Cycling Through the Unknown
Like wars, financial crises are remembered more for their human costs than the reasons they happened in the first place. A full century after the end of World War I, for example, the motives behind one of the world’s most deadly conflicts remains a mystery to most of us. The same could be said of our most recent market meltdowns. We understand the painful legacies of the 2008 crash but relatively few people know what financial engineering is and how it drove the global banking system over a cliff.
Or consider the record-setting equity drain of October 1987 which, despite its association with junk bonds and programs trading was triggered largely by growing trade imbalances and disputes over foreign exchange rates. In that way, Black Monday, as it is known, was very much of the analog-era as it implied a close link between macroeconomics and financial markets. (Just as it was a global swell of protectionism that, according to some economists, triggered the Great Depression alongside the 1929 crash.) Since then the financial economy and the real one have drifted into separate orbits. Indeed, we’ve been tracking their estrangement and its consequences for some time though we never anticipated the current tear in equity markets, which has left in its wake decidedly uninspiring rates of growth.
A market that hurtles forth so relentlessly that it leaves little daylight for day-traders is new to the current generation of market players. The prevailing cycle, as Bloomberg marveled last month, is driven by “an extraordinary level of cognitive dissonance. The ability of people to string together utterly inconsistent arguments to describe what’s going on in markets, and the world for that matter, is staggering.”
The industry seems to have divided itself into two camps: those who believe this historic bull run is due for a serious correction – read “crash” – and those who think Newtonian physics should be tossed out the window – where, if the bulls are right, it will presumably levitate until gravity re-imposes itself. Though we at Anfield remain bullish we are not so inclined to jettison the lessons of history in favor of a new, crash-free market cycle as some analysts and bloggers seem to be peddling. What drives share prices today is a triad of factors that bring to bear significant measures of uncertainty and risk: a decade-long, global stimulative program that is nearing termination; relatively low interest rates despite successive Fed increases that appear to be at odds with the bond market; and the quant and artificial intelligence programs that increasingly seem to be running the roulette wheel.
In a June 23 blog post on Seeking Alpha, Lawrence Fuller of Fuller Asset Management declared that consumers have been “duped” into thinking that a red-hot financial economy will eventually jump-start the real economy. Instead, he wrote, financial markets will continue to reach record highs “thanks to the monetary support provided by the Federal Reserve and foreign central banks … as the rate of economic growth slows.”
Fuller was referring to the debt-purchasing program launched by the Fed and other central banks after the 2008 financial crises to keep interest rates low and investment buoyant. As it turned out, the $10 trillion or so that the central banks have spent hoarding debt was invested largely in financial instruments rather than small business, plant capacity, infrastructure and other means of growth. It is that gusher of liquidity that has kept share prices aloft even as the brick-and-mortar economy has struggled.
All gushers tap out eventually, however, and the Fed has made clear it will begin to deplete its estimated $4.5 trillion stockpile of debt next year – a delicate transaction that will require a steady hand so as not to spook investors. (The European Central Bank and the Bank of Japan are expected to follow the Fed’s lead.) In a warning issued last month, JP Morgan senior analyst Marko Kolanovic clearly implied that Janet Yellen’s Fed is not up to the task. The winding down of the global stimulative program, he argued, “poses significant market risk,” echoing similar misgivings circulated by Citibank and Bank of America.
At the same time, the Fed and the bond markets are sending mixed signals. A series of interest rate hikes have failed to rattle inflation from its decade-long snooze. Not only that, the spread between short- and long-term interest rates is narrowing, a sign that investors expect growth rates to slow no matter what the Fed does. Meanwhile, yield curves have flattened to pre-election levels as markets have all but discounted meaningful fiscal stimuli out of Washington anytime soon. Absent legislation that would invigorate the economy, a market correction is inevitable. As Fuller noted: “Unless we see an unprecedented transfer of wealth from capital to labor, ideally in the form of higher wages, then I expect the financial economy will fall in line with where the real one is today.”
That leaves technology as the third prong in the pitchfork. A May article in The Wall Street Journal declared that “The Quants Run Wall Street Now,” an admission that computerized trading – at best a minor consideration in the Black Monday-era – is now very much a peer competitor to those legacy systems known as humans. It has done as much as anything to inflate the financial economy to leviathan proportions and it provides much of the thrust behind the run-up in share prices. It also represents a considerable market risk.
Let me be clear. Anfield is still optimistic about the future. We also know through experience that market cycles are like bottles of wine. Some pack an overwhelming bouquet but finish poorly, while others sneak up on you and keep beyond your expectations. In the end, they’re all bottles of wine. Enjoy in moderation.