Why panic in financial markets is overdone

Eric Chaney, Head of Research at AXA Investment Managers (AXA IM), outlines why panic in the financial markets seems overdone

August 2015

The opening of the US stock market on Monday 24th August saw another deep dive on the heels of European and Asian markets, with the S&P 500 (US stock market index) down 3% in mid-session. Since China is at the core of the news flow, be it for good or bad news, the global equity correction must have something to do with China. It seems that many market participants were counting on a decisive action by the Chinese central bank (PBoC) and are panicking at the idea that there might be no pilot in the Chinese plane. True, Chinese policymakers have not been helpful in their management of their own stock market crash, as well as on the macro policy reactions to hints of slower domestic demand.

However, China has the means to support its own domestic demand by combining fiscal and monetary stimulus, even if this requires twisting the arms of some local authorities and senior bankers. One of the paradoxes of the crackdown on corruption, cherished by the new leadership, is that it may have frozen infrastructure spending initiatives by local governments. Yet, the bigger picture is that Chinese leaders may disagree on many economic and financial issues but all agree on the idea that they need robust domestic demand and consumption trends, in order to pursue their higher political goals, starting with political stability. So, yes, there is a pilot in the plane, whom we are likely to hear of soon – that is what our Hong-Kong based economist Aidan Yao believes.

A much weaker US dollar may soothe the Fed’s concerns about low inflation

A weird feature of current market gyrations is the free fall of the US dollar against major currencies such as the euro. Were markets concerned by a potential global systemic risk, such as a Chinese hard landing reverberating like a major earthquake in the global economy, the US dollar would rise, as the traditional safe haven. Actually, the opposite is happening, probably because investors are no longer convinced that the Federal Reserve (Fed) will start increasing interest rates this year. The next question is: if a stronger dollar is a roadblock to a rate hike, what should be the impact of a weaker dollar? It is hard to see why the Fed’s reaction function should be asymmetric. A weaker dollar implies higher inflation, other things being equal, and stronger growth thanks to more competitive supply on the domestic and overseas markets. Therefore, the weaker the dollar, the higher expected earnings and, in the end, the higher the likelihood of a rate hike this year.

Short term, PBoC matters more than the Fed

In summary, the current wind of panic in the markets, possibly amplified by thin summer volumes, seems very much overdone. Unless unexpected political events happen and transform the slow growth and deflation scare (which has some rationale) into a systemic risk, the correction should prove short-lived and fundamentals, such as growth prospects which are not brilliant but very far from recessionary conditions, should prevail. The trigger for a more positive market view might well be the next decision of the PBoC, which we expect should be a cut in the reserve requirement ratio for banks and the official policy rates as well.