When we started writing this weeks’ commentary, we did not realise how long it would be. We hope that you find it interesting, as we truly believe that we touch upon the most important dynamic affecting markets at this time. For those looking for a short term market update, it appears to us that some sort of capitulation low was seen in risk assets last Wednesday and the likelihood is that prices will grind higher for a week or two or three. We have significantly reduced our bearish exposure, however we will be looking for evidence that any rally is simply a bear market rally, and as such we will be looking to position bearishly again quite soon. Let’s move on to the real topic of the day.
What with Davos and the first ECB meeting of the year, all at a time of heightened volatility in financial markets, there has been an unusual amount of commentary this past week from officialdom. Let’s try and pick our way through some of the interesting stuff and have a think about prospects for financial markets in the big picture.
In an interview with The Telegraph’s Ambrose Evans-Pritchard (AEP), William White reiterated some stark warnings he has been giving for some time. We would point out that Mr White is not a lunatic member of the tinfoil hat brigade. He is currently chair of the OECD’s review committee having retired as the chief economist of the Bank for International Settlements in June 2008. AEP notes that “Mr White was one of the very few voices in the central banking fraternity who stated loudly and clearly between 2005 and 2008 that Western finance was riding for a fall, and that the global economy was susceptible to a violent crisis.”
In the interview, Mr White is quoted as saying “The situation is worse than it was in 2007. Our macroeconomic ammunition to fight downturns is essentially all used up…Debts have continued to build up over the last eight years and they have reached such levels in every part of the world that they have become a potent cause for mischief…It will become obvious in the next recession that many of these debts will never be serviced or repaid, and this will be uncomfortable for a lot of people who think they own assets that are worth something.”
So with a warning from a highly credible economist who foresaw the financial crisis, should we not expect our policymakers, all gathered merrily at the exclusive ski resort of Davos, to be hard at work trying to rectify the situation? Should our political leaders not be discussing plans for things like infrastructure programmes that will add to the productive capacity of our economies? Should our central bankers not be exercising prudence so that financial markets do not mis-allocate capital as they did in the 2005 to 2007 era and speculators are not encouraged to push financial markets to insane levels?
Whilst there has been an unusual amount of commentary this past week, we believe our politicians fall well short when it comes to fiscal ideas to help the global economy. Furthermore, our central bankers remain convinced that the extraordinary policies that they have pursued post crisis, which have been so successful in pushing up financial markets without generating self-sustaining economic performance, are effective and they may need even more extreme policies to help us through the current sticky patch.
To try and be fair to the Fed, they have taken a few steps away from the extraordinary policies of recent years. They have stopped QE and taken the baby step of a first rate rise away from the zero lower bound. Indeed, Fed officials were quite clear at the start of 2016 that they wanted to raise interest rates another four times to about 1.50%. William white says that the Fed is now in a horrible quandary as it tries to extract itself from QE and right the ship again. According to Mr White, “It is a debt trap. Things are so bad that there is no right answer. If they raise rates it’ll be nasty. If they don’t raise rates, it just makes matters worse.”
When you’re in a financial hole, we reckon it makes sense to stop digging. At the ECB, Mario Draghi clearly takes a different view. With interest rates already in negative territory (the deposit rate anyway), and the ECB printing EUR 60 billion per month until March 2017, Draghi is worried about dynamics outside of his control (“emerging market economies’ growth prospects, volatility in financial and commodity markets, and geopolitical risks”).
During his press conference last week, Draghi clearly stated that lower oil prices were a good thing for the economy, as “the renewed fall in oil prices should provide additional support for households’ real disposable income and corporate profitability and, therefore, for private consumption and investment.” In almost the next sentence, he told us that “On the basis of current oil futures prices…the expected path of annual HICP inflation in 2016 is now significantly lower compared with the outlook in early December.”
So on the one hand, lower oil prices are great for the economy, but because it also means that inflation will be below his target, he is highly likely to cut rates further into negative territory and print even more money. Interestingly, although Janet Yellen over at the Fed has consistently claimed that lower oil prices are “transitory”, Draghi is now worried about how the decline in oil has become so persistent and may lead to second round effects.
Basically, there may be no easy answer for the ECB, but they are in a hole and digging more and more furiously. This will not end well, but financial markets do seem to love a dovish ECB, at least in the short term. In the bigger picture, we think it is notable that ECB QE is really struggling to push up asset prices, and Japanese QE seems to be less than fully effective as well. In other words, although the “success” of central banks’ extraordinary policies have been seen much more in supporting financial markets than the real economy, even here, we are seeing diminishing returns.
Chart 1 below shows the European equity index, and we have marked on the chart the important ECB meetings. The first meeting in May 2014 was when Draghi pre launched extraordinary policies and the Euro topped versus the US Dollar near 1.40 (currently 1.08 – more than a 20% devaluation). The ECB cut the deposit rate into negative territory in June and September of 2014, and in December 2014 pre launched QE which was officially started in March 2015.
The first point to make is that over the last two years, the European equity index has made no progress in Euro terms and lost approximately 20% in US Dollar terms, despite increasingly extreme policies of negative interest rates and QE. Clearly a case of either diminishing returns or other factors having an offsetting (or worse) affect.
