Tuesday, 22 February 2011

A textbook example of increasing risk

One can only have sympathy for the protesters in the Arab countries, demanding democracy and the most basic of personal freedoms. The stories continue to dominate the headlines and the TV screens.

But when it comes to the effect on the financial markets, there has been a strange silence. It is as if the events have no real impact on the rest of the world and we can treat it with the same indifference as if it was a Soccer World Cup final. It makes us feel good, but Monday everything is back to normal.

I shall not try to guess where the Middle East is going. But if we look at the influence on the financial markets, a few remarks are necessary.

The risk is not skewed in the direction of a positive outcome for the stock markets. If we see a quick return to orderly conditions, possibly with democratic governments, civil rights, and rule of law, it will make us all feel better. Best of all, it will give us the same stability in terms of oil deliveries as we had before the whole thing started in January.

In terms of impacts on the stock market it is not good news that things remain unchanged. In fact, It is no news at all.

On the other hand the situation can also escalate in ways that could seriously impact us all. Trouble in Saudi Arabia, supply disruptions, new regimes with limited democratic credentials but with a serious grudge against the Western world. Now that is a situation that would make itself felt in the stock markets.

Facing a choice between several outcomes, where the best is a return to status quo ante, and all other events are worse, it simply translates into an increasing risk for trouble in the financial markets in the short term.

If we add that risk willingness has clearly been increasing in the past months, we have a convincing case for limiting exposure to the stock markets. It is interesting to see that this message obviously has not yet made it to the stock markets. The reason for this appears to be clear.

The whole chain of events has unfolded quickly. The financial markets were in a sweet spot and economists and analysts have been busy improving on their outlooks for growth and earnings, and now reality suddenly shows its ugly face. Right when we were busy doing other things.

For investors interested in timing their exposure to the stock markets, it may still be too early to exit (unless you are a high-risk, high-leverage, high-everything hedge fund manager in which case you probably already have left). The rest of us are just waiting for the stock markets to wake up. And panic.

Friday, 18 February 2011

On markets and monetary policy

Seen as an asset class, equities continue to rally on the familiar background of ample central bank liquidity and a surprisingly late rotation into equities by institutional and private investors alike. A major reason for this rotation appears to be that the return on bonds is unattractive – to say the least.

 However, in the background several trends are quietly working to change the dynamics of the financial markets. We have already described the fact that monetary policies are being tightened at different speeds in different countries. The relative performance of the stock markets shows this clearly. The countries that have already started tightening experience underperforming stock markets.

Apart from Japan – who increasingly looks like a total basketcase – USA is the laggard among the large economies and the main culprit in flooding the markets with central bank liquidity. Recent data from the US Loan Officers Survey indicate that things are changing. Banks are resuming lending activity, albeit on a small scale.

This is important news for the financial markets. It is an early indication that event the US will at some point in time begin to tighten. The discussions whether Federal Reserve will be “behind the curve” are interesting, but irrelevant in this context.

The conclusion is that the dynamics in the financial markets increasingly will be determined by the timing of monetary tightening, and this movement will reach a crescendo once the US Fed decides to rein in liquidity.
For investors it means that we cannot any longer rely on just buying stocks and commodities when the market mood is for increased risk. Or buying bonds when the market mood is for decreasing risk.

The markets/asset classes will have to be bought and sold on their individual merits. And exactly the same goes for currencies.

As an example, take Sweden. The SEK plunged in 2008 as the Riksbanken lowered interest rates aggressively. Sweden – like Germany – is a strong manufacturer and exporter of industrial goods. Sweden therefore profited nicely when the European demand began to pick up.

Now the SEK has appreciated and seems set to continue. Exports are strong. Unemployment is falling and predictably, Riksbanken is tightening as it should be. Having been one of the strongest performers in 2010, Swedish stocks are now underperforming, as the market is discounting the combined effect of higher interest rates and a stronger currency.

Take this story and compare with recent developments in China, Norway, Australia, Canada, and several other countries. The stories may differ in their details, but the main tenet is the same.

Does all of this sound way too simple? Maybe it is. But it is a clear sign that after nearly 3 years of turmoil in the markets, we are returning to some kind of normalcy.

There is, however, one European aspect that should not be overlooked. Germany is the leader inside the Euro zone. Guess who are the laggards. Just look south.

It can be argued that for a long period, Europe had too low interest rates because of sluggish German growth. Maybe we will now have a period of too high rates because of strong German growth. Creating a one-size-fits-all monetary policy is not as easy as it seems. We will hear more about this.

Monday, 14 February 2011

The New Inflation

Long time ago, back at university, I tried to make sense of the concept of “core inflation”. Consumer price inflation minus what was known as the volatile components, food and energy. I sort of understood it, but never really came to terms with it.

It is correct that by keeping the notoriously volatile elements out of the equation, one arrives at a notion of inflation that can be used in analysis of such important questions as the deflationary effects of the output gap. We have all been conditioned to believe that this is the most important way to think of inflation.

But still we have a slight problem. We, the consumers, let our economic decisions rule by the inflation as we see it in the shops or in the street. No matter how much the textbooks tell that the core inflation is the most important to watch, shop owners who increase their prices would be unwilling to let me pay only part of the increase just because the “core inflation” was lower than the headline inflation. The supermarket bill goes up and it will have to be paid, no matter where the increases come from.

So while core inflation is an element that makes sense to economists, headline inflation makes sense to the rest of the population. Including possibly even some of those working in the financial sector.

Right now we are at a point where this distinction between core inflation and non-core inflation is as important as ever. Looking at core inflation in most of the OECD area tells us that inflation is not a problem. Looking at the output gaps gives the same conclusion.

But inflation is on the rise. Food and energy prices are pulling up the headline inflation to a point where it is getting uncomfortable. A combination of financial market speculation and adverse production circumstances are working their magic.

Add a point we have made several times in 2010. Federal Reserve’s re-acceleration of the QE programme in September was bound to create asset inflation and nowhere more clearly in the comparatively small markets for commodities and energy.

The increase in the volatile inflation components have been one of the elements in destabilising regimes everywhere from Venezuela to North Africa. Following a very bad harvest, the Chinese Government is seriously concerned about food inflation – to the point where initiatives have been implemented locally to curb the inflation.

It all adds to an uneasy feeling: are we heading towards a period of inflation, pulled by exactly the elements that according to economists are irrelevant for understanding the “real” inflation? Can policymakers be forced to step on the brakes early in order to avoid inflation expectations taking hold, even if core inflation remains benign? Or, will the financial markets – in particular the bond markets – begin to take discount this inflation, no matter if bank economists tell that it is irrelevant.

The answer to this question is more important than the financial press seems to have understood. If the markets begin to fear inflation, bond yields will push upwards and threaten to put the brakes on the recovery at a time when policymakers consider using the increasingly self-sustained recovery to begin cutting the budget deficits. The combination could prove very negative for the economic growth in a global economy where consumers in the western world still need to consolidate their balance sheets.