What is behind the dramatic shift in markets

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

Financial markets have witnessed a dramatic change that is overturning the consensus trades that dominated until early February of this year.

Falls in US stocks and their under-performance relative to other countries reflect a remarkable turnaround in investors’ views about the economic outlook for America and Europe — and to a lesser extent China. What is less clear is whether the resulting mix of all this is favourable or unfavourable over the longer term. And that matters a lot for global wellbeing, inflation and financial stability.

Three key factors underpin the recent 180-degree turn in consensus views on stocks, bonds and currency: growing worries over the US economy; a potential “Sputnik moment” in Europe driven by a possible change in Germany on fiscal policy and European funding; and hints of a more determined policy response from China. Belief in American exceptionalism has been eroded with not only US shares dropping but bond yields falling on growth concerns and the dollar weakening.

Having dealt with a whiff of stagflation, markets are suffering a good old-fashioned growth scare due to a significant bout of US policy volatility. The uncertainties associated with the on-again/off-again tariffs on America’s major trading partners and allies such as Canada and Mexico were compounded by concern about the impact on employment and income of the ongoing public sector cuts.

US government officials argue that these “disturbances” are small and should be seen as part of a bumpy journey to a much better destination — one of fairer international trade, great public sector efficiency, reduced fiscal dominance, and the unleashing of more powerful private sector entrepreneurship and activity. Indeed, according to them, it is only a matter of time before the journey itself improves due to lower energy prices, tax cuts and significant deregulation.

The worry is that the bumpy journey may lead to a different, less favourable destination. The recent bout of US unpredictability risks robbing the US of one of its important and differentiating “edges” — long-term investor confidence in policy framework and decision making.

US policy is also responsible for the markets’ sudden change of view about Europe that now sees the potential at long last for a dramatic economic policy shift. Jolted by America’s treatment of long-standing security alliances and the change in its Ukraine policy, Germany, is suddenly contemplating a relaxation of its long-held fiscal constraints. This could translate into increased defence spending, larger infrastructure investments and greater regional funding.

Meanwhile, China is signalling a move towards a more potent mix of stimulus and reforms. Markets see this as essential to counter the growing threat of the Japanification of the Chinese economy which was highlighted again in data on Sunday with both consumer and producer prices falling in February.

On paper, this confluence of factors presents two possible scenarios for convergence among what was previously the good (US), bad (China) and ugly (Europe) of the global economy. The optimistic view anticipates an upward convergence of global growth, with Europe and China accelerating to get closer to the hitherto exceptional performance of the US economy. This would result in a higher overall level of global growth as a short-term US deceleration is more than compensated by the pick-up in China and Germany.

The more pessimistic outlook would be a downward convergence featuring stagflation. This scenario would be due to delays in Germany’s policy implementation; China’s continued struggle to balance stimulus and reforms; and a US economy decelerating towards stall speed amid low consumer confidence, job insecurity, a corporate wait-and-see approach on investment, and the stagflationary pressures of tariffs.

While it remains unclear which path the global economy will take, absolute and relative price levels in markets suggest expectations that are slightly more weighted to favourable convergence over the long term. This implies a belief in Europe’s ability to overcome its fiscal inertia, China’s capacity to navigate its policy challenges and the resilience of the US economy despite its current disturbances. The bet is that the global economy is still likely to escape the clutches of stagflation and achieve a more balanced and sustainable growth trajectory. We should all hope this is right.