Chart 1 – The EuroStoxx 50 Index with ECB meetings marked by the red vertical lines
To us, the picture is similar in Japan where the printing presses are working overtime and the cognoscenti are almost pleading for more. Indeed, although the whole Japan trade started just prior to the election of Abe in December 2012, the latest rounds of QE did not start until April 2013. After the recent declines, it is perhaps notable that there has been barely any progress for 2 ½ years, with gains perhaps driven more by currency weakness than anything else.
Chart 2 – The Japanese equity market along with the USDJPY exchange rate
With politicians either unable or unwilling to do the right thing, central bankers have taken it upon themselves “to do whatever it takes”, and unfortunately, they are completely disregarding the efficacy of their policies and the potentially damaging unintended consequences. But rather than get into that lengthy debate here, we would like to expand upon a theory we first discussed back on 12th September in our report titled “Global Liquidity is Deteriorating Badly – Serious Macro Trends Developing (link here).
We have noted before how global liquidity conditions have tightened as the US Dollar strengthened and global FX reserves fell. We are increasingly of the view that market participants are underestimating just how powerful the declining liquidity story is for financial markets. From 2003 to 2014, global FX reserves grew from about US$2 trillion to US$12 trillion, or about US$1 trillion per annum. Now, these reserves have to be invested in an asset of some sort. Originally, reserve managers would have invested mainly in US Treasuries and other safe Government debt instruments. Indeed, Ben Bernanke alluded to the power of these reserve managers when he discussed the savings glut in the mid 2000s and how that depressed US yields.
Despite a small decline during the financial crisis, reserves continued to climb at a rate of US$1 trillion a year, and reserve managers began to diversify their holdings into corporate bonds, equities and direct investments. The investment of these reserve assets created a massive and continual bid in markets that very few understood at the time.
The picture is now changing, and in a potentially very bad way. Since June 2014, reserves have declined by about US$1 trillion or over US$600 billion per annum and the decline appears to be accelerating. What this simply means is that, having been a major support for financial markets up to 2014, reserve managers are now selling assets. This will cap markets gains at best, and at worst actively push prices lower.
As is always the case historically, when global liquidity (usually that means US Dollar liquidity controlled by the Fed) turns, it is the far flung parts of the world that react first. We therefore believe that the decline in reserves since 2014 matches the underperformance of Emerging Markets perfectly. As the liquidity deteriorates further, the pain begins to impact developed markets, which is where we are today.
Gillian Tett wrote about these reserve flows in the FT this past week, noting “Capital flows, fuelled by politics and policy change, are where the important action is taking place. Deep in the bowels of the system all manner of financial flows are switching course, creating unexpected knock-on effects for many asset prices.” Miss Tett goes on to say that “…but the real problem for investors and policymakers is that it is often fiendishly hard to track the scale and pace of these stealthy shifts since the data are so patchy. Indeed, the workings of China’s banking system are as opaque as the US subprime mortgage sector was in 2007.”
We agree with Miss Tett that tracking capital flows is fiendishly difficult, and so the way we are looking at this important (perhaps the most important) dynamic is that reserve managers bought US$10 trillion of assets between 2002 and 2014, and central bank policies have been boosting the market impact of those flows, both directly and via the corporate sector. The fact is that these reserves are now falling and the Fed (US Dollar liquidity trumps all in the global system) is no longer printing money. On top of this, there is a strong case to be made that the size of corporate share buy backs will decline this year.
Recognising our own limits on tracking global liquidity, but suspecting a strong connection between global FX reserves and the Fed’s QE on the one hand, and the performance of global assets on the other, for fun, we created the chart below showing the MSCI World Equity Index and global reserves plus the Fed’s balance sheet since the start of the bull market. The fit between the two is pretty close, even down to the market wobble between 2011 and 2012. Of course, the real slowing and then breakdown in equities has coincided with the decline in FX reserves.
There is much more to debate on this subject, and we do hope to tackle this more in the future. In the meantime, we would welcome any thoughts/feedback anyone has, but we do hope that people realise that, as Gillian Tett suggests, it is in the changes of capital flows where the really important action is taking place.
Chart 3 – The MSCI World Equity Index v. simple measure of global liquidity or demand for assets
So to try and wrap up, we have highly regarded economists openly stating how worried they are and how matters may now actually be worse than in 2007. We have different central banks giving different messages about the effects that lower oil prices and emerging markets are having on their domestic economies.
We have the ECB warning that the decline in oil has been so persistent that they are worried about potential second round effects (whilst admitting lower oil should be great news for household consumption and business investment) whereas the Fed insists that the effects are only transitory. We have the ECB telling us that the “heightened uncertainty about emerging market economies growth prospects, volatility in financial and commodity markets, and geopolitical risks” have increased downside risks again, whereas the Fed is officially sticking to its forecast of four more rate rises this year.
We also have evidence that the extraordinary policies pursued by central banks in recent years have had limited success in sustainably boosting aggregate demand and we are now seeing diminishing returns when it comes to boosting financial markets. Although we have little doubt that central banks will greet any bad news with even greater policy stimulus, we believe that this will only create greater unintended consequences down the road.
Perhaps William White is right when he says that “things are so bad there is no right answer. If [central banks and not just the Fed] they raise rates it’ll be nasty. If they don’t, it just makes matters worse”. We continue to believe that the best that investors can hope for is the very low returns that were delivered by mainstream assets last year. In the increasingly likely scenario that we have entered another bear market similar to 2008, then holding cash on the side-lines will be an increasingly attractive place to be.
Stewart Richardson
Chief Investment Officer
