Financial markets are beginning to regain a degree of composure after a torrid January. However, such has been the volatility over the past month that it is too early to signal the all-clear.
Although oil prices have recovered a portion of their January declines, and equities and bond markets are a bit more stable, significant questions still remain about the outlook, even as some of January’s concerns appear to have abated.
The recent improvement can be put down to three main factors, namely China, central banks and oil. However, in each case there have only been partial improvements, suggesting that downside risks have not gone away. The first is that the early-year concerns about China appear to have been exaggerated. Although economic data showed that the Chinese economy remained sluggish at the end of last year, it was by no means collapsing.
Growth slowed to 6.8 per cent year-on-year in the fourth quarter, and this was a far cry from the contraction implied by some of the other data.
Furthermore, the Chinese authorities appear to have learnt a little from their mishandling of the markets earlier this month, improving some of their communication.
However, there is still a long way to go. Chinese purchasing managers’ data in the coming week will be a crucial test of confidence, given that it was the catalyst that appeared to set off a chain reaction of yuan depreciation and equity and commodity market falls at the start of the month. The Chinese authorities still have much to do to convince the markets that they are in control of the situation domestically, and are not going to act rashly when it comes to letting their currency slide.
Secondly, and more broadly, central bank policymakers appear to have got a better grip of the situation in a way that they did not appear to have at the start of the month. The European Central Bank and the Bank of Japan have stepped up to promise more stimulus measures in the ECB’s case, and to actually deliver further easing in the BoJ’s. This was necessary because both central banks at the end of last year had disappointed markets by suggesting that they might have already done enough.
In contrast to his message last month, downplaying the prospect of more QE (quantitative easing), the ECB president Mario Draghi said this month that the bank has “plenty of instruments” as well as “the determination, and the willingness and the capacity of the governing council to act and deploy these instruments”.
This was probably a turning point during the month, the first indication that policymakers were responsive to market pressure. Now, with the BoJ announcing negative interest rates, there is a chance that the markets might be able to progress a bit further. However, there remain significant risks. The first of these is if the ECB does not live up to its promise to ease further at the March council meeting. The stakes have been raised and any disappointment would be met by a very negative reaction.
There is also a risk that the markets equate the reactions of the ECB and the BoJ with the likelihood that the US Federal Reserve might also hold back from tightening policy at its next meeting in March. This could prove to be a mistake, as even though the Fed revived its concerns about global developments at this month’s meeting, its message certainly did not preclude a further tightening in March. Markets will have to learn to differentiate between countries where further policy easing is justified, such as in Europe, Japan and China, and other countries such as the US, where monetary policy tightening is probably overdue.
The third ingredient in the recent recovery is probably the most important one – the oil price. This has risen on the suggestion that Russia might be prepared to talk with Opec about output cuts.
However, with the steep January falls in the oil price being mostly sentiment-driven, rather than based on any new information about fundamentals, the lack of substantiation of these latest rumours leaves the upside rally equally unconvincing.
The fundamentals of the oil market are likely to justify an upturn in prices at some point this year, but assuming that the latest headlines will be the basis for this could still be premature.
As with the progress from China, and from central banks, the latest oil price improvement is encouraging but does not guarantee that the volatility is completely behind us.
Tim Fox is the chief economist and head of research at Emirates NBD.
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