The Financial Times has kindly printed my letter below, arguing that it seems the default answer to almost any economic question has now become “more stimulus” from the central bank.
After 15 years of subprime lending and then quantitative easing, last week’s warning from the Bank of England suggests there are fewer and fewer economic questions to which the default answer is not “more stimulus”.
But it is still disappointing to find the Financial Times supporting this reflex reaction when considering the risks associated with Brexit next month (“Bank of England must grapple with the risks of a no-deal Brexit”, February 6). Nobody would dispute that the bank has a critical role in terms of ensuring financial stability through the Brexit transition. As the FT says, the “potential outcomes are discrete and the impacts vary widely”.
But the bank has already fulfilled this role by publishing its November assessment of the no-deal risks for government and parliament to consider. There is therefore no justification for the bank to pre-emptively impose its views by deciding to keeping interest rates artificially low.
The political risks associated with such an intervention would be large, particularly if the bank’s assessment or its proposed solution proves wrong. And there is also the risk of unintended consequences.
The history of stimulus does, after all, suggest that the only certain outcome of lower interest rates would be a further rise in today’s already sky-high level of asset prices.
The pH Report
Interviewed for this Reuters article, I suggest today’s low levels of market volatility could be “the calm before the storm”
Saikat Chatterjee and Vikram Subhedar, AUGUST 11, 2017 / 5:06 PM
LONDON (Reuters) – After this week’s war of words between the United States and North Korea triggered the biggest fall in global stocks since the U.S. presidential election, investors are wondering what other off-radar shocks may be waiting to rock world markets.
Although there is little sign so far that investors are protecting themselves against a major sell-off, some say the current environment masks latent risks.
“Every day, our risk models tell us to take more risk because of falling volatility but with markets being where they are, we have to be very careful in not following them blindly,” said James Kwok, head of currency management at Amundi in London. ”So we try to project scenarios on what can go wrong and where are markets not looking.”
Such has been the extraordinary period of stability in financial markets in recent years that world stocks have hit a series of record highs while gauges of broad market volatility have plunged to record lows. That benign investment environment has been fostered by central banks which have pumped vast sums of cash into economies since the global financial crisis that began a decade ago, lifting asset prices globally.
Flows into most asset classes have already overtaken peaks reached before the financial crisis. For example, inflows into active and passive equity funds have nearly doubled to $10.9 trillion at the end of June 2017 from a September 2007 peak, according to Thomson Reuters Lipper data. Inflows into bonds have meanwhile increased nearly three-fold to $4.1 trillion in that period.
Broad market gauges of risk, such as the CBOE Volatility Index .VIX, better known as the VIX, and its bond market counterpart, the Merrill Lynch Option volatility index .VOL remain pinned near record lows despite a spike this week. But analysts say low market volatility masks the heavy weight of options written on these gauges by investment banks betting that the calm conditions will persist for a long time.
That has been accompanied by the growing popularity of inverse-volatility ETF products, which have doubled in value this year as market volatility has cratered. Morgan Stanley strategists say the volume of bets on volatility remaining low means even a small increase in price swings could force some of these leveraged bets to unwind, triggering shock waves in the financial system and sending stock markets tumbling.
Daily percentage changes are important in the volatility world because a lot of these exchange-listed products and notes are rebalanced daily based on these changes, so that any large change would automatically trigger selling pressure elsewhere.
“This is why lower volatility creates higher risk,” said Christopher Metli, a Morgan Stanley quantitative derivatives strategist in a recent note. He estimates that a 12 point rise in the VIX could send the S&P 500 index down by 3.5 percent. A move of that magnitude was last seen after Britain’s shock Brexit vote in June 2016.
But a spike in volatility is not the only scenario worrying investors.
Other risks markets may be ignoring include the implications of a messy British exit from the European Union and the risks that the Qatar crisis could spiral out of control in the Middle East and hit oil prices. Even the prospect of a newcomer at top of the U.S. Federal Reserve when Janet Yellen steps down in 2018 could prove unnerving.
“Today’s low volatility is the calm before the storm and doesn’t reflect the real world in which companies are operating, or the major uncertainties that are developing,” said Paul Hodges, chairman at International eChem, a consultancy.
Another variable is the expectation that central banks will soon start unwinding their massive post-crisis stimulus measures, with unpredictable results. One of the biggest risks seen lurking is the rise and growing influence on the world’s stock markets of passive funds, which aim to track rather than beat benchmarks and charge lower fees than their more actively-managed peers.
The proportion of stocks on the main U.S. benchmark equity index that are now owned by such passive investors has nearly doubled since the 2008 crisis to 37 percent. But redemption pressures on large passive investors could exacerbate any market selloff.
