In the lead up to the global financial crisis central bankers were hailed as maestros. A sort of Deus ex Machina elite pulling the strings of the world economy and keeping economies stable, inflation under control and markets going up.
That has all evaporated. The near collapse of the world's financial system has exposed their shortcomings. They were reckless in over estimating the untrammeled market's capacity to self correct. They also allowed traders to make up their own rules of money in what was a massive Ponzi scheme, a casino that is still with us.
There has been a considerable amount of navel gazing, fully justified, in the world of the financial authorities. But as fund manager Hugh Hendry observes, there is little evidence that they have made great advances in their understanding of what to do about unfettered capital markets. They still don't know what the solution is:
The structural deficiency of global demand continues to radicalise the central banking community. I believe they are terrified: the system is so leveraged and vulnerable to potentially systemic price reversals that the monetary authorities find themselves beholden to long only investors and obliged to support asset prices.
However, I clearly confused everyone with my choice of language. What I should have said is that investors are perhaps misconstruing rising equity prices as a traditional bull market spurred on by revenue and earnings growth, and becoming fearful of a reversal, when instead the persistent upwards drift in stock markets is more a reflection of the steady erosion of the soundness of the global monetary system and therefore the rise in stock prices is something that is likely to prevail for some time. There is more to it of course, as I will attempt to explain, but not much.
This sounds about right. The bull markets are not responding to better economic prospects. The inequity of wealth works against strong economies. When middle classes collapse, as is happening in the US and Europe, it is hard to find adequate levels of demand. The top 1% simply can't spend enough to make up the difference. Indeed, the wealthy tend to be pretty tight fisted.
Hendry implies that the cart is trying to push the horse. They are creating asset bubbles in an attempt to catalyse demand:
This should be a great time to be a macro manager. It is almost without precedent: the world’s monetary authorities are targeting higher risk asset prices as a policy response to restoke economic demand. Whether you agree with such a policy is irrelevant. You need to own stocks. And yet, remarkably, the most contentious thing you can say in the macro world today is “I’m bullish”.
In a world dominated by the existentialist angst of identifying and trading qualitative value, there is profound mistrust of equity values today; macro investors see prices as overvalued and few are willing to capitalise on the opportunities to make money. This angst and fear of big drawdowns in risky assets in part reflects astonishment that policy makers were able to rescue investors from the folly of their misallocations in the years preceding 2008 and that stocks have massively outperformed the modest rise in global nominal GDP. I should know. I, like others, became a moraliser who just couldn’t forgive the Fed for bailing out Wall Street. I read one “death of money” polemic after another and luxuriated in the work of people like Marc Faber, James Grant, Nassim Taleb, Raoul Pal and Albert Edwards. I became a moral curmudgeon rather than a money maker.
As you know, I have sought to overcome this deficiency. However my risk controls, or rather my procedures for dealing with big monthly losses, seemed to anchor me to the bearish camp (against my better wishes). No-one wants to lose more than 5% in any one month (for the record, we have recorded only 9 such months over the Fund’s previous 144). But typically this has entailed selling when there has been a spike in volatility; since the end of last year I have been a bull that had to sell for lower prices. No wonder I couldn’t make you money. But perhaps you don’t need such reactive stop loss policies when the world’s central banking community is intent on protecting you; which is to say, I needed to apply greater risk tolerance and intervene less often.
You are not convinced? Japan was down 16% from its highs earlier this year. I was particularly long Japanese equities at the start of the year and so at some point, fearing greater losses, I swallowed my pride and booked a loss. However, the ongoing policy intentions of the BoJ meant that the stock market clawed back all of its losses. Why did I sell?
European stocks fell almost the same over the summer but again the ECB upped its ante, pushed short term rates negative, tolerated a weaker currency and promised to re-stock its balance sheet with more local risk asset purchases. Lo and behold, European stock prices recovered sharply in August and early September. So why did I reduce my holdings?
Hendry then applies some interesting history. The Plaza Accord was when governments globally acted on currency imbalances. This is an era of government intrusion in the markets because the after effects of the GFC are still being felt:
To my mind the current period is analogous to the Plaza Accord of 1985 when central bankers agreed to intervene in the currency market to drive the value of the dollar lower. The fast moving world of FX was deemed a more expeditious way of correcting for the huge US current account deficit than the laborious and slow process of waiting for the totality of countless micro wage and productivity deals to rectify the yawning trade gap. No one really knew for sure how high the yen or Deutsche Mark should trade back then but this didn’t stop macro managers from being very long such positions.
The FX market tends to take the US Supreme Court view. Overruling an obscenity charge for showing a salacious French movie in Ohio in 1964, Justice Potter Stewart wrote that the Constitution protected all obscenity except hard core pornography. Unwilling to define the latter, the judge maintained that he would know it when he saw it. And likewise currency values; you just know the wrong ones when you see them. This is to say that the market becomes more treacherous once the imbalances of the primary economic transactions (the US current account) show signs of improving from the remedy of the price changes engineered via the relative currency movements.
Which is a rather long preamble to describe what I believe is a very analogous central banking intervention in today’s financial markets. It would take just too long for the Fed, ECB or the BoJ to rely on a return of animal spirits in the real economy to lift their flagging economies. They need the remedy of fast moving risk asset prices. By using QE to promote more risk taking, asset values in the US have risen faster than fundamentals and, with better perceived collateral and more confidence, the demand for risk taking in the real economy has recovered somewhat. At a lag, the theory runs, so will the rate of expected inflation.
So I think we find ourselves especially in Europe (and Japan) with a situation whereby the central bank has to use all of its powers to engineer higher stock and bond prices. And I think the precarious nature of France and the election timetable in 2017 means that they need higher European stock and bond prices NOW or there will be no economic recovery, budget deficits will continue to overshoot 3% and the Euro area will get trapped in the poisonous and perpetual cycle of having to demand more and more unpopular austerity measures. This is high stakes: boost European stock prices or risk losing France and the euro. To my mind the message is simple: don’t short French bonds, buy European stocks and short the euro.
It will only become a bubble when slow moving price inflation and real wages start moving; we’re obviously nowhere close to that just now in Europe (or in Japan) and hence my large net long.