"We're doomed, well that's a relief!" - What happened to behaving rationally?

                      

                           It’s been just over a week since my last post, and it’s been quite a week. As mentioned in last week’s blog the market decided that the potential end of the Fed stimulus was enough to reach for the sell button on almost all assets globally. In the days following the announcement, the major global equity indices dropped as much as 7%. Bond Yields rose as investors predicted rising interest rates of the back of reduced stimulus, and Gold dropped (and continues to drop) to levels not seen in years. The overnight Shibor rate (That’s the interest rate that banks lend the Chinese Yuan to each other at for overnight lending) spiked whilst predictions for Chinese growth were cut to be close to the 7% level further worrying investors in the west that growth in the developed world would be worse off as a result. All this while the markets continued to stomach the fact that the Fed might reduce stimulus should the economy improve. In the words of Dad’s Army’s Private Fraser, you could imagine traders running around the floor screaming "We're Doomed”!!! Then at the weekend the Bank of International Settlements (effectively the central bank’s central bank, although it has slightly darker past in history) released its annual report proclaiming that central banks around the world had done their bit in using effective monetary policy (zero bound interest rates and QE) and it was now up to governments to work harder to save the economy. The markets digested this in addition to everything else as a sign that all central banks were going to begin to reduce their stimulus further.

                            As has been the habit over the last 4 years, just when the markets were going round screaming “We’re Doomed”, the central bankers (or guardians of the financial world as I referred to them in my first blog), went on the defensive to rescue the situation. Mario Draghi of the ECB reassured the world that their monetary policy would "remain accommodative for the foreseeable future" with any exit in the "distant future", while soon to step down Bank of England Governor made similar noises clarifying that from the BoE's perspective that while eventually QE will need to end, and interest rates return to normality, "that point was not today". This along with several Fed board members coming out and clarifying that stimulus would only be reduced should things actually improve served to calm the markets and set equity markets back on an upward trajectory again. This was all simply clarifying and reassuring investors on something which I picked up on quite clearly from Bernanke's original comments last week.

                      If the initial comments all seemed so clear to me originally, why does it seem that professional investors (effectively the majority of the market), react in such a panic and so negatively, only to come to their senses after several guardians have explained it to them in plain English? Several commentators in the US have referred to the fear of the "punch bowl being taken away" from the markets. As we spoke about in the first blog, the fear that what is currently driving the markets is the alcohol being fueled through by the Feds QE. If they take away the alcohol, they may not be able to enjoy themselves quite as much and a sense of reality might settle in and things won't seem as rosy as we've made them seem. The problem with that is, continued over consumption on the alcohol will only lead to alcoholism and we won't be able to stop wanting to drink.

                   The market as such is in danger of being severe alcoholics, addicted to the stimulus as a way to turn away from reality. By continuing to want to receive the stimulus, even when things appear to be recovering, they are ignoring the signs that they might not need it any more. This was no better clarified when all US markets rose steadily on Wednesday off the back of US GDP growth for the first quarter only growing at 1.8% instead of the originally reported 2.4%. An ecstatic, almost celebratory, response to the fact that things aren't so great after all, and it might be a while longer before the punch bowl is taken away! "Phew! Well that's a relief! e're still in a bad place." And here was I thinking that bad news was the real reason to panic! As a result of this most markets have now rebounded significantly since last weeks falls to sit, as of last night, only 2-3% off where they were before the Fed announcement. Yet to get there you were looking at absolute movements of between 7-10%.

                     When I was first starting out, it was always intriguing walking down to the trading floor on the days when something truly worrying had happened and markets around the world started tumbling by 1.5-2%. You'd see panic and fury all around and would do well to avoid being hit by whatever object was being thrown in despair. But at least it was clear as to why markets were reacting the way they were (and you knew which traders to avoid.) Nowadays we're in an environment where bad news is good, and good news is......well it depends how the market feels on the day. It feels as though if chicken licken were to wander round and tell them the "sky was falling in" it would be welcomed with a great cheer!

                    It's like the child who doesn't want his parent to leave him behind because of work and is happy when some disaster occurs to keep the parent at home, even though actually the child would rather strive to have that independence to do what they wanted. From that perspective it's time to grow up and strive to get that independence back. Let's assist the the central bankers in weaning ourselves off the alcohol and look to what can be done, and what we know, instead of aimlessly speculating about impending doom before changing our minds every few weeks.

