(Bloomberg Opinion) -- After a relatively smooth ascent in valuations and profits since March 2020, stocks had a bumpy and unsettling first month of 2022. In addition to the sharp drop in markets in January, the dizzying intraday volatility added uncertainty and contributed to an unsettled feeling about the future, and not just because of the marked change in the policy stance of the Federal Reserve. The volatility is likely to stick around, at least for a while.
Investors and traders in the past few weeks have radically shifted their view of the 2022 policy stance of the Fed, the world’s most powerful central bank. Initiated by Chair Jerome Powell’s belated pivot at the end of November away from the “transitory” characterization of inflation, market expectations for interest rate increases have moved rapidly to incorporate five hikes this year alone. The possibility of starting the raising cycle with a 50-basis-point move is no longer out of the question.
In addition to repricing fixed-income markets, this is starting to fuel discomfort about the impact on the economic recovery of what was an avoidable bunching of three contractionary policy measures within just a few months: increasing rates, ending asset purchases and initiating the shrinking of the Fed’s balance sheet.
With such a global liquidity reversal firmly in the cards, it should come as no surprise that markets have become so sensitive to macroeconomic data releases, be they a hot labor market and higher-than-expected consumer price increases or lower-than-expected employment costs.
While this is the main factor driving the current bout of volatility, it is being accentuated by two factors that attract too little attention even though they have become a structural feature of today’s markets.
The first is patchy liquidity, including for even the most widely held stocks. This reflects, first and foremost, the giant structural imbalance that has been years in the making: one of an expanding universe of end users, both in scale and scope, versus smaller balance sheets for intermediaries, thereby limiting the system’s capacity to absorb risk. The imbalance is particularly pronounced when there is a shift in the conventional wisdom in markets.
The second structural factor speaks to the growing role and influence of exchange-traded funds. In the hectic day of trading last Monday, they accounted for 40% of the record trading volume. In the process, they intensified contagion and underscored the contrast between the seemingly high liquidity of ETFs and the relative illiquidity of some of their individual holdings.
Looking forward, three factors are expected to stay in play for a while, promising continued volatility. Consider the following as an illustration:
- While it is clear that we are leaving the long-standing regime of abundant and extremely cheap central bank liquidity, it is far from clear where we are going, how fast and with what set of collateral damage and unintended consequences – a consideration that looms big given how late the Fed is in adjusting policies to economic realities.
- By fueling the notions of TINA (there is no alternative), FOMO (fear of missing out) and BTP (buy the dip),the recent era of abundant liquidity has conditioned markets in a manner that has contained disruptive market outflows, at least until now. Indeed, price action in January has generally led outflows rather than the other way around. It is uncertain how long this conditioning will persist, an issue that adds to concerns about the resilience of many investors who have become accustomed to markets that move in a single direction: up.
- Corporate issuance behavior also has to change. In rising markets, new inflows of funds into the marketplace easily absorbed record bond issuance and initial public offerings, including through special-purpose acquisition companies. It is yet to be seen how quickly corporate issuance will adjust, especially in light of the private-to-public transactions on deck at several large private equity firms.
After such a dizzying January in markets, many of us are hoping for a quick return to the 2021 days of low volatility. Unfortunately, this is likely to take a while, risking both market and economic damage.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is president of Queens’ College, Cambridge; chief economic adviser at Allianz SE, the parent company of Pimco where he served as CEO and co-CIO; and chair of Gramercy Fund Management. His books include "The Only Game in Town" and "When Markets Collide."
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