Blood on the trading floor: A year of fear and greed for world markets  

The year 2017 was one of smooth tailwinds – even though everyone was mesmerised by the Trump reality show. Moving deeper into 2018, one issue on everyone’s minds is whether headwinds will finally blow as the tide goes out.   
Last week in Tokyo, Fed vice chairman Randy Quarles was visibly confident about the US economy. Real gross domestic product growth through the final three quarters of 2017 averaged almost 3 per cent – faster than the 2 per cent average recorded over the previous eight years.  
The European recovery, barring Brexit, looks just as rosy.  Euro zone growth has stepped up to 2.7 per cent in 2017, with inflation at around 1.2 per cent and unemployment down to 8.7 per cent, the lowest level recorded in the Euro area since January 2009.  
In Asia, 2017 Chinese GDP grew by 6.9 per cent to 59.7 trillion yuan ($9.4 trillion), just under half the size of the US. With per capita GDP reaching $8,836, China is expected to secure advanced country status by 2022. The Indian economy, meanwhile, has recovered from last year’s stumble and may overtake China in growth speed in 2018, with an estimated rate of 7.4 per cent.
The tailwinds behind the growth recovery seem so strong that the International Monetary Fund’s World Economic Outlook for 2018 sees growth firming up across the board. “Brighter prospects, optimistic markets and challenges ahead,” is the IMF’s headline outlook, tempered with “risks to the global growth forecast appear broadly balanced in the near term, but remain skewed to the downside over the medium term”.
Having climbed almost without pause in most of 2017, the financial markets skidded last month. On February 5, the Dow plunged 1,175 points, its biggest drop in history. The boom in 2017 was too good to be true and fear was back with the reappearance of volatility.  
Amazingly, the drop of around 11 per cent from the Dow peak of 26,616 on January 26 to 23,600 on February 12 has been followed by a rebound of 9 per cent in the last fortnight. Global stock market indices dovetailed as losses in Wall Street resulted in profit taking in other markets which then also reacted in the same direction.  
Will headwinds disrupt the market this year or will there be tailwinds as the economic forecasts suggest?
What makes reading 2018 difficult is that the current stock market buoyancy (and weakish bond market) is driven less by the real economy than by the ongoing loose monetary policy of leading central banks.  
Amid clearer signs of real recovery, central banks are beginning to hint at removing their decade-long stimulus by cutting back their balance sheet expansion and hinting at coming interest rate hikes.  
The projected three hikes for Fed interest rates in 2018 auger ill for stock markets and worse for bond markets.    
The broad central bank readout is as follows. The Bank of England and the Fed are leaning on the hawkish side, the European Central Bank is divided and the Bank of Japan retains a quantitative easing stance. 
In his first testimony to Congress, new Fed Chairman Jay Powell sounded hawkish: “In gauging the appropriate path for monetary policy over the next few years, the FOMC [Federal Open Market Committee] will continue to strike a balance between avoiding an overheated economy and bringing PCE [personal consumption expenditure] price inflation to 2 per cent on a sustained basis. … In the FOMC’s view, further gradual increases in the federal funds rate will best promote attainment of both of our objectives.”
What is more interesting is the divided stance facing the European Central Bank. In his latest statement to the European Parliament, ECB President Mario Draghi reaffirmed that the euro zone economy is expanding robustly. Because inflation appears subdued, despite wage growth picking up, he argued that “patience and persistence with respect to monetary policy is still needed for inflation to sustainably return to levels of below or close to 2 per cent”.
In an unusually critical and almost unprecedented article published last month by Project Syndicate, former ECB Board member and Bundesbank Deputy President Jurgen Stark, called the ECB “irresponsible”, suggesting that its refusal to normalise policy faster is drastically increasing the risks of financial stability. In short, the bigger partners in Europe think monetary tightening is the right way to go.
If both central banks begin to reverse their loose monetary policy and unwind their balance sheets, liquidity will drop and interest rates will rise. Financial markets have therefore good reason to be nervous about central bank policy risks. 
There are many cases of mishandling policy reversals. 
Following the so-called taper tantrum of 2014, when markets fell on the fear of the Fed unwinding too early and too fast, central bankers are now acutely aware they are walking a delicate tightrope. If they reverse too fast, markets will fall and they will be blamed. If they reverse too slowly, the economy could overheat and inflation will return with a vengeance, subjecting them to more blame.  
In the meantime, trillions in liquid funds are waiting on the sidelines, itching to bet on recovery at the next market dip. But this time round, it is not the market’s invisible hand, but visible central bank policies that may pull the trigger. Man-made policies will always be subject to fickle politics. The raw fear is that once the market drops, it won’t stop unless the central banks bail everyone out again. This means that central bankers are still caught in their own liquidity trap: blamed if you do tighten, and damned by inflation if you don’t.
There are no clear tailwinds or headwinds in 2018 – only lots of uncertain turbulence and murky central bank tealeaves. Fear and greed will dominate the markets in the days ahead.  

Andrew Sheng is a distinguished fellow at the Asia Global Institute, University of Hong Kong.