How 2014’s upbeat story turned into a scary thriller

Last updated: February 6, 2014 5:57 pm

How 2014’s upbeat story turned into a scary thriller

By Ralph Atkins

It is China that markets are now watching closest, writes Ralph Atkins

The story seemed so simple at the start of the year. Shares were rallying on optimism about a world economic recovery; US and German bond yields were widely expected to edge higher as the Federal Reserve tapered its asset purchases, or quantitative easing. Investors positioned accordingly.

But then the narrative took unexpected and disconcerting twists. Five weeks into 2014 and markets are reeling from renewed turmoil, especially in emerging economies. The FTSE All-World index is down almost 5 per cent; Japan’s Nikkei 225 index has dropped 13 per cent. Rather than rising, yields on 10-year US Treasuries have dropped almost half a percentage point – a big move in a usually stable market.

So what went wrong? Investors have been offered many different explanations (which has probably added to their nervousness) with central banks’ historically unprecedented monetary policy experiments significantly confusing the plot. Market volatility points to surging investor uncertainty over whether this is just a correction – or the early phases of the next financial crisis.

As a service to Financial Times readers, here is a brief guide to market thinking as to why things went awry but the end of the world is not necessarily nigh.

Reverse thrust

Initially we saw “idiosyncratic” emerging market woes exacerbated by the Fed’s tapering plans. A decision by Argentina’s central bank to stop supporting the peso led to the currency falling precipitously, creating shockwaves in other developing economies, especially those most dependent on foreign capital, which the Fed’s actions threatened to constrict. The problems were idiosyncratic because they were not on the scale of the 1997 Asian crisis and concentrated within a few countries with obvious weaknesses.

But the negative impact on investor sentiment spread. The story was of broader “reverse portfolio rebalancing effects” (in central bank-speak) triggered by the Fed’s recent actions.

During the crisis years, quantitative easing deliberately drove investors into riskier assets or sectors, such as equities and emerging markets. Logically, the Fed’s decision to gradually taper its asset purchases, announced in December, would send that process into reverse.

That appears to have happened. As investors searched for havens, yields, which move inversely with prices, fell on US Treasuries and German Bunds. The story became one of a generalised “risk-off” market, of the sort that characterised the down phases of the global financial crisis.

But if “reverse portfolio rebalancing” or “risk off” were the story, why was there no significant sell-off in the bond markets of crisis-hit countries on the eurozone’s periphery? Spanish and Italian bonds were among the biggest beneficiaries of investors’ “hunt for yield”. So far this year the rally has continued largely uninterrupted.

Too much consensus

One explanation is that eurozone prospects had improved such that even its periphery economies’ debt markets were relative havens. An alternative is that after last year’s powerful rallies, US and European equity markets were anyway vulnerable to a long overdue correction.

Market strategists I have spoken to this week rue their failure, with hindsight, to spot the dangerous degree of consensus at the start of the year about how 2014 would unfold. When investors are acting as a herd, the smartest investors take profits; the rest scramble to follow.

The emerging market turmoil may have provided the trigger for the correction in equities – or it may have been weak US economic data, which cast doubt on the strength of the country’s recovery and the timing of Fed tapering.

Here was another subplot: indicators of US economic activity were distorted by bad weather – always a handy explanation when things go wrong – in January when much of the country was gripped by an icy polar vortex.

All the while, lurking ominously in the background, were worries about Chinese economic growth stalling. This year’s jitters were exacerbated by weak purchasing managers’ indices for the world’s second-largest economy.

More alarming was a near-default last month at a Chinese trust fund company, which was averted at the last minute but left big questions about how China is going to control its massive shadow banking system.

It is China that markets are now watching closest. Most of the other storylines refer to temporary phenomena that could fade – although the impact of Fed tapering in months to come remains unclear. But Chinese authorities’ ability to steady the country’s economy could prove crucial to preventing a far worse global sell-off and ensuring the tale of financial markets in 2014 does not have an unhappy ending.