Moritz Kraemer

Macroscope | Through Brexit and signs of China’s slowdown, investors have kept their cool – but it can’t last

Political uncertainty usually means market volatility yet, since 2016, this hasn’t been the case. But whether it’s disorder in Europe or a slowdown in China, turbulence is coming and investors should be cautious or risk getting burned

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Traders work ahead of the closing bell on the floor of the New York Stock Exchange on March 18, on a day when stocks finished higher thanks to gains from petroleum companies and banks. Photo: AFP

Moritz Kraemer

Published: 3:00pm, 20 Mar 2019Updated: 10:31pm, 20 Mar 2019

During the introductory statement for his last press conference in January, European Central Bank President Mario Draghi’s most picked-up sound bite was that “the risks surrounding the euro-area growth outlook have moved to the downside on account of the persistence of uncertainties”. Indeed, what he stated about the euro zone can be repeated for the world at large.

The International Monetary Fund sang from the same hymn sheet when updating its World Economic Outlook in January, citing “high uncertainty” as a key concern for its outlook. When looking for possible policy-induced risks, there is an unusually rich canvass: the risk of a sustained trade war, a populist surge in some large euro-zone countries, the risk of a hard Brexit, and the fear of possibly successive US government shutdowns. Maybe even a cliffhanger on the US debt ceiling.

Add to that the slowdown of global trade growth and a slowing and highly leveraged China economy, in recent years the principal contributor to world growth (at around one-third of the total), almost twice the US’ contribution and over four times that of the euro zone’s.

In normal times, any one of the aforementioned risks would have given investors the jitters. But not this time. Historically, we have observed a fairly tight relationship between the global Economic Policy Uncertainty Index and Vix, a common measure of market volatility. That is what you would logically expect: more uncertain economic policy leads to more uncertainty in the markets.

But this correlation has broken down and was turned on its head in early 2016. Since then, higher policy uncertainty has actually led to lower market volatility. Other things being equal, this makes no sense. Maybe other things are not equal, however. Could it be that the ultra-loose monetary policy comforted investors to such a degree that they were willing to overlook the policy fog? Unlikely.

The ECB had begun its quantitative easing operations a year before the relationship broke down and the Fed had just launched its interest rate tightening cycle in December 2015. Even last year’s fourth-quarter sell-off and the ensuing volatility has not closed the gap with policy risks. The latter rose even faster. The gap remains large.