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Didn’t wait for the bear market to announce its safe arriva

By David Scott | Monday 10 July 2017


Markets are starting to adjust to the idea that interest rates are going up and they are now questioning exactly what this means. This generally means less risk-taking, which means lower asset prices. We are at a point where small shifts in absolute terms have an outsize relative impact. If interest rates rise from 5% to 5.25%, that’s not a big move. But if they rise from 0.25% to 0.5%, they’ve doubled. 

Supposedly free markets around the world are currently hanging on the word-by-word nuances of a few key Global Central Bankers meetings in global capitals. The economy is not a price setter nor are corporate reports. What really matters is a raised eyebrow from Draghi or a furtive cough from Janet Yellen at the US Federal Reserve. For now though, the default view seems to be that central banks are making a “mistake”. By mistake, the market means anything that might stop stocks from going up in a straight line. Because as investors have learnt since 2008 this is the key role of a central banker.  If evidence doesn’t start to confirm inflation or economic strength or rising wages, or governments don’t step into the void on such poor news then we will start to see panicky volatility return to markets.
While markets are busy worrying when the European Central Bank will announce plans to taper its bond purchases, but the move may have already begun, according to ABN Amro. It believes that the central bank’s buying of German debt has remained below capital-key guidelines, which require purchases to be broadly in line with the size of each economy, for the last three months. The ECB has been underweight in Finland for six months and the Netherlands for two and may have scaled back buying of core European bonds on approaching the 33 percent issuer limit, asset purchases data for June show.

A shortage in core government securities, while somewhat offset for now by the ECB’s overbuying in France and Italy, could increase pressure on the central bank to officially start tapering even if inflationary pressures remain subdued. The monetary authority has removed a yield floor for its purchases, which allowed it to buy lower-yielding German debt and reduce the weighted average maturity of its holdings to a record-low 3.99 years in May.
In its latest annual report, published last week, BIS warns about the serious debt-related vulnerabilities in today’s global economy. At a time when financial markets and most policymakers are complacent, BIS highlights asset price bubbles and poor banking practices across some of the world’s major economies. The principal BIS concern is that global debt-to-GDP levels are, on average, some 40 percentage points higher than before the 2008-09 global market meltdown. Equally troubling is that debt levels have increased by even larger amounts in a number of systemically important countries. BIS notes that since 2008, overall debt-to-GDP levels are up by 50 percentage points in Japan, 70% in Canada and France, and by a colossal 190% in China. The Anglo-Saxons have been slightly more restrained – the UK debt-GDP ratio is up 36%, that of the US up 29%. But these economies were already carrying heavy debt burdens when the financial crisis struck.
Thomas Jefferson was strongly against government debt because he believed that it was a way for one generation to steal from another generation.  And he actually wished that he could have added another amendment to the U.S. Constitution which would have banned government borrowing. “I wish it were possible to obtain a single amendment to our Constitution. I would be willing to depend on that alone for the reduction of the administration of our government to the genuine principles of its Constitution; I mean an additional article, taking from the federal government the power of borrowing.”
For years after the financial crisis any bad news was seen as good news in markets, because any economic weakness meant a higher chance of money printing  and that pushed the price of shares and other assets upwards, but now the mood music is definitely changing pitch. The Bank of England was restructured after the financial crisis to try to enable it to address bubbles in individual markets, so it has more options than just raising interest rates, a blunt tool which affects every market, when it comes to limiting growing risks in the economy. Carney and his colleagues on the Financial Policy Committee hope that gradually restricting excesses in the market will take the edge off the boom and prevent a crash later. In either case of a slow deflate or a sharp sell off, this bull market in equities is drawing to a close.

Today, we are living in the terminal phase of the biggest debt bubble in the history of the planet.  Every debt bubble eventually ends tragically, and this one will too. Bill Gross recently noted that “our highly levered financial system is like a truckload of nitro glycerin on a bumpy road”.  One wrong move and the whole thing could blow sky high. Low rates have both kept the lid on debt servicing costs, creating the illusion of affordability, and help mask the renewed risks in the financial system.As central banks contemplate tighter policy, they do against a backdrop of neutral underlying price and wage inflation. The usual signs like supply constraints and overheating – are all absent. Rather than producing higher wages, a decade of monetary stimulus has created (MOAB) the mother of all asset price bubbles.These are feed corn for the next financial crisis, which is currently brewing. 

In a bull market and particularly in booms the public at first makes money which it then later loses simply by overstaying the bull market.

David Scott is an Investment Manager & Market Commentator at Andrews Gwynne

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