This recent article from the Upshot over at the NY Times attempts to explain why stock markets across the world have been experiencing so much volatility. Surely some of you have noticed and have even heard reports about how the “fear index” is unusually high right now, how the “VIX has jumped”, how “China is slowing”, how “Commodities are plummeting”, how the “Fed might hold on raising rates”, and so on. Basically, if you pay attention to financial news, it’s clear that something’s amiss and volatility is back. Well, to understand the why, we should first review the what.
Volatility is another way of saying “shit’s gone crazy”, or, slightly more formally, “the markets are all over the place” and it’s unclear what’s happening and how it will end. There’s a lot more uncertainty. One day the DOW is rocketing down and another it’s up, only to be followed by yet another drop. Or, within one trading session, the markets yo-yo themselves into the closing bell. Repeated down days also increase volatility as everyone starts thinking about their own exit or wondering what to do next. Again, uncertainty.
As the article points out, the why is multi-faceted. Just as in the years leading up to the crash of 2008, we’ve recently had many years more of easy money in the form of easy-to-be-had credit. Yes, we had a credit crisis, the credit bubble burst, and we found our legs again with…more credit. While high credit availability and low interest rates help certain industries like real estate, such rates offer nothing a saver or professional investor would call a good return. Besides, the government still prefers that you savers spend your credit…pardon me…money, not save what cash you have, so that the country’s economy can really get moving again. From an investment standpoint, low rates drive many to look elsewhere for higher returns on their capital. This is known as the search for yield. Lots of investment money has been plopped into emerging markets, where equities and bonds offer higher rates of return. And at least some of that money has been borrowed at low rates like those in the United States and Japan, in dollars and yen.
China is one place where a good deal of money has been flowing to, but as stock investing by foreigners is still restricted in China, most of the China stock market craze and recent crashing has been fueled by Chinese nationals. Don’t get me wrong, there was enough investment in some form or fashion by London elite for instance that earlier this year a delegation of Chinese fund houses flew to London to soothe and placate the UK investors there and inform them that “now is the golden period for investing in China’s stock markets”. Hence, the involvement of outsiders clearly cannot be seen as negligible. Continuing, the stock market returns in China were the gift that kept on giving, causing many US-listed Chinese companies to consider going private so that they could relist in China, and causing many retail investors to plunk not only the money that they had but the money that they didn’t have into equities there; many have gone on margin, or borrowed investment money, through brokerages on the Chinese mainland, or they have taken out loans from internet financiers, or they have gone over to Hong Kong and the brokerage houses there where they can borrow even more at lower rates and where fees are lower, or all three, and have gone the proverbial all-in. And wouldn’t you know it, it isn’t just these investors borrowing money – they’re actually borrowing borrowed money from these brokerage houses and internet financiers, which means that the debt dragon goes at least two levels deep and the number of parties involved is at least three levels deep. Such lending and other transactions are part of the ever-growing shadow banking complex, which sees very little regulatory scrutiny.
Now the Chinese markets seem to be turning from dream to nightmare, and one misstep by one party in this fragile network starts a cascading effect that can lead to ruin and triggers desperate measures by the Chinese communist planners to catch falling knives. What has been most fascinating about the Chinese story is how many “experts” are saying China is in trouble versus how many “experts” have said that China’s doing just fine, it’s still growing at a healthy clip, and the government has everything it needs and then some to deal with whatever trials and tribulations come along. Alas, China is not doing fine. Following a credit glut throughout the economy and various brick-and-mortar industries and falling property values, they are now facing a margin glut in the stock markets, among their population, and in the investment industry. It has hit them and they are doing all that they can, from bailouts to radical market support to the cutting of interest rates to the flooding of the interbank money markets with fresh liquidity to the cutting of reserve requirements for banks. And they are doing all of this very quickly, one after another.
