Return of risk is root cause of market shock

At first glance, the present sell-off in equity markets may be attributed to three factors - weak oil, which indicates soft global demand and hence is a harbinger of poor growth; the worry of deflationary forces being unleashed, especially in Europe, that could then lead to "Japan style" lost decades of growth; and a drastic slowdown or possibly hard landing in China that would feed into already slowing growth and spawn a global recession.

These are all valid concerns but they are not new.

The slide in oil for example, extends back almost 18 months when the price for Brent crude fell from US$110 (S$158) per barrel in June 2014 to US$60 six months later, while deflation in Europe and China's potential hard landing have been worries for at least two years now.

A fourth concern, higher interest rates, has also been heavily discussed ever since mid-2014 when the US Federal Reserve started tapering its quantitative easing (QE) monetary stimulus programme.

The seeds for the present collapse in equities were therefore not sown in the oil market or in China, even if that's how it appears now. Instead, it has its roots in misplaced faith in the "wealth effect''. In simple terms, this posits that elevated and ever-rising asset prices would produce benefits for consumer sentiment, retail spending, corporate capital expenditure and hiring. This in turn would boost the economy - or so the thinking goes.

This faith was given legitimacy by former US Federal Reserve chairman Ben Bernanke when the US central bank undertook several rounds of money pumping that included three rounds of QE, to bail out Wall Street from 2008 to 2014.

In an opinion column for The Washington Post on Nov 5, 2010, Mr Bernanke defended the Fed's actions: "Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion".

Mr Bernanke's successor, Janet Yellen, also believes that higher stock prices would be good for the economy. In the Jan 20, 2014 issue of Time magazine, she said: "And part of the [economic stimulus] comes through higher house and stock prices, which causes people with homes and stocks to spend more, which causes jobs to be created throughout the economy and income to go up throughout the economy".

While it is true that a robust stock market is a sign of a strong economy, it is important to be clear on cause-and-effect: it is the economy which causes the market to rise or fall and not the other way around. However, because it is much easier and faster to pump-prime the market than it is to engineer proper, lasting economic change, the market-before-economy approach was vigorously pursued by the Fed and in due course was copied by other central banks.

Thanks to frequent guarantees of central bank intervention if trouble loomed, the VIX index, which measures expected volatility and thus risk, sank to all-time lows for much of the period 2008-2015.

Meanwhile, stocks on Wall Street - even as the US economy narrowly escaped a second Great Depression in 2008 and struggled hence to regain its footing - more than doubled, setting hundreds of all-time high records in 2013 and 2014.

However, placing the cart before the horse and persistently juicing the cart in order to drag the horse forward is flawed because of the distortions it introduces. First, the positive effects tended to be short-lived; Second, resources were not being allocated optimally; and Third, risk was effectively taken off the table because of the explicit guarantee of support from officialdom.

What markets are presently experiencing is an abrupt re-pricing of market risk brought on by a realisation that artificially-fuelled carts really cannot be relied upon to push horses for long.

Over in China for example, several rounds of interest-rate cuts and liquidity injections appear to have failed, and there is now real worry that monetary policy, having been used exhaustively to prop up asset prices for several years, has lost its effectiveness.

Adding to the loss of confidence is China's amateurish handling of stock market circuit breakers - dismantled four days after their introduction - and other ineffective measures to stem the bleeding.

In the US, there is fear that the Fed may have been prematurely sanguine on China when it raised interest rates in December. A policy reversal back to more QE cannot be ruled out if the economy starts to show signs of backsliding. That however would be sending a distress signal to already nervous markets.

Even so, it is now doubtful that monetary policy tools - conventional or otherwise - would have much effect.

In the meantime, investors, having not had to contend with risk as a major consideration for several years, are now having to grapple with its painful and sudden return. The present panic is but inevitable.

This article was first published on January 15, 2016.
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