Apple Inc (AAPL.O), a stock market darling, has a fifth of its outstanding stock held by index funds with Vanguard, BlackRock and State Street making up the top three holders, according to latest Thomson Reuters data. The head of sales of a large British-based bond fund said some of its clients are trying to put together pools of money with which to snap up beaten-down stocks if a large emerging market-focused ETF is faced with sudden redemption pressures.
“We get a lot of queries on what are some of the risks that markets may be overlooking, and that is what keeps us up at night,” he said.
Reporting by Saikat Chatterjee and Vikram Subhedar, Graphic by Saikat Chatterjee and Ritvik Carvalho; Editing by Catherine Evans
Its been a great few months for financial markets. All the major markets have seen gains, as the chart shows – something that has happened only once before, since my half-yearly reviews began in March 2009:
□ Long-term US Treasury bonds have gained, as long-term interest rates have been falling
□ The 30-year bond is up 18% since March, and is up 35% since my first review in March 2009
□ Emerging Markets (EM) have also been stars – Brazil up 20%, Russia up 16%, India up 17% and China up 10%
□ Developed markets have joined the party – the UK was up 12%, Germany up 9%, US up 8%
□ Japan was the only weaker link, up just 1% as investors began to worry about policy side-effects
The key to the move is shown in the second chart from the Financial Times, which highlights the number of central banks who are now experimenting with negative interest rates – Denmark, the Eurozone, Switzerland, Sweden and Japan. Pension funds and other investors need to earn a positive return in order to meet their obligations, so there has been a frantic “search for yield”.
They have therefore rushed to buy long-dated bonds, and stock in the EMs (where yield was highest) as well as in developed markets. As Lord Rothschild, current head of the famous banking dynasty, has warned in his latest report:
“The six months under review have seen central bankers continuing what is surely the greatest experiment in monetary policy in the history of the world. We are therefore in uncharted waters and it is impossible to predict the unintended consequences of very low interest rates, with some 30% of global government debt at negative yields, combined with quantitative easing on a massive scale.
“The geo-political situation has deteriorated with the UK having voted to leave the European Union, the presidential election in the US in November is likely to be unusually fraught, while the situation in China remains opaque and the slowing down of economic growth will surely lead to problems. Conflict in the Middle East continues and is unlikely to be resolved for many years.”
These two factors are, of course, linked as I discussed on Monday.
What is particularly worrying, from a markets perspective, is the collapse of volatility. The benchmark S&P 500 Index, for example, has swung between 2157 – 2194 over the past 4 weeks, a range of just 1.7%, as investors have become complacent over risk – believing central banks will never, ever, let financial markets fall. As market analysts OTAS note, this is creating the same behavior patterns that we saw before the subprime disaster:
“Sustained periods of low volatility correlate well with steadily rising equity prices. Yet concern is mounting that the current low volatility is storing up future problems, because investors are doubling up on high share prices. By selling put options on shares and indices, thereby committing themselves to buy shares should the prices fall, these funds are exposed to an equity market sell-off through both their ownership of stock and the recently written put options.
It is perfectly rationale to sell puts if you believe that markets are rising. The concern however, is that funds are so starved of yield that they are writing puts for the short-term income benefit and relying on the world’s central banks to bail them out should stock markets take a dive. A parallel is drawn with the sub-prime mortgage debacle, when it was not the size of the market for poorly underwritten mortgage loans that triggered the financial crisis, but the vast number of derivatives layered on top that magnified risk throughout the financial system.”
The dilemma this creates for investors and companies is well summarised in Robert Frost’s famous poem, “The road not taken”:
Two roads diverged in a wood, and
I took the one less travelled by,
And that has made all the difference
Of course, central bank policies might finally be seen to work and deliver the promised economic recovery. And it is certainly hard for any investor to go against the consensus, and effectively give up on the prospect of seemingly risk-free gains, by refusing to join in the “search for yield”.
But as another famous writer, Ernest Hemingway noted in “The Sun also Rises”, bankruptcy happens in “Two ways. Gradually, and then suddenly“.
“Central banks have created a debt-fuelled ‘Ring of Fire’, and we will no doubt have felt many tremors (large and small) as a result, by the time my next 6-monthly update appears in September“.
That was my forecast for world stock markets back in March, and I imagine few would argue with it today, as we review developments since then. Central banks have spent almost $25tn since the Crisis began in 2008 in the belief they could kick-start global recovery by boosting asset markets, particularly stock markets. As then US Federal Reserve chairman Ben Bernanke explained in November 2010:
“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”
Today, 5 years later, it is hard to see why the policy was adopted. It was meant to be a temporary support, whilst economies recovered. But instead it has become semi-permanent, with the world’s major financial organisations now warning against even a 0.25% US interest rate rise next week:
What was the point of spending all this money, and building up so much debt, to have achieved so little?