In other words, the Chinese are attempting to resolve an internal credit crisis with easier access to money and credit. For the outside “experts” that don’t seem to be concerned, the Chinese planners seem very much concerned themselves and it is cause for consternation that what they have already done is not working, not stemming the stampede, not stopping the bleeding. China has more than enough to maintain its sovereign debt and currency, or so it would appear now, but we’re talking about severe confidence and internal credit crises here the depths of which are hard for us to comprehend, especially given that we don’t have access to all the info. Not to mention that China is not the global exporter it once was, and it knows it. The country has to transition to more of a liberalized market model, and at the same time, maintain economic growth. If growth slows, it has a large population on its hands with a multitude of problems to face. Moreover, countries and corporations outside of the country, having pinned their hopes on selling into Chinese markets, will obviously also hurt if China slows down.
The NYT piece further mentions oil as a cause and effect of all the volatility. Low energy prices are great for drivers and manufacturers and transporters and any business that relies on oil as an input, but they’re terrible for the countries that have commodity-based economies. Low energy and commodity prices also are a signal that the global economy is slowing, meaning unemployment could start getting worse again. OPECs current supply stance has hurt the oil and gas industry in the US, Canada, Mexico, Russia, Venezuela, and numerous other countries, plus it has hurt recycling efforts, plus it has hurt the alternative energy industry, among other things. But, when the global economy seems to be slowing at the same time as all these countries continue to pump out the oil, because really, what else can they do, then oil prices fall even more and industries and entire countries feel the burn even more.
Now enter the Federal Reserve and the possibility that they will raise interest rates. The dollar is already ridiculously strong due to flight to safety investments and other countries devaluing their currencies and cutting their interest rates. For one, a strong dollar makes it harder still for American exporters to do business. Raising interest rates will make the dollar even stronger, but it will also put downward pressure on growth in some industries and cause the investment community to wind down their leveraged bets in other parts of the world. Indeed, this is already happening as nobody wants to be holding the bag when the Fed finally does raise rates or when it becomes clear China can’t pull the same weight it used to. It doesn’t matter if the increase is small, it will be enough to change the game. Plus, an increase in rates will make it harder for those countries that have debt denominated in $USD to pay those debts. Emerging markets will be under even more strain and growth will slow even more within their borders. Disappearing investment money, low commodity prices, and more expensive debt is not a good combination for them to face (the potential flipside, of course, is that these countries may invite more offshoring from businesses in countries like the US with stronger currencies, but that depends on a variety of other factors).
We have a global margin and credit glut (the main point the NYT article is missing), numerous sovereign debt crises, a slowing global economy. After 2008 people are still pretty jumpy and nervous, but not just because of that crisis; many are so because they know they are way out on a limb. Again, nobody wants to be the last out of the exit of a burning movie theater. Add to this algorithmic trading and the fact that the global banks and insurance companies are still running derivatives operations on everything under the sun and “insuring” strategic trading positions and the like, and the first hint that people smell smoke and are heading for the door causes dramatic movements in the markets these days. As everyone is more connected to each other than ever before, well, it only magnifies the domino effect, and that domino effect is truly global. Hence, some are sitting on cash right now, waiting to see what happens. Others already see buying opportunities. And yet others are selling and expecting things to get much worse. There is no consensus, making the news look like a patchwork quilt. One article reads one way, another takes a completely different position. This is volatility – complete uncertainty, uncertainty as to whether things are indeed getting better or getting worse, are better than we think or worse than we think, that we’re going to be okay or that we’re walking the edge of another canyon. The host of reactions that are occurring across the world is the manifestation of that uncertainty and feeds that uncertainty at the same time. People are confused or simply unsure as to what is going to unfold.
The big question for China is how and when to finally address their internal credit crisis and reign in that human instinct to get it while the gettin’s good. For the United States, being as they more or less alone, without even the support of the IMF, are looking to raise rates, the question is at what point do you knowingly trigger a further global unwinding in the name of properly managing the economy that you are solely responsible for?
In the end, how much more credit and debt can the world accumulate? Someone will have to – and is going to – take it on the chin, eventually.