There is more to market volatility than Ukraine

The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy

It is tempting to pin the recent volatility in markets only on the fluidity of the Russia-Ukraine situation.

After all, every day we seem to get competing indications of a stand-off that confronts Europe with the highest possibility of an armed conflict with Russia since the collapse of the Soviet Union.

After an initial flurry of activity, markets settled into mostly trading the conflict within a range bounded by the hope of an eventual diplomatic resolution and the more protracted period of “no peace and no war”.

This has accounted for most of the daily volatility in the main US stock indices in the past few weeks when we have seen swings of 0 to 1.5 per cent. The stronger moves occurred when markets sensed the possibility of a decisive move towards one of these bookends.

After all, depending on which scenario is in play, the global economy would either benefit from a sharp reduction in commodity prices or, at the other end, deal with a major stagflationary shock.

But this should not blind us to two important structural issues that will be with us for a while, almost regardless of how the conflict plays out.

First, markets are losing the anchor of abundant and predictable liquidity provided by central banks. This unifying theme proved an extremely powerful driver to repress volatility, insulating markets from a wide range of worries while driving asset values higher.

With a US Federal Reserve belatedly seeking to tackle high and persistent inflation, markets must now navigate a fundamental shift in their liquidity regime. This involves not only higher interest rates but also a contraction in the Fed’s $9tn balance sheet.

Equity valuations may be more attractive than they were a few weeks ago but have not reached the level needed to constitute an obvious standalone and generalised investment case to buy stocks.

This is not to say that markets are without anchors. Solid corporate earnings and behavioural conditioning of investors tempted to ‘buy the dip’ are still in play. But these are inherently less strong and highly sensitive to the Fed being able to deliver an economic soft-landing.

The likelihood of this has been significantly undermined by the extent to which the Fed first mischaracterised inflation and then dithered in adjusting policies. Even today with 7.5 per cent consumer price inflation, the Fed is still injecting liquidity into the economy.

I would estimate the probability of a comfortable soft landing for the economy and markets over the next 12 months at 10 per cent, well below three other macroeconomic scenarios.

One is that economic growth is severely damaged by a late Fed that is forced into slamming on the policy brakes in response to persistently high inflation (40 per cent probability). Another is a Fed that gives up for now on its inflation objective in the hope that exogenous favourable developments will emerge such as a productivity surge or fast-healing supply chains, helping to accommodate rising labour costs (30 per cent). A third scenario is stagflation (20 per cent), the most worrisome outcome for livelihoods, financial stability and policy effectiveness.

The second structural factor overhanging markets is the structural erosion of market liquidity.

The past decade has seen a significant reduction in the risk absorption capacity of markets as intermediaries have been both less able and less willing to expose their balance sheets. This has coincided with an enormous expansion in the size of asset holders who deal through those intermediaries.

As such, this mismatch in supply and demand can lead to big market moves. or ‘price gapping’, whenever there is a change in conventional wisdom, a phenomenon that has been visible not only for individual stocks but also for other market segments.

Now lacking a strong unifying theme and navigating a wide range of potential macro scenarios without a first best Fed policy option, stocks will remain sensitive not just to the vagaries of the news on Russia-Ukraine, but also other factors such as competing remarks by central bankers and data releases that are significantly different from the median forecast.

This requires investors to anticipate more unsettling volatility and have a strong stomach for dealing with it (remember, many of the major investment mistakes occur at such times).

It also warrants favouring individual name selection over indices, and subjecting holdings to granular quality reviews on a much higher frequency basis than has been warranted in recent years.