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Get Ready for More Financial Market Turmoil

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Get Ready for More Financial Market Turmoil

Think the worst is over for the global markets? If you do, the chances are good that you will be sorely mistaken.

Financial markets are all about volatility. Never forget that there is an entire group of traders and trading firms who make their living off of simple arbitrage; when there's volatility on the markets, these arbitrageurs make a pretty penny due to their high trade volumes (i.e. large scale). Financial markets rely upon these traders for liquidity. Without them, there's no guarantee you could sell your shares close to full price whenever you chose. With this in mind, volatility is an ingrained feature of these markets.

Mohamed El-Erain/Photo by Norbert Schiller Mohamed El-Erain/Photo by Norbert Schiller

Mohamed El-Erain, one of the preeminent economists in the world, has suggested that the current market calm could be a temporary blip on the way to more painful losses. This is what volatility is truly all about—the roller coaster goes up and up only to fall down further than where it started.

Let's take a look at some of his main points in support of this view.

Corrections Never End

Source: pgm-blog.com Source: pgm-blog.com

The cycle of up-and-down in the stock markets is a constant feature of how financial markets operate. This has as much to do with economic conditions as it has to do with the nature of trading. Traders respond to momentum. The ways in which prices move therefore come down on one side of a trade or the other: up or down. Based on the positions that groups of traders are taking in the aggregate, the momentum for a particular stock or stock market will be positive or negative.

This means that all it takes is for investors to believe something for it to "come true" on the markets. Perception is everything! Financial markets are therefore based on belief more than anything else, and its participants behave mostly as players would in a game.

Part of that game is known as repricing, also called a "correction." If one sector has been losing lately, others will follow this trend. At a certain point, contrarians believe the trend has gone too far, and then the markets "correct" back in the other direction. As flimsy as this sounds, some traders and investors bet the entire farm on this dynamic.

Weakness Contagion

El-Erain points out that corporate earnings are being challenged by the worldwide slowdown in economic activity. Those markets overseas represent important customers and sellers alike, so everyone's interconnected.

No such thing as a quarantine when it comes to markets. No such thing as a quarantine when it comes to markets.

No matter what tools policymakers try to use to shield themselves from these problems, they can't avoid "contagion"—the spread of economic weakness in one area to another. When productivity slows in China, it influences markets in Japan, Europe, and the United States; in turn, this hurts other emerging markets. This simplistic example plays out in every way imaginable.

No matter what country it is, no single economy can completely protect itself from the problems in other parts of the world, especially in the age of the Internet and open global trade.

Central Banks

These first two issues are a direct hit for central banks. As these monetary authorities attempt to meet their mandates of stable currencies and consistently growing economic output, they also attempt to control volatility and make outcomes more predictable. This is a virtually impossible task, and El-Erain says that many investing models are going out the door as a result. Central banks struggle to keep everything calm despite the futility of the task.

piggy.bank.balance.scaleIn the process, they generally dig the hole deeper. By relying more and more on economic stimulus and extreme measures (like negative interest rate policy, NIRP), the central planners are really making things worse. Some analysts have suggested that NIRP should be directed against the big member banks rather than consumers. Such a policy aimed at the Goldman Sachs and JPMorgan types could spur more lending without placing the burden on individual savers. In theory, this could be a viable way to stop digging the financial hole deeper.

Even liberal economists like Paul Krugman have expressed similar resignation about how the worst is far from over for global markets, echoing El-Erain. The main takeaway: Prepare for more volatility!

 

The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.

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