So what do we know for now?

             The US economy is growing - it has grown every quarter now since Q4 2010. It's not out the woods yet and is in a delicate situation, but the signs are there that the recovery is moving along. The Fed,as clarified by several members this week, that should it continue to improve then it doesn't need additional support and we can begin a long road to return to normality, but is there to help to try to keep it going should it stutter.

                     The UK and the Eurozone on the other hand are more of a concern. The eurozone is still in a recession with 6 consecutive quarters of decline and unemployment at 12.1%. Meanwhile the UK has only very narrowly avoided entering into a "double dip" recession at the end of last year and has just announced further austerity measures to try and reduce the large debt being accumulated. For these 2 there is no doubt there is a long slow road ahead with potential bumps along the way. But then we knew that was going to be the case for some time, which is why the ECB and the BOE have given no indication of any impending stepping off the QE gas.

                     It's time for the market to get back to looking at the fundamentals and behaving accordingly, instead of wild speculation. Efficient markets should price assets based on all publicly known information. If that were the case then we shouldn't see the extreme panic and sudden recovery evident in the past week, something repeated several times over the past 4 years. Let's not celebrate when things look shaky in the hope that we continue to get free booze, and let's react positively (within reason) and rationally to the good news again.

                    There's still cracks in certain parts of the sky, but then that's because it almost fell down a few years ago. The plaster put up to keep it from falling in is still in the process of drying.....but no one is talking about tearing it down, just about leaving it alone to dry in the parts that don't show the cracks any more.

                         Could Private Frazer and Chicken Licken be right? Not from where I'm standing, but we just might need to be a little more patient in waiting for the plaster to dry. If we remember the basics and judge things on what we know, then we might look at things with a much more rational perspective.

The Economy's heading in the right direction.......Don't Panic! Don't Panic!

"Don't Panic! Don't Panic!"

             The famous phrase often heard shouted by Lance-Corporal Jones in the 70's comedy Dad's Army. For those of you not familiar with the show, it was set in an English village in World War Two showing the events encompassing the home guard for that town. In most episodes some minor disaster begins to unfold and Jones runs around trying to keep everyone else calm by panicking himself and screaming "Don't Panic! Don't Panic!" This is kind of what I feel is happening in the markets at the moment. The major difference being that the equity markets are actually panicking at the suggestion of an improving economy!

          Yesterday, Federal Reserve chairman Ben Bernanke spoke about how the Fed was potentially going to look to reduce QE in the coming months, potentially ending it completely in mid-2014. The reaction of the markets......all 3 major stock market indices in the US (S&P500, Dow Jones & Nasdaq) dropped between 1.1-1.39%. The main Asian markets slid over 1.5% on average this morning, whilst European markets are on the whole currently down over 2% as I write this. This reaction was inevitable, as I mentioned in my previous blog, because, to put it using the same analogy, the kid feels that he's going to fall of his bike just because the parent has suggested they might remove their hands from the handlebars. Lance-Corporal Jones is running up and down the S&P500 and global markets screaming don't panic and hitting the sell button!

     But should we be panicking? After all the Fed is potentially going to reduce some of the stimulus into the economy, how will it survive without it. Well firstly markets really need to think a bit more rationally and calmly about what Bernanke actually said.

Bernanke posted predictions for 2014 of US GDP growth (the main indicator for the economy) between 3-3.5%, US unemployment falling to between 6.5-6.8% (it's currently at 7.6%) and inflation being close to the long term Fed target of 2% at between 1.4-2% (it's currently at approximately 0.7%). Bernanke then said:

“If the incoming data are broadly consistent with this forecast, the committee currently anticipates that it would be appropriate to moderate the pace of purchases later this year, we will continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year." 

However he then went on to say:

“If you draw the conclusion that I just said that our policies -- that our purchases will end in the middle of next year, you’ve drawn the wrong conclusion, because our purchases are tied to what happens in the economy, If the economy does not improve along the lines that we expect, we will provide additional support.”

       So to be clear, if the Fed believes that the key economic indicators mentioned above roughly become inline with what they've forecasted, then due to the improved economic performance they can begin to reduce the amount of QE (bond purchases) being used each month. The hope being that by the middle of 2014 they will no longer need to be pumping extra money into the market through asset purchases. The second part of the statement more importantly says that they are not definitively going to end QE by that point, and for the market not to draw that conclusion because, in his own words "If the economy does not improve along the lines that we expect, we will provide additional support".

