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Macro matters: Positions of fragility not strength

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Are investors behaving complacently, ignoring the warning signs of markets still reliant on central bank generosity?

Key points

  • Markets are celebrating a decade of strong returns since the global financial crisis
  • A gulf has grown between financial markets and the real economy
  • Low volatility reflects a herd mentality
  • Th is equilibrium is likely to be transient at best

This year marked a decade since the global financial crisis. And 10 years on, notwithstanding the tepid growth and social challenges of recent years, markets are celebrating a decade of positive returns.

Since June 2007, the S&P 500 index has doubled once dividends are taken into account and its total return is over 70% in real terms. That is an annualised return of 7.2% in nominal terms and 5.5% in real terms for those that bought at the highs of the last cycle and held through the pain to today. 

Take it from the bottom of the cycle and returns are even greater. The annualised total return is 17.4%, thanks to a near tripling of the index from its March 2009 lows. 

We see the same pattern repeated globally, with investors across almost everything (barring commodities) making stellar returns. 

Yet, economically, the recovery since 2007 has been tepid and disappointing. GDP growth has been consistently below expectations, productivity has been abysmal, wage inflation has never really taken off and sentiment – consumer and business – has been mixed at best. Inequality has risen in more than half the world’s countries over the last three decades and for the majority of its population. In October, a new paper by Olivier Blanchard and Larry Summers, former chief economists at the International Monetary Fund and World Bank respectively, forecast that by 2019 GDP per head in the US will have recovered less in the dozen years since the financial crisis than it did in the same period following the 1929 Wall Street crash. 

Jingoism, protectionism, nationalism – any and every form of economic self-interest – are also on the rise. Over the weak economic data hangs a host of socio-political concerns such as North Korea, the Catalonian secession, Brexit, the rise of populist and often authoritarian parties, stalled reforms, trade disputes, Russia and so on. 

To put it bluntly the world is miserable rather than euphoric.

This is not another analysis of why. We have previously discussed the role of central banks in supporting markets, the spill-overs of quantitative easing and the impact of artificially suppressing the yield curve, particularly on investor behaviour. 

Rather, this is an exercise in what direction now.

Risk versus uncertainty 
It does not pay to be a bear these days. The gulf between a world rife with uncertainty and racked by populist tension, and the euphoria of markets has created a bear trap. 

As talk moves from quantitative easing to tapering and tightening, a divergence has appeared between economic uncertainty and financial volatility. This is borne out by hard data. 

Policy-related economic uncertainty is associated with increased stock price volatility. But over the last few years, the two have diverged. Economic uncertainty has risen and barring the recent spike associated with Brexit and Trump’s election win, is at elevated levels more typically associated with financial turmoil. In contrast, volatility is hitting all-time lows. 

The trend is clear and the gap today is stark. The implication is one of complacency. Financial markets are ultimately yoked to the real economy and over the long run, their behaviour must reflect underlying economic reality. 

Either uncertainty must fall to match expectations or volatility must rise to reflect the dilemmas facing policymakers.

The question is which path do we take. 

Since the last financial crisis, central bank monetary support has first sustained markets and increasingly led investors into a sense of security. Forward guidance has accentuated this, and even as uncertainty has grown, the belief that policymakers will muddle through and support markets has led to the chasm we observe. 

The age of euphoria
Cheerleaders will tell us that we are on the path to normalisation. 

Returns are there, systemic risks have ebbed and even inflation is welcome as a sign of returning to more mundane concerns than the collapse of the financial ecosystem. The US and European economies have recovered and showing signs of sustained growth. Defaults have fallen and though change is in the offing, such as in the retail sector, that is thanks to the engine of creative destruction as technology drives our societies and economies forward. Brexit is an idiosyncratic self-inflicted outlier.

The VIX index showcases this perspective, touching all-time lows in 2017, and flirting with single digits for most of the year. Yet, of all the pieces of evidence in support of a renewed normal, this is by far the most terrifying. 

Financial markets are not static entities. They are collective nouns for the actions born of the hope, greed, and fear of countless human participants. What they portray is emotion as much as any economic reality and the volatility that we observe is driven by the competition between these emotions. Different worldviews vie for dominance, coalescing into temporary paradigms – transient accepted wisdoms – that ebb and flow over time, euphemistically creating the peaks and troughs of volatility we see. 

From this perspective, the (near) absence of volatility is not a boon. It is a reflection that there are no competing world-views. What we are seeing is clear signs of a herd mentality that has developed over the last decade. The lows and the sustained period spent around them are below the depths observed pre-crisis and, going further back, below those seen in the 1990s. 

That is a sign of fragility, not strength – particularly when set against the growth in policy uncertainty. 

In the last couple of months, seven G10 central banks have talked hawkishly or indicated the time may have come to move away from extraordinary policies. Markets may have acquiesced to the thought of quantitative tightening, but do not appreciate the stark trilemma facing central banks. 

Many central banks a decade on are still struggling with fragility, as noted earlier. At the same time, debt burdens beneath the surface have risen significantly, with total global debt exploding from $70trn (€60.4trn) in 2007 to over $105trn today. 

Central banks face an unenviable choice. Do they maintain dovish practices to support their economies or yield to the growing dangers of doing nothing? 

And then there is the need to build up the capacity to fight the next inevitable recession or even worse, crisis. In a future downturn, central banks have little leeway to cut rates or unleash further quantative easing, particularly given the growing criticism of these policies. 

The likelihood of being behind the curve is high. The US Federal Reserve has begun talking of the neutral interest rate being lower in the coming cycle, an unexpected vibe of dovishness, even as other members stress the need to reduce the balance sheet. 

These are indicators of potential problems. And coupled with the low volatility we observe today, they demonstrate a worrying sense of complacency. 

Investors have derived a simple correlation between monetary accommodativeness and rising asset prices, even in the face of uncertainty. But, there is no mathematical or economic relationship between the two, merely a psychological link based on perception and faith. Based on the data, it is clear that it is fraying behind the scenes. 

Equilibrium is transient at best and the exception, not the rule. The constant fine-tuning by policy makers and the role of sentiment evidence the dynamic nature of our stability. 

It should not be mistaken with permanence. Given today’s populism and policymaker obsession with inequality, the next bailout may be directly to society and not to investors.  

Dr Bob Swarup is Principal at Camdor Global Advisors, a macroeconomic, investment and risk advisory firm focused on complex balance sheets and holistic analysis. He can be contacted on swarup@camdorglobalcom

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