The generally smooth sailing for global stock markets over the past six months looks set to be disrupted as cross-currents change and tensions start to build.
This is based on two key expectations: first, that monetary policy will tighten once economies recover; and second, that the outsized wave of liquidity in the wake of the pandemic will reverse.
“As investors have been paying scant attention to the surge in quantitative easing, its reversal will probably surprise markets,” said Nikolaj Schmidt, international economist at T. Rowe Price.
For these reasons, he expects the coming months will be much harder for investors to navigate than the liquidity-pumped markets of the past few months.
“The change in the liquidity tide, and the discussion about when the Fed will raise interest rates and taper asset purchases, is likely to bring volatility back to the financial markets,” said Schmidt.
Deceptive backdrop
The most significant of the forces that have driven the strong performance of risk assets is the early stage of expansion in the business cycle.
Yet, as economies reopen fully and as pent‑up demand is released, the transition will likely begin, Schmidt warned. “At that point, fuller resource utilisation will justify a tighter monetary policy stance.”
At the same time, after the US treasury spending spree since early 2021, the acceleration in quantitative easing (QE) has now reached a crescendo.
T. Rowe Price believes it will begin to reverse over the coming months. “Unlike the business cycle, liquidity can change rapidly. It seems to me that we are at the cusp of an inflection point,” added Schmidt.
Another challenge to liquidity is the global shift among central banks in peripheral countries to tighten monetary policy, both by scaling back their QE and by hiking interest rates.
“Until now, these forces have had only a negligible impact on the financial markets given that the core central banks – the European Central Bank and the US Federal Reserve – have been resolutely dovish,” said Schmidt. “However, a growing number of FOMC members have begun to voice concerns about the dovish posture.”
Looming volatility
Whatever happens with rates, these dynamics are leaving investors at a crossroads.
From one perspective, the business cycle remains friendly enough, suggesting equities still have an upward trajectory. However, the change in the liquidity tide, coupled with discussions about when the Fed will raise rates and taper asset purchases, will likely bring volatility back to the financial markets.
“My guess is that these forces will collide in the late summer/early autumn, and I anticipate an autumn that will be much harder for investors to navigate than the liquidity‑pumped markets of the past few months,” added Schmidt.
As a result, he said he will look to the currency markets – typically much more jittery than equity markets – for any indications of a changing storyline.