        In my view, the market should be embracing what the Fed has come out and declared. It should be a reason to be optimistic about the future, with indicators showing that the US economy is improving, albeit slowly for now, but on an upward trend. What Bernanke has come out and said is that the Fed believes the economy will improve significantly in 2014, and if it does so, there is not the need to keep the hands on the handlebars. If inflation is able to remain stable close to the 2% target on it's own and unemployment is at a more acceptable level, with GDP growth pointing towards a potential for further reduction in that unemployment number, then there is no need for that stimulus to be continuously provided. They would view the economy as being in a position to stimulate itself into gaining further momentum and surviving on its own. If we go back to the bikes, if the parent sees that the kid can ride the bike, then holding the handlebars still will only hold the kid back. Let's let go of those handle bars gradually and see if the kid can pedal themselves and stay upright. We can always grab the bars again.

        If we're not seeing the progress as we want to see then the Fed is going to continue to go with QE. But even if it ends QE, it has not indicated that it is actually going to start reducing the money supply, it has indicated that it is just not going to continue to increase it every month through QE. The next obvious step is that it will begin to increase interest rates, and perhaps this is what the market is concerned at. But there's been no clear indication that the Fed has even broached this.

     The market should stop predicting the worst, when this hasn't even been indicated, and concentrate on what the figures are telling us, and more importantly what Bernanke has actually said and what this means. To quote from The Shawshank Redemption, one of my favorite films, we have a choice, "to get busy living or get busy dying".(Spoiler.....don't watch the link if you haven't seen the film!!) Things are still tough out there, but it's time to "get busy living" and look towards the positive indicators that things are looking up and stop panicking at what might go wrong.

Don't Panic! Don't Panic! Or in the words of the motivational posters from Britain in the second world war, Keep Calm and Carry On!

Have the financial guardians created an inescapable cycle?

     Whilst I'm sitting at home contemplating the next steps in my career path it occurred to me that with all the time spent looking at financial data for personal reasons, it may be worth sharing my thoughts via a blog. Who knows, I may even get a following out of it!

     I've spent quite a bit of time since my enforced retirement reading the thoughts and advice of financial gurus such as Bill Gross (chief exec of PIMCO - don't think he's any relation), trying to gain a greater understanding as to what exactly is going on within the markets following the period now known as 'The Great Recession'.

             Interest rates are currently at record lows and seemingly not going up anytime soon, whilst most developed economies continue to only chug along keeping their heads just above water in terms of GDP growth (that is if they are even growing at all). However equity markets are continuing a march towards record levels and beyond, with the S&P 500 and Dow Jones in the US hitting new index level highs in the past few weeks. The FTSE 100 in the UK also got to within 0.8% of the all time high of 6,930 set during the tech boom in 1999. In a normal recession you would traditionally look towards the equity market rising as an indicator that we are on our way to an improving economy (cause everyone assumes institutional investors know something the rest of us don't!). Here the buoyancy with which the market has gone towards highs does not seem to be a reflector of this. Various market analysts are suggesting that stocks are still "cheap" with respect to the earnings that have been posted (both in the past year and predicted) but this doesn't really tally with what is going on in the real world and the man on the street.

          However a lot of the commentary around the reason for this renewed spike in equity markets centers on the fact there simply isn't enough "safer" investments for investors to put their money into which are also going to give a level of return above inflation. This is due to traditional safe haven assets such as US Treasuries and UK Gilts having their yields pushed to close to zero, so investors are having to look elsewhere and look towards more risky assets classes to get any return, the most traditional of those being equities. This is as a result of an effort by the financial guardians (central banks) to try to stimulate the economy, which has been going on for a few years now.

        Traditionally, using monetary policy, the main way to stimulate the economy is to reduce interest rates (which in effect should discourage people from saving as they get nothing for their money and instead invest it in various activities which in turn hopefully leads to an increase in production). However with the existing recessionary period, interest rates are already at all time lows (and in many cases close to zero) so this as a policy is no longer working on its own to encourage investment. (This is a by product of the current recession also having a banking crisis but I fear going into any more detail on that one unless we have a 20 page blog!! Maybe another time.) As a result, some of the leading central banks (the main actors being the Fed in the US, the ECB in the Eurozone, Bank of England & Bank of Japan) have resorted towards a measure known as QE (That's quantitative easing, not Queen Elizabeth - although some might say she'd have just as much chance of reviving the world economy!).

