Reading the tea leaves amid market turmoil

Further escalation in the US-China trade war sent global stock and bond markets into a tailspin. Photo / AP

Volatility in financial markets returned in full force this week.

Further escalation in the US-China trade war sent global stock and bond markets into a tailspin as lingering hopes of a permanent truce evaporated. Uncertainty is a given as the outlook for both trade and investment has deteriorated. Global economic growth is also set to slow.

Worse still, the best-case scenario for the world economy is now simply the status quo.

Turbulence in financial markets ricocheted from Toronto to Tokyo, via London and New York. Government bond yields collapsed early in the week — touching new lows across Europe — equity markets came under pressure with the S&P 500 recording its sharpest one-day fall of the year on Monday, and oil sank to levels not seen since January. Safe haven currencies strengthened.

While markets staged a partial correction by the end of the week, particularly equities, any reversion back to earlier norms is unlikely. China's decision to let its currency weaken past Rmb7 to the dollar — and the subsequent, incoherent, decision by the US Treasury to designate China a currency manipulator — leaves a new and more volatile backdrop for global markets.

The August upheaval tells us that all is not well in the global economy. But it does not signal that the world economy is careering towards recession. First, all major central banks barring the US Federal Reserve already have monetary policy stimulus at extreme levels. New record lows for Bund yields should not be too much of a surprise in this context. The German (and Italian) economy is sputtering and the European Central Bank has clearly signalled further easing will come. With no guidance from the ECB on a precise floor for rates — nor any historical norms to guide the market — these new lows may be tested again.

Distortions also exist within US monetary policy. Although the Fed gradually raised interest rates until late 2018, the absolute level does not leave enough room to offset any full blown recession. This has become particularly evident now that July's "mid-cycle adjustment" looks certain to mark the start of a series of interest rate cuts.

The heightened inversion of the US yield curve — with the gap between short and long-term bond yields reaching a level not seen in a decade — signals a deteriorating longer term outlook. But it is not anywhere close to the inversion seen in the mid 1970s or early 1980s. Nor is the rising risk of recession in the US a guarantee of a broad-based global slump. Add to that, the unpredictable nature of US economic policy under President Trump leaves a more fragmented set of expectations on monetary policy.

Quantitative easing, a necessary tool to avert depression 10 years ago, may also have damped the signalling power of long-term rates.

This unpredictability combined with the new policy extremes explains some of the disconnect between bond and equity markets. The S&P 500 is just a few per cent below the July all-time high signalling expectations for corporate earnings remain strong. Equity markets therefore expect monetary stimulus will be effective. Bond markets worry about a lack of ammunition.

Layered on top are geopolitical tensions and political discourse in the UK and elsewhere that stand in the way of coherent economic policies. Rising protectionism means past US-led co-ordinated policy action to restore global economic order will not be repeated.

Central banks will have no option but to come to the rescue. One quarter of the world's entire bond stock is already in negative territory. More will follow. In the absence of a sturdy anchor, a very bumpy ride lies ahead.

Written by: The editorial board

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