight than the babblings of economists, is that the nice long rally driven by little more than massive injections of liquidity from central banks has finally been handed a reality check. Investors are, apparently, finally taking the view that economic growth and earnings growth are too good to be true.
Generally speaking, what is too good to be true gets shut down at some point. We may be at that point. Or we may be one big shock away from that point. The rapidly rising dollar, rapidly falling oil and outperformance of one economy – the United States – all tell us that something has gone wrong.
Since 2011 or so, the markets have been both remarkably unvolatile and remarkably optimistic. A chart measuring the volatility of about 25 asset classes, from the Aussie dollar to wheat, from 1995 until last year, is revealing. Until 2011, the price swings of many of the assets – the difference between the six-month highs and lows – was routinely 20 to 30 per cent, and sometimes more than 40 per cent. Collective volatility dropped off a cliff in 2011, trending at 10 per cent or less (that was bad news for the hedge funds, which draw their oxygen from high volatility).
Why did this happen? The implementation of QE2 –the second phase of the U.S. Federal Reserve's quantitative easing – probably played a big role. It was followed by QE3, which is being phased out. The massive buying of Treasuries and mortgage-backed securities, combined with a federal funds rate of close to zero, seemed to convince the markets that volatility would not be tolerated, and it duly vanished.
Complacency set in as central bank liquidity seeped into every corner of the market – the Bank of England and the European Central Bank (ECB) were manning the pumps, too. The complacency was a powerful force and overcame a series of events that should have been shocks but never achieved that status. The civil war in oil-rich Libya, the Ukraine crisis, the brutal victories of the Islamic State group in northern Iraq, the slowing Chinese growth rates and, lately, the pro-democracy protests in Hong Kong, had surprisingly little effect on the markets. Investors kept the party going, as if drunk on cheap money and denial.
Then, rudely, Germany and the International Monetary Fund crashed the party and told everyone to go home.
Ever since the financial crisis, Germany was billed as the euro zone's great saviour and it duly complied. As the other big economies – France, Italy and Spain – hit the wall, Germany got back on its feet and exported like mad. The weaker euro helped. The German data were almost always encouraging and, lately, Germany reported strong consumer demand, record-high employment and, finally, an uptick in wages. The odd instance of disturbing economic news, like the selloff in the high-yield market, was dismissed as a blip; even Germany's 0.2-per-cent contraction it the second quarter failed to set off alarm bells.
Everything changed this month when August's export and manufacturing figures were released, both of which went into the tank. The figures point to a new German recession, and if Germany contracts, all bets are off for the long-touted and oft-delayed euro zone recovery, especially with Italy in recession and France close to one. The Ebola scare hasn't helped.
The IMF delivered a reality check, too. On Tuesday, the IMF essentially admitted that its growth forecasts were a tad upbeat. It now puts the chances of the euro zone sliding into its third recession since 2008 at 40 per cent and cut its 2014 global growth forecast to 3.3 per cent, a downgrade of 0.4 percentage points since the April outlook. In a sea of laggards, only growth in the United States' economy will remain robust.
The selloff in the equity and oil markets since Germany and the IMF worked their dark magic has been stunning. Brent Crude, the international benchmark, is down 20 per cent from a year earlier, with all of the decline coming since July. Oil prices are a superb indicator of economic performance and they say that, at a minimum, Europe is heading back into the toilet. And the kicker is that the ECB won't be able to save Europe this time. It is running out of ammunition, meaning the risks of a prolonged downturn are not to be discounted. Expect more market volatility to come, and maybe a European recession. It was fun while it lasted.
Eric Reguly