Even in stock markets, the impact has been underwhelming, as the chart above highlights, showing the percentage change in major financial markets since their pre-Crisis peak:
- The best performer is the US 30-year bond, up 38%, as investors focus on the risks of deflation
- Germany’s DAX is up 26% as a ‘safe haven’ from the Eurozone crisis
- The US S&P 500 is up 24% – but has fallen 6% since my March update, with the IMF warning that prices ”are approaching levels that may be hard to sustain given profit forecasts“
- BRIC member India is up 23%, but down 13% since March as premier Modi’s reform programme seems to stall
- Japan has seen zero growth, despite its $480bn/year stimulus and 50% devaluation versus the US$
- The UK is down 8% as its London housing bubble starts to burst as foreign buyers rush for the exits
- The other 3 BRICs were supposed to lead the world out of recession – but Brazil is down 37%, China down 48% and Russia down 68%
Today’s globally ageing populations and falling fertility rate are inevitably having a major impact on the economy. But unfortunately, politicians have wanted to believe that printing money would somehow change the fact that the BabyBoomer-led demographic dividend has now become the demographic deficit of the future.
Financial market developments over the past 6 months are warning us that we will all pay a heavy price if this wishful thinking continues to dominate economic policy.
Global stock markets turned in a vintage experience last week for those who like horror movies.
Continued sell-offs in China finally convinced some financial investors, and some senior Western policymakers, that its economy might not be quite as strong as they had assumed. The ensuing panic led to record profits for the high frequency traders (HFTs), as the Dow Jones Index fell 1000 points at one very scary moment – and then recovered.
The market recovery was led by Ray Dalio, boss of the world’s largest hedge fund, Bridgewater Associates, who forecast that the US Federal Reserve would not raise rates – and would instead launch yet another round of Quantitative Easing:
“We are saying that we believe that there will be a big easing before a big tightening”
And almost immediately, the head of the New York Fed rushed to assure investors that, indeed, bursting the stock market bubble was the last thing on the Fed’s mind, saying that:
“the argument for tightening monetary policy as early as September seems less compelling to me [now] than it was a few weeks ago”.
This highlights how the role of stock markets has changed completely due to the Fed’s money-printing. They used to be a place where companies would go to raise money to expand their business. But today, companies have become the biggest buyers on Wall Street. Goldman Sachs report that share buybacks are running at a $600bn rate – around 30% of companies’ total cash spending.
STOCK MARKETS NEED MORE QE TO RESUME THEIR RISE
The Fed, like other central banks, has counted on creating a ‘wealth effect‘ via ever-rising stock markets to create economic recovery. In turn, this has encouraged hedge funds like Bridgewater to borrow heavily in the belief that the Fed would never let markets fall.
But one day, all this borrowing has to be repaid. And so Fed governors have recently tried to boost the market via speeches and press comments rather than new money-printing. But whilst talk can stop markets falling, it can’t push them higher. As the above chart on New York Stock Exchange margin debt shows, the S&P 500 peaked in May (blue line), once margin debt had peaked in April (red). And as I noted back in June:
“New highs for margin debt have not been good news for investors in the past. The astonishing surge in leverage in late 1999 peaked in March 2000, the same month that the S&P 500 hit its all-time daily high…. A similar surge began in 2006, peaking in July 2007, 3 months before the market peak.
So Dalio is therefore quite right to suggest that more QE is needed if stock markets are to move higher. But this could be a very risky move in a US Presidential election year. Populist candidates such as Trump and Sanders might well ask what had happened to the $4tn the Fed has already spent on QE since 2009.
MARKET SELL-OFF IS A WARNING SIGN FOR THE AUTUMN
Volatility on last week’s scale is normally a sign that the underlying direction of the market is reversing. The bulls are trying to take prices higher, but the bears have spotted that their firepower is reducing. This confirms the insight I was given by one money manager back in December:
“His view was that the lower oil price would help to keep inflation low, and so delay interest rate rises till Q4 2015. This view means he has to continue investing in the markets, even though he thinks they are all wildly over-valued. His argument was simple, namely that the Fed and Bank of Japan and others are forcing him to invest in stocks as the money earns nothing sitting in the bank. He is being effectively held hostage by the central banks.
“His own personal worry, having experienced the 1994 bond crash, is that whilst everyone thinks they can get out ‘before the market turns’, common sense also says everyone will try to stay in until the last possible moment, to maximise returns. Then everyone will charge for the exits at the same moment, and there could be blood on the street.”
Today, as we enter September, its hard to argue with his forecast. What happens next is anyone’s guess:
- History would suggest that the most likely outcome is for a repeat of the 2000 and 2007-8 experience, where margin debt is unwound quite violently as investors rush for the exits in a panic
- But maybe, ‘this time is different’. Maybe the Fed will not only abandon hopes of being able to raise interest rates, but also follow Dalio’s advice and go for another multi-$tn QE stimulus package
It could be a fun-packed autumn for those who love horror movies, whilst this battle is fought out in the markets.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 56%
Naphtha Europe, down 57%. “Market fundamentals are weak on signs of softening US summer gasoline demand and cuts in cracker run rates in the key export market of Asia.”
