Wednesday, August 26, 2015

Making sense of crashing markets

Markets have crashed all over the world, including the US. It's not easy to make sense of this phenomenon. The glib explanation is that it has to do with the inability of Chinese authorities to stem the crash in markets there and the devaluation of the yuan. Both point to clear slowdown in Chinese growth and falling Chinese demand for imports. China is a big source of incremental global growth, so this is bad news for the world economy.

All of which is true. But what's new in that? Why should markets crash instead of declining in an orderly way? How does that explain the panic? One possible explanation is that the slowdown in China will be more severe than thought- growth won't be even 7 per, it would be, say, 6 per cent. But, again, why would markets latch on to this virtually overnight?

The other suspect is the impending Fed rate hike. But this has been long in coming. Also, it's not as if the Fed will press ahead regardless of what's happening to markets worldwide. An article in Business Insider highlights these points very well but does not come up with a plausible alternative. So let me stick my neck out and offer one.

Might worsening geo-politics be a factor? There's been news in recent days that both Russia and Nato have carried out exercises that military analysts see as a clear preparation for war. Then, there's been news that the US is moving some of its most advanced aircraft to its European allies. Oil prices have fallen to close to $40 and there's been another run on the rouble. This adds to Russia's economic woes and puts Russian president Putin under further pressure.

It could well be that the flight of funds from emerging markets is a sign of a full-blown global crisis that is not just economic in nature. I read in the Economist recently that Russia will find it difficult to hold on to Chechnya and other states in the federation the moment it runs out of cash. Any impending turbulence in Russia, with all the uncertainties it carries, would certainly frighten the life out of investors.

Worsening ties between the west and Russia are part of worsening geo-politics in general: think the situation in West Asia, China- Japan, India- Pakistan, etc. Don't get me wrong. I don't see any of these crises playing out in the near future. But worsening geo-politics makes it difficult to get the necessary focus on the economic situation. Indeed, crashing asset prices, notable that of oil, which is crucial to Russia, may just suit the  agenda of the western powers.

My sense is that the US and its allies under-estimate Russia, as it has been under-estimated by others in the past. When this becomes clear enough, the geo-political situation should improve and panic should dissipate. However, this learning could be a long and painful process. Until then, however, risk aversion will be high. It's the combination of a weak economy and worsening geopolitics that, perhaps, explain the current panic.

(Updated on August 27, 2105)

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