Risk assets such as stocks, corporate bonds and bank loans have been trading in a wide and volatile range, taking investors on a roller-coaster ride up and down, including most recently a rally of about 10 percent in U.S. equity markets.
This phenomenon is likely to continue in the short-term, so here are eight characteristics of this financial environment:
- Pronounced fluctuations within the trading range reflect primarily the tug of war between a weakening global economy and continuing liquidity injections from central banks and corporate balance sheets.
- The fluctuations are accentuated by patchy market liquidity: On the way up, prices overshoot levels warranted by the exceptional funding that markets obtain. That backing includes the monetary stimulus programs of central banks (notably the Bank of Japan, the European Central Bank and the People's Bank of China), as well as the deployment of corporate cash for share repurchases, higher dividend payouts and mergers and acquisitions. On the way down, prices fall below what would otherwise prevail on the basis of fundamentals.
- This behavior is likely to continue in the short-term, shifting the opportunities for higher monthly/quarterly returns away from conventional strategic long-term portfolio positioning and toward more short-term trading and volatility trades.
- Because today's markets are heavily influenced by the direct and indirect involvement of central banks, correlations among asset classes are less reliable, weakening the effectiveness of risk mitigation through traditional portfolio diversification. Although it remains necessary, such diversification is no longer sufficient to ensure effective risk management. Accordingly, fluctuating cash levels not only provide agility for tactical positioning but also act as a risk mitigator.
- Over time, the trading range is more likely to get wider than smaller. As this occurs, the probability of either a policy mistake or a market accident will increase. And even absent these two disruptive developments, the range itself will become increasingly fragile as its gets wider.
- It is too early to determine with certainty whether the eventual dismantling of the trading range will result in an upward or downward breakout. Much will depend on the policy responses in the systemically important economies in Asia, Europe and North America.
- A constructive policy response would require a transition from the excessive reliance on central banks to a set of policies that reinvigorates growth engines, deals with aggregate demand imbalances, addresses excessive pockets of indebtedness and makes progress in completing regional and global economic/financial architectures (which also would counter the rise of political extremes on both sides of the Atlantic). If this approach were successful, range-bound trading would yield to genuinely higher financial asset prices that are firmly supported by strengthening fundamentals.
- But the more this policy handoff is delayed, and the greater the political polarization, the higher the probability of notably lower markets that, in turn, would risk contaminating economic fundamentals and making the politics even messier.
This post originally appeared on Bloomberg View.