Albert Einstein is widely credited with saying “the definition of insanity is doing the same thing over and over again, and expecting different results”. The laws of physics dictate that a particular phenomenon will always occur if certain conditions be present. So Einstein was simply stating the obvious that repeating the same process under the same conditions has to produce the same results. Star Trek fans know this to be true as Scotty the extraordinarily capable engineer famously told us that “ya canny break the laws of physics”.
So, we sit here watching asset prices trade at levels that indicate that, at a minimum, they are bending the laws of finance. There is probably not one investor/trader/analyst/commentator who does not recognise that Central Bank policies are influencing market prices so much that they are bending the laws of finance. There is not one developed country central banker who won’t admit that central banks have done all the heavy lifting since at least 2010 and that there is very little they can do to affect the future economic outcome. There is also no one who can be sure how central banks will be able to normalise policies without affecting asset prices.
Warren Buffet is credited with saying “if you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy”. We’ve been playing this game of central banks bending the laws of finance for six years or so now and yet the bull market in both bonds and equities remain the most hated bull markets in history; especially the bond bull market. So who are the patsies here? Is it the bears for not realising that financial assets can become dislocated from the underlying fundamentals for far longer than they care to admit? Is it the bulls for simply staying on board the bull market, making good returns in the short term, but seemingly without a care for potentially disastrous risks in the years ahead? Or is it the central banks for thinking they can continue to distort the price of assets with no long term consequences? Or is it the politicians who have failed to understand that enriching the rich whilst the poor become poorer risks creating upheaval?
Well, in their own way, they are all patsies. Bears have found it costly for the most part in recent years, although they may well be proved right in the years to come, which would therefore make the bulls look like the patsies. Central bankers have successfully levitated or even boosted asset prices without major unintended consequences so far, and the global economy continues to muddle through. We do worry a lot about the long term costs that have to be borne after such extreme policies. The politicians who have idled by whilst the majority have failed to participate in the post crisis recovery are at risk of “losing” as voters move away from the centre ground.
Apart from the tiny minority who will call the exact turn in financial markets, we fear that we are all patsies. Bending, or arguably breaking the laws of finance will end up with many more losers than winners. When will this happen? Well, perhaps it’s a bit like going bankrupt. At first it happens very slowly and then it happens very quickly. By this we mean that markets muddle along ignoring any and even all risks until we wake up one day facing what may well be viewed as an existential crisis. For those that have prepared for the crisis, they look like idiots until the crisis is actually upon us. For those that do not prepare for the crisis, by the time it happens, it will be far too late to take any action.
We see significant imbalances in both markets and in debt profiles and in economic policies. The European project will continue to lurch from crisis to crisis without full union. China is facing a critical point in its development after a debt fuelled surge that is unsustainable. Abenomics is failing. There is US$12 trillion of negative yielding debt in the market place. Developed economies have very high debt levels and huge future liabilities. There are too many “liquid” fund structures investing in illiquid underlying assets. All of these imbalances have to be addressed at some point and the various scenarios that will lead to resolving these imbalances simply cannot be bullish for both bond and equity investors alike, and will leave tarnished reputations in central banking and political circles. We will tackle these imbalances in future weekly commentaries.
In the chart below, we show the US equity market versus the US 10 year Government bond yield. Prior to this period, bond yields and equity price were broadly inversely correlated. This was the period of great moderation, in that lower inflation allowed lower bond yields which boosted the valuation of the equity market. Then, in 1998 things began to change and bond yields and equity prices became positive correlated. Viewed somewhat differently, during equity bear markets, bonds rose in price and vice versa, and so bonds became a great portfolio diversifier. We have called this post 1998 period the old normal.
Chart 1 – US Equity Price versus US Bond Yield 1998 to date
Then something changed in 2011 and equity prices and bond yields became negatively correlated again. Or put another way, what seemed good for bond prices (low growth, low inflation, safe haven buying) became good news for stock prices. We have called this period the new “un normal”. So what actually happened in 2011?
In the early Summer of 2011, the Fed’s QE2 programme came to an end. This was a somewhat feeble (by modern standards) US$600 billion programme which failed to ignite the US economic recovery and ended just as the European crises were erupting. By September 2011, the Fed embarked on their operation twist programme, followed by the enormous QE3 programme starting in September 2012. August 2012 was the month Mario Draghi promised to do whatever it took. Abenomics was launched in December 2012 when Abe was elected, followed by the start of enormous QE in April 2013. The European Central Bank first cut their deposit rate into negative territory in June 2014 and announced their QE programme in Dec 2014.
In hindsight, it’s pretty easy to see what changed in in the second half of 2011. Then central bank policies were failing, and all major central banks embarked on extreme and untested policies that have been bending the laws of finance ever since. In Star Trek terms, central banks have accelerated in to warp speed squared, and Scotty is screaming “she canny take it any longer!”
Does anyone really think that bond yields can continue to move lower whilst equity prices move higher? Not over the long term, but if you are bearish on either, you look like a patsy! Does anyone believe that bond yields can remain this low if nominal economic growth is above 4% (real growth of 2% plus inflation of 2%)? Does anyone believe that equities can sustain current valuations in a low growth environment and without extreme central bank policies? Do central banks believe that they can continue with such extreme policies without any unintended consequences? Do politicians really believe that extreme monetary policies alone will suddenly generate economic growth so that the man on the street feels that he is sharing in the wealth creation?
We believe that chasing markets at current prices is financial insanity, bonds arguably more than equities especially in Japan and Europe. Staying away from these markets or even shorting them may be the sane long term decision but comes at a short term cost and the risk of being the patsy. However, at some point, bond yields will start rising again and or stock prices will start falling. At some point, the costs of extreme central bank policies will become apparent. At some point, unless politicians improve the lot for the average household, they will be voted out for more extreme politicians.
We cannot predict how and when things will change, but change they must. The world of finance and politics needs to hit the reset button either by choice or through crisis. There will always be patsies in this world (there has to be one at every poker table) but the cost of keeping your long term sanity may well be being the patsy in the short term.
