Flash crash as the markets take a dose of economic reality

Sluggish global growth and concerns over the effectiveness of central banking policies to quicken the pace, mixed with a downbeat investor psychology — hurt in part by bad geopolitical news — set off market tumbles around globe this week. Yet the degree to which the bearish demeanor in Wall Street is indicative of wider gloom has divided experts, bringing to mind the old quip that if you laid out all the economists in the world end to end, you still wouldn’t reach a conclusion.

However one slices it, economic indicators and market reaction have been less than rosy. On Tuesday, the European Union announced that industrial output in the eurozone fell further in August, marking a 1.9 percent total decline over the course of 2014. Then on Wednesday, the S&P 500, a leading stock market index, saw its biggest single day plunge since 2011, spurred in part by news that U.S. retail sales had fallen 0.3 percent in September. On the same day, America’s Dow Jones fell more than 1 percent and Britain’s FTSE ended down 2.8 percent.

Given that most markets have been steadily on the rise in 2014, the news represented an uncomfortable blip to many traders. The so-called flash crash was short-lived, as markets on Thursday were pretty dull — the Dow ending down 0.15 percent — but there are several structural indicators that suggest that there may still be cause for concern.

“The first is a legitimate concern about global growth, particularly the news coming out of the eurozone,” said Sherle Schwenniger, director of the Economic Growth program at the New America Foundation. He said that was compacted by “the worries about the impact of a China slowdown.”

The worry of sluggish global growth in particular was floated last week by the International Monetary Fund’s (IMF) downgrading of 2014’s global growth forecast to 3.8 percent. Although it corrected it by just 0.1 of a percentage point on earlier estimates, it is perhaps notable that it was the ninth such quarterly downcast on GDP expansion.

Ahead of the IMF’s annual meeting with the World Bank, IMF chief Christine Lagarde warned of “the risk of a new mediocre.” She said, “The global economy faces the prospect of prolonged subpar growth, accompanied by high unemployment and rising inequality."

Such comments echo concern that investors have been getting ahead of the economy in recent months, with benchmark indices climbing higher and higher despite the recovery seemingly lagging.

There has been a general “uneasiness that the gains of the market over the last several years have been driven by monetary accommodation” rather than growth, said Schwenniger. 

A second concern contextualizing the market tumble concerns monetary policy by leading central banks, primarily the U.S. Federal Reserve and the European Central Bank (ECB). Since the Great Recession — a result of 2008’s financial crisis — the Fed has held interest rates at near zero, part of a broader bond-purchasing scheme known as quantitative easing that has seen more than 3 trillion dollars enter the U.S. economy.

That policy, enacted by former Fed chief Ben Bernanke and continued by current head Janet Yellen, is expected to taper off at some point, a major worry for investors absent resurgent economic growth.

But the ECB was perhaps a more proximate lightning rod for panic this week, where a eurozone that has twice suffered recession since 2008 risks entering a prolonged deflationary period given sluggish growth from its leading economies, especially Germany, and a central bank that has found it difficult to overcome divergent agendas from its constituent members.

“The European Central Bank bitterly disappointed investors who had expected the bank to follow the Federal Reserve’s example and announce dramatic monetary measures,” wrote economist and journalist Anatole Kaletsky in his Reuters blog.

A third factor that potentially complicated markets this week is the ongoing multitude of geopolitical maladies denting financial confidence.

Schwenniger said there was an investor psychology “which has been buffeted by things like Ebola and ISIS (an acronym for the armed group Islamic State of Iraq and the Levant) and a general sense of drift and a sense of a lack of leadership” globally.

Likewise, Simon Kennedy and Andrew Mayeda writing for Bloomberg noted “the sense of tumult is being exacerbated by war in the Middle East, the standoff in Ukraine, street protests in Hong Kong and the spread of Ebola to Dallas.”

Among these geopolitical worries, an additional cause of some investor fear is a decline in oil prices brought on by the battle between Middle East oil producing nations, particular Saudi Arabia, and the United States over its booming shale production. OPEC-producing nations have dramatically increased their supply of oil in a bid to make North American production lest profitable. While that is generally good news for consumers, it has created a temporary panic among traders in the energy industry.

Still, others see this week’s market news as less of a sign of new or rising trouble, but as an inevitable, if still bleak, correction by markets whose gains have outpaced more humble economic realities.

“For quite a while now, too many investors have been comforted by two intoxicating notions: that the global economy would continue in a low-growth equilibrium, thus avoiding both a recession and an inflationary boom, and that central banks would succeed in repressing market volatility, not just pre-emptively but also after the fact should an unanticipated event occur,” wrote Mohamed A. El-Erian, chief economic adviser at Allianz SE and chairman of President Obama’s Global Development Council, for Bloomberg.

In the U.S., while this caught the markets off guard, it may not be surprising to many people whose economic realities haven’t matched Wall Street’s exuberance.

“While job growth has been solid this year, wages are rising barely faster than inflation, and the United States economy is producing far below its economic potential by most official estimates,” wrote Neil Irwin in The New York Times. “Yes, things have improved, but maybe not enough to justify stock prices that are quite so high relative to corporate earnings.”