Global financial distress: a new chapter

Global market sentiment towards the end of April was by no means upbeat. The downward asset price adjustment to higher projected interest rates was compounded by the knock-on economic effects from Russia’s war in Ukraine, deteriorating growth prospects in Europe and multiple issues in world’s supply chains owing to the severe pandemic-related measures implemented by China’s government. However, there are rational grounds to believe that another factor is also playing a key role in financial gyrations.

?In early March the U.S. Federal Reserve conducted its final open market of assets, effectively ending the COVID-19 Quantitative Easing (QE)program that started two years before. Along with the increase of the Fed funds rate, the move signals the reversal of the ultraexpansionary monetary policy pursued to contain and mitigate the deflationary shock triggered by the pandemic. Technically speaking, it was QE 4 and its predecessors were QE 3 (from September 2012 to October 2014), QE 2 (November 2010 to July 2011) and QE 1 (November 2008 to March 2010). Moreover, there was a Quantitative Tightening (QT) in between, from January to December 2018. Because the authorities have also announced a QT 2, which should shed up to U.S. $95 billion of assets a month from their nearly U.S $9 trillion balance sheet (they will build up to that level over roughly three months starting in May), it is instructive to investigate the possible effects of such measures in asset prices.

While the impacts of changes in the benchmark interest rate have drawn the analysts’ attention, less understood are the consequences of quantitative easing and tightening. Probably this owes to the fact that these are novel, unconventional expedients, which raise several methodological and empirical issues. At least for the expansionary part of the experiment, the outcome expected by policymakers is straightforward: large purchases of assets should drive their prices up, ward off deflationary crises and stimulate investment, production, and employment. Whereas the jury is still out about the results on economic activity, the effects on asset prices were overwhelmingly favorable.1

Perhaps more intriguing are the consequences of quantitative easing and tightening programs pursued in one specific economy on global asset prices. By comparing the changes in the balance sheet of the U.S. Federal Reserve tochanges in the World (stock market) MSCI index, one finds an exceedingly high correlation (Chart I), along with evidence of diminishing returns. On average, the four QE cycles in the United States resulted in an increase of 57.1% in the Fed’s balance sheet, which compares to an average appreciation of 28.4% of the World MSCI index in these episodes. The only experiment with QT to date led to rates of change that were -8.2% and -3.9%, respectively. Therefore, even factoring int the disclaimer that the data sample is prohibitively small, there are rational grounds to believe that the financial distress of the past weeks speaks of investors adjusting their portfolios to a new scenario in which, in addition to a variety of adverse shocks, the era of ultra-easy money in America is over and the mopping up of liquidity in that geography will lead to a significant revision of valuations worldwide.

But then the year-to-date outlook suggests that a sharp differentiation is also taking place in global markets. Sure enough, commodity prices continue trending upwards (Chart II), thus indicating that, instead of swings in U.S. monetary experiments, a more fundamental imbalance between global supply and demand is driving these valuations. Accordingly, stocks in the regions that are net producers and exporters of these primary products have vastly outperformed those in the rest of the world. Currencies and fixed income, by the way, show quite similar performances.

As for commodities, there seem to be two stories. The first of which is about supply disruptions (notably in fossil fuels, fertilizers, wheat, and barley) more than compensating for a reduction in worldwide demand because of slower economic growth. The most interesting story, though, is the second, which has to do with long-term historical trends (Chart III). Arguably there is no single narrative for primary products since the so-called Nixon shock in 1971, which ended the Bretton Woods international financial arrangement by terminating the convertibility of the U.S. dollar to gold, thus giving rise to the existing floating foreign exchange regimes.

In real values, the prices of gold and commodities with cartelized markets (e.g., oil) bottomed in the early 1970s and since the Nixon shock have been trending upwards, although with significant volatility. On the other hand, the prices of primary products more closely related to business cycles or to basic consumption needs of populations didn’t show any credible sign of recovery until the early 2000s (in the case of wheat, for instance, the through apparently occurred as late as 2016). Consequently, the recent price uptick can simply result from the fact that they were too cheap in historical terms, which led to underinvestment and other problems that are typically solved by providing effective stimuli to increase production, exploration, and extraction. Against this backdrop, higher market prices over the medium-term are likely to be part of the solution to address the excess demand situation, being also congruent to historical trends.2

To be sure, countries that are net exporters of commodities and whose asset prices were comparatively less affected by the episodes of monetary easing in the U.S. are in a more comfortable position to navigate roiling market waters. Of course, basic macroeconomic conditions in these geographies must be right as well. Taking into considerations these factors, major Latin America economies should continue outperforming other regions.

?1 See, for instance, “The FED Ends the $6 Trillion QE4: How the Markets May React”, by Henning, J. D. in Seeking Alpha, 11-March-2022.

?2 See, for instance, “From boom to bust: a typology of real commodity prices in the long run”, by Jacks, D. S. in Cliometrica, 2019, 13:201-220.

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