Benzene Europe, down 63%. “Prices hit their lowest point since April 2009 earlier this week amid global downward movement and the wider macroeconomic bearishness stemming from the collapse of Asian stock indices.”
PTA China, down 47%. “Market fundamentals remain weak”
HDPE US export, down 34%. “Domestic export prices continued to drop, as suppliers ran after demand in offshore markets.”
¥:$, down 19%
S&P 500 stock market index, up 2%
Crude oil prices continued to fall towards $30/bbl last week. Markets are finally starting to recognise, as the BBC reported last year, that ‘China fooled the world‘ with its stimulus programme. It had not suddenly become middle-class by Western standards in 2009. Instead, aided by developed country stimulus policies, its own stimulus had helped create a commodity super-bubble to rival the dot-com bubble in 2000 and the subprime bubble in 2008.
Now financial markets around the world are being hit by the contagion from the unwinding of this bubble. China’s Shanghai index is down 38% today from its June highs. London down 8% from its August peak; Frankfurt down 13%; and the US S&P 500 was down 6% in the week.
The problem is that much of the buying of oil and other commodities has been done on margin. This risks creating a vicious circle, as buying on margin with borrowed money can be a very dangerous game . The reason is the way that margin works to magnify gains, or losses, from your trades:
- On the upside, you can invest $1m in oil futures for just $100k, if you use the standard 90% margin. If prices then go up $1/bbl, you have made a lot of money with your $100k
- But if prices go down $1/bbl, you now have to either close your position and hand over the $900k you have lost, or put in more margin
This is what has been happening in recent days. As oil and other commodity prices have continued to fall, so the speculators have either had to sell their positions at a loss, or provide extra margin. In turn, this often meant they had to sell something else to raise the necessary funds. And all of this has to be done in a hurry, as margin calls have to be paid in full each night as the market closes.
This would be bad enough. But in addition, much of the buying of stocks has also been done on margin. This is exactly the contagion risk that concerned me a year ago, when I worried that developments in China could lead to a downturn in global financial markets:
- “The prices for those metals and other commodities caught up in the trade would be hit first
- Mining company shares would also be hit, as people worried their vast capacity expansions were wishful thinking
- Investors may put 2 and 2 together and worry, as the BBC described in February, that “China Fooled the World”
“Next to be hit could be other financial markets. Complacency and low interest rates have encouraged investors to borrow heavily. Each night, therefore, they might start to receive margin calls as prices for their commodity-related investments decline:
- Some investors might decide to sell out, pushing prices further down
- Other investors might need to raise funds by selling non-commodity related investments
- At the same time, buyers might then immediately disappear for anything that appears to be high-risk
“A third phase of the downturn could then develop in our globally-linked electronic world:
- These forced sellers might have to sell in more liquid markets to secure the cash they need
- This would mean selling blue-chip shares and high-quality government bonds
- In turn, investors who have borrowed heavily to invest in these markets would then start to receive margin calls
“The risk is therefore that major declines could then take place quite suddenly in a number of major financial markets, just as Hyman Minsky would have forecast:
“His insight was that a long period of stability eventually leads to major instability
- This is because investors forget that higher reward equals higher risk
- Instead, they believe that a new paradigm has developed
- They therefore take on high levels of debt, in order to finance ever more speculative investments
“As in 2008, another ‘Minsky moment’ could thus occur as ‘distress sales’ start to take place.“
As the chart shows, the contagion has also been impacting the major chemical markets. They have been signalling for some time that all is not well with real demand, with operating rates well below pre-Crisis levels. Now we are seeing prices fall across the board, and revisit January’s lows, as buyers retreat.
Of course, markets may stabilise in September as people return from holiday. But the risk is that the recent head-fake rally in crude oil has left companies with high inventories, as they bought ahead of rising prices.
With demand in China and other emerging markets now weakening very fast, these inventories may take time to run down. In addition, last week’s report that Jurong Aromatics is in talks over debt restructuring, highlights the potential for wider disruption of supply chains if companies cannot wind down their inventories profitably.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 55%
Naphtha Europe, down 56%. “Gasoline demand soft amid high Nigerian output”
Benzene Europe, down 55%. “the downturn in Asia appears to be driven by sentiment and some panic among market players.”
PTA China, down 43%. “prices continued to fall amid a weaker upstream energy structure and bearish sentiments in the downstream polyester market.”
HDPE US export, down 27%. “Competitively priced cargoes from North America dampened the market’s confidence. However, traders were unwilling to accept those deep-sea cargoes due to the uncertainty of the Chinese yuan exchange rate”
¥:$, down 20%
S&P 500 stock market index, up 1%