It’s been a while since I’ve written – which in and of itself should give you a clue as to the gravity of the “adjustment” taking place in financial markets. As a flow rates guy, the extent to which I’m working ludicrous hours and fully occupied professionally depends on whether things are changing in the world, forcing market participants to materially change their views and therefore their positions. Price action certainly helps, but it isn’t everything. Things have to happen in the world.
And what is happening? Essentially, having tried to cure a debt crisis by shifting debts from the private to the public and banking sector rather than simply allowing the defaults and creative destruction that financial crises have caused down the ages – central bankers the world over have continued on their heroic postponement of the inevitable. Like the Daughters of Dannaus – they are attempting to carry the water of purchasing power from the future to the present up the hill of duration, in the sieves of quantitative easing. It isn’t working – but instead of finding a proper vessel, ie, implementing policies that might increase demand by real economic actors – they’re trying to make the hill flatter. They’re even hoping, via negative rates, to make uphill downhill and have the water flow by itself! All of this “Unprecedented” stuff is getting markets very excited – but not the way you might think…
As an aside, when people describe central bank action as unprecedented I don’t think they have any idea of the breadth and depth of their inanity. The reality is that central banks have only been operating in their quasi independent state for the past 30 or so years, and during that time, the world has changed. Indeed, the Federal reserve was only incorporated in 1913 – and if one thinks about the changes that have occurred in the US economy in that time, it’s just absurd to talk about any given action being unprecedented – of course it is! The world has never been similar enough for enough time. There is a more particular point here too. What is considered “monetary policy”, ie, the remit in which central banks operate, has constantly changed over time. It may seem to us as though quasi-independent inflation targeting, base rate setting central banks are the norm – but this hasn’t been the case for long at all.
Pre-amble over, let’s look at what this has meant for asset prices without the use of frilly metaphors. In a nutshell, the market appears to be losing it’s love for the interventions of the central bankers. I’ve observed, as have clients and colleagues, that the half life of central bank action’s effects on the market is diminishing. Last year, the ECB managed to get real interest rates under -1% for over a month – in November they managed it for a couple of weeks. The BoJ managed, through threatening QE, to get USDJPY above 115 for months, but surprise negative rates in Japan, even in the context of low rates in the US (bad for the dollar!), were worth 3 days of strength in USDJPY – which came unstuck violently. And in the midst of continuing global easing of monetary policy – global stock markets are down 10-15 % on the year. With all that money chasing financial assets – how can stocks selling off?
Well, because of what they represent. And what they represent is a stream of returns from the arrangements of capital and labour embodied by those companies. And whose arrangements of capital and labour are ineffectively deployed. Instead of allowing creative destruction – useless arrangements of capital and labour to be replaced by others which is what happens in a recession – governments the world over chose to ossify what was already there. To stop the patient from dying, she was flash frozen. This is fine up to a point because living standards are relatively high in many economies, but the financial market is far too addicted to positive real rates of return. Rather than having the opportunity to build big new companies, we have tiny amounts of people engaged in increasingly desperate rent seeking activity in the tech sector, and because of the perceived upside (those sweet, sweet, positive real rates of return around which the financial system has been built!), the financial assets which might give participation in the returns of those companies, ie tech stocks, were trading at daft valuations.
However, the chase for returns is called off as soon as you stop believing in the power of the central banks. If you don’t think they can prop up asset prices, then the chance of some upside on your tech stock is irrelevant compared to the fear that you will lose your capital. The hunt for yield is called off as soon as one realises that the price of assets has already been bid up by years of cheap money chasing a shrinking pool of returns.To annoy people who know about charts and illustrate the magnitude of what can happen when the music stops, I plot Potential NGDP and the Dow on one chart indexed to 100 just before the last recession.
Chart Crimes like the above prove nothing but they can be circumstantial evidence. If my idea is correct and stock markets have been bid up to stretched levels by easy money and belief in the efficacy of central banking – then I’d expect the above chart to look like it does. Many other things could explain the progress of those two lines, but I think my explanation contains enough grains of truth to justify continued bearishness. I’ve been fully divested from equity since mid 2015. I’ll continue to be so until I see a 30% correction.