Investors have just suffered through a second week of angst around the looming “end of easy money”.
For those of you really worried about an impending crash, you have a wonderful choice: would you like the risk of losing money very quickly in riskier asset classes such as shares, or slowly but definitely losing money in cash? With negative real cash rates around the world — including here — I would suggest that at this point people will stay invested until they are absolutely forced out. How the global economy performs is shaping up as the key catalyst either way.
Emotions are running particularly high around what many see as a global turning of the monetary tide. The US Fed is talking more rate hikes and shrinking its bloated balance sheet. The Bank of England is conflicted, but seems e more inclined to lift rates than a few weeks back. The Bank of Canada might even raise rates this week. The Bank of Japan is not really making any noises. And then there’s the European Central Bank.
Investors have just suffered a second week of angst around the looming “end of easy money”. The European Central Bank’s minutes released on Thursday night from its last meeting reminded folks that European policymakers were keen to pull back from their extraordinary monetary stimulus measures. And fair enough: the European Union will likely grow faster than the United States this year, the second in a row. Unemployment has been falling. Banking risks have dissipated.
Still, markets reacted quite strongly to talk of another “taper tantrum” in the works, and investors dumped bonds. German bonds hit their highest in 18 months, shooting to — wait for it — 0.56 per cent. More worryingly, sharemarkets dropped with bond markets. This is not good news — they should move in the opposite direction. Indeed, the 20-day rolling correlation between the local sharemarket and Aussie bonds flipped to being positive for the first time since the start of the year.
Why would higher global rates hurt shares? At this point, some context might be helpful.
Let’s have a look at the world’s biggest economy. America’s addiction to credit began in the early 1980s. That was when central bankers stopped worrying about debt levels and instead focused on measures of consumer price inflation, Citi’s credit strategist Matt King says. Instead of the usual excesses appearing in CPI, it was in asset prices that the inflation wildfire took hold. That situation continues to this day.
More extreme moves
Closer to home, China’s credit addiction began much more recently, in 2009. As a proportion of GDP, total credit went from one and a half times in 1982 to three times today. In China the moves have been even more extreme: the real credit-to-GDP ratio moved from two in 2009 to six today. The world’s two most important economies are hocked to the hilt.
King makes a good case for how ramping lending growth around the world drove asset prices higher. But he believes this “wave of credit” has peaked. Crucially, rather than the total level of lending, King focuses on what he calls the “credit impulse”, or the change in the rate of growth, as a primary driver of markets.
That credit impulse is on the wane, he says. If the US Fed stops replacing a portion of its maturing bond book and the ECB begins to cut back its monthly bond buying, then the synchronised tightening will reduce the securities purchases by global central banks from a 12-month rolling average of $US2 trillion to around $US1 trillion, King estimates. And if all central banks shrink liquidity together, rates in fixed-income markets could rise significantly, with a nasty spillover effect on equities.
Is the risk of an end to the credit tailwind enough to stop people buying equities? At what point do professional and individual investors decide they would be better off heading out towards the exit before it gets too crowded to escape unscathed? So far the lead strategists at major investment banks are telling their clients to stay in the market and await the last hurrah. It’s an easy message to sell — after all, where else are savers supposed to go? In many markets, after inflation you are likely to lose money on cash. At best, break even.
Admiring the tight relationship between the credit impulse (driven by central banks) and the performance of various equity, fixed income and property markets, Citi’s King wonders: “Who needs fundamentals when the fit is this good”.
Back to fundamentals
By fundamentals he means the raw data that should be the key ingredients for asset price performance: things like earnings growth, the economic cycle and the jobs market. Who needs to analyse that stuff when it’s all about credit growth?
In a very broad sense, he might be right.
But I would argue that right now the fundamentals matter more than ever. As central banks threaten to take away stimulus, investors are trying to gauge whether the underlying real activity is enough to keep things on an even keel.
As Warren Buffett famously said, it’s “only when the tide goes out do you discover who’s been swimming naked”. Expect a lengthy array of such “swimsuit” tests.
Societe Generale strategists note, rather less pithily: “Rising interest rates in the absence of improving growth sentiment or, in the worst-case scenario, rising inflation expectations and declining real yields, is problematic for equities”.
That’s why you should probably be a touch worried that the Citi economic surprise index — which aggregates actual data outcomes versus expectations — has taken a sharp turn for the worse in the US. And it’s why you’re better off putting money in Europe where the cyclical upswing is at an earlier stage.
Central banks will tighten policy for as long as the economic cycle allows. The risk of a policy error is higher. Investors should ignore shrill narratives, and watch the numbers instead.