          In a very small nutshell, QE is where the central banks use a set amount of money each month to purchase additional assets to those they would normally buy in creating money supply. Normally the central bank would control interest rates through the purchase (or sale when looking to increase interest rates) of short term government bonds. With QE, the central banks are now purchasing a set amount of more risky assets such as longer term bonds and even Corporate Bonds and Mortgage Backed Securities (think things which helped caused the credit crunch). This results in an increase of the money supply each month which in turn should be used by the banks to increase lending which in turn it is hoped will lead to greater investment in real assets. If it all goes as planned, then hey presto, the economy grows and you can start reducing central bank intervention (and QE) and going back to how things were.

      Potentially the biggest problem created by this is how the central banks pull back from QE once (or if) the economy is back on enough of a forward footing (or indeed if inflation starts to get out of control). As I've already mentioned, this extra money into the economy has served to assist in driving the stock market over the past couple of years in the lack of any substantial positive corporate data to back it up. Most commentators agree that QE has worked with respect to stopping the various economies from completely spiraling out of control and has acted to ensure that a prolonged depression hasn't occurred. Eventually there will need to be an easing off of QE, before it is withdrawn completely. This could happen sooner rather than later with murmurings coming through that the Fed is already considering scaling down it's bond buying scheme (there still remains fear of the long term inflationary effects of the policy). The issue is, even just with these whispers from certain Fed board members, equity markets have seen falls of 1-2% on those days that such news came out. If it starts to become a more real possibility of a reduction in QE then the prospect is that equity markets would begin to fall even further to the point where we could start to see an adverse effect on the real economy. The Fed then without having had the opportunity to begin to raise interest rates again is forced to go back to a renewed bond buying program in order to restore confidence in the economy (and the markets) and round we go again. Except perhaps this time even more stimulus is required to encourage investors that central banks won't withdraw support so "quickly" next time, becoming even harder to withdraw that support in the future.

      It seems to me that we may have created a financial system where we have given it so much support it feels unable to cope on its own. Compare it to the situation where you are teaching your kid to ride a bike. The first time you take the stabilizers off he falls and hurts himself after a short cycle. He's then afraid so you agree to hold on for a bit longer this time, but when you let go he is too afraid and wobbles and falls off again. The next time he wants you to hold on for longer and this time when you let go at the first wobble you grab the handle bars again to prevent him getting close to falling. By now, he's so afraid that he's always going to fall over that that you can't let go at all because if you do he fears he'll fall over straight away.

            It's not the greatest analogy, but it's kind of where we are at now. The trouble is with many of the steps the central banks (and governments) have tried to take to stabilize things, investors feel they now cannot survive without the lifeline that's been provided. When Lehman Brothers collapsed the financial world went to the brink of the abyss because governments gave the impression before that (with Bear Sterns, Fannie Mae, Freddie Mac etc.) they would always assist in stopping large financial institutions going bankrupt. After the collapse they then had to act to show they wouldn't let the same thing happen again. The same with the euro crisis where the mistakes weren't learned. Greece could have been made an example of  (as the first one) but instead gave the impression that any country would be rescued even if it would drag the euro down. In fact it has even now got to the point where Mario Draghi (ECB chairman) has said they would "do whatever it takes" to save the eurozone.

               And so with QE, what was a necessary measure to stabilize the global economy at the time, must one day, and relatively soon, be removed from the bike so that the wheels can turn on their own and speed can be generated by the real economic actors on the ground. Investors must realize that the economy was able to grow and function effectively before without the hand-holding parent. The only way it can do so again is if we let the parent take their hand off the handlebars so we can pedal, steer and balance all on our own. If investors panic too much then the fear of falling off will drive us to the ground again. We just need faith we can guide ourselves with the distant knowledge that the Central Banks have powers to help if we really need it again.

            In the words of Bruce Wayne's father in Batman Begins - "why do we fall, so we can learn to pick ourselves up". Yes the global economy and financial markets have had quite a fall, but the central banks have acted to help to pick ourselves up again. It will soon be time for them to let go of that helping hand, and investors must show the faith and belief that they can pick themselves up on their own and be stronger for it. Otherwise I fear we face an inescapable cycle of a lifetime of support.