Markets withstand tremors, but real test is yet to come

The turmoil in Chinese stock markets was among several recent shocks to the global financial system, yet there has been no widespread domino effect. Some analysts, however, are warning against complacency.
The turmoil in Chinese stock markets was among several recent shocks to the global financial system, yet there has been no widespread domino effect. Some analysts, however, are warning against complacency.PHOTO: REUTERS

Beware of domino effect when central banks reverse course on rates

LONDON • A trading shutdown across Chinese markets, a multi- hour disruption at the New York Stock Exchange (NYSE) and the financial quarantine of Greece sound like the plot of a disaster movie.

Yet their collision last week left only a flesh wound. For a post-crisis market structure that is frequently lambasted by investors as fragmented and vulnerable to a global liquidity shock, this is no mean feat.

More broadly, despite a pick-up in volatility in bond, currency and equity markets, major benchmark indexes have kept within a fairly narrow trading range. Is our imperfect system stronger than previously thought? After all, while these shocks were clearly painful on a local level - Greek household savings are stuck in limbo, Chinese stocks have lost 25 per cent of their value in three weeks and the NYSE faces more scrutiny - no "domino effect" occurred.

One answer is that a fragmented system can help local shocks stay local. Foreign ownership of Chinese equities is feeble, Greece is a tiny slice of European corporate exposure and US stocks trade on a plethora of electronic venues that can absorb the disruption of the world's most famous exchange.

"I hesitate to say fragmented markets are a universal good... but in these particular circumstances, the lack of linkages has certainly been an important contributor to relative stability," said Mr Bill McQuaker, co-head of multi-asset at Henderson Global Investors.

Another answer lies in shifting investor expectations of market shocks, five years after the US "flash crash" that briefly wiped out nearly US$1 trillion in market value and seven years after the sub-prime crisis pushed investment bank Lehman Brothers into bankruptcy and redrew the financial landscape.

The real test for post-crisis global markets has yet to come, in other words, and may only come when central banks reverse course and start to raise interest rates. The Bank for International Settlements said as much last month, comparing low rates to an elastic band being stretched to breaking point.

Markets may simply have become more tolerant of technical glitches and rapid-fire bouts of selling, some say, pointing to a system that is not necessarily more robust or more immune to shocks but that is able to trade around cracks when they appear. "It's not an environment of resiliency. It's an environment of fault tolerance," said Mr David Weiss, senior analyst at research firm Aite Group.

The elephant in the room when it comes to contagion risk, however, remains the influence of central banks. After all, one obvious reason why panic selling failed to hit last week was because central banks and regulators took action. China's securities regulator banned shareholders with large stakes from selling, while the European Central Bank reiterated its ability to fight any contagion risk from Greece.

While there was less need for the US Federal Reserve to intervene in the case of the NYSE disruption, years of easy money may have locked investors into complacency.

Nomura's Mr Bob Janjuah warned that markets were "way too optimistic" about global growth and were underestimating contagion risks. "All global central banks are guilty of market manipulation, either explicitly or implicitly," Deutsche Bank managing director Nick Lawson said on Friday. "China just provides a little more clarity about the consequences of certain actions."

The real test for post-crisis global markets has yet to come, in other words, and may only come when central banks reverse course and start to raise interest rates. The Bank for International Settlements said as much last month, comparing low rates to an elastic band being stretched to breaking point.

This in turn may topple the dominos in a bond market that has seen liquidity dry up.

So even if the return of volatility to financial markets for now remains limited to mini-tremors, there is still a fair amount of anxiety over the system's ability to withstand bigger shocks. "We have not yet had the true test of the market, " said Mr Lon Erickson, portfolio manager at Thornburg Investment Management. REUTERS

A version of this article appeared in the print edition of The Sunday Times on July 12, 2015, with the headline 'Markets withstand tremors, but real test is yet to come'. Print Edition | Subscribe