‘When markets move a lot there must be a reason why.’ Most of the time this mind-set works well for us: there is an earnings announcement, policy decision, or macro data release, and markets appear to respond (sometimes) in the way you would expect.
Other price moves are not so clear cut. Sometimes markets move without a clear cause and you scramble to find out why: searching news sources, asking dealers, or even consulting blogs to find out what is going on.
Unfortunately in many cases these sources have done just the same thing as you: they have observed price moves first and then searched for a story that explains them. We have seen many instances in the past where markets have been down in the morning and then finished up in the afternoon, and market commentary has used the same piece of data to explain both states.
Today, trying to fit stories to price action is a futile exercise. What we are seeing is panic, a correlated sell-off in which assets apparently unrelated to the fundamental issues but viewed as a ready source of cash are being hit just as hard – if not harder – than assets perceived as being ‘in the eye of the storm.’
An interesting characteristic of the recent phase has been for the stories put forward to justify price moves to change, almost on a daily basis. We take comfort in the fact that this is happening; it suggests markets are being confused by price action and are trying to adjust their analysis to explain it rather than considering the facts first.
Has the economic situation changed significantly?
The main changes have been in prices, and these themselves can influence fundamentals. The oil price is lower than at the start of the year – but not as low as in January – and many companies have seen their costs of capital rise. But the same risks that were there on New Year’s Eve are still there today and so are the same positive trends. What have changed are prices, and our apparent willingness to focus on the risks at the expense of the positives.
Our investment approach is not about forecasting so we won’t try to make the bull case for the world economy. However, we have spoken extensively on our observations regarding the many positive signs that are out there, with an emphasis on the US (improving labour markets, wages, and consumption) and the stimulative effects of lower oil. We would also add to this the signs of improvement in Europe (see GDP chart below) and elsewhere (chart 2 shows the PMI’s of various regions).
Banks’ exposure to energy and commodity sectors
The current phase looks more to us like a general fear of financial crisis (in no small part due to echoes of 2008). Banking stocks have fallen everywhere, from the US to Japan and Europe and so attempts to explain the declines as anything but a generalised panic seems futile.
Initially market commentators put the bank declines down to energy and commodity exposure, and then to the impact of negative rates, and now to Europe-specific issues surrounding Deutsche Bank. All of these have an element of truth; but given the globally correlated nature of price declines, their rapidity, and the lack of a consistent explanation for why they are happening, it is hard to see any justification other than fear.
Of course the financial system is highly inter-connected and is subject to panics becoming self-fulfilling as ‘runs’ take hold. However, as we have emphasised before, it seems unlikely given the experiences of 2008 and beyond that the market is complacent about these risks. Investors and regulators have been focused on this issue and banks are undoubtedly in a better place than they were.
This does not mean that the risks aren’t there. After all, of what use are the charts above if the financial system seizes up? But we are not convinced that stock market moves alone should be taken as an indicator that risks have increased.
Lack of ammunition of central banks to fight the new leg of the financial crisis
We think the link between interest rates (and Central Bank policy in general) and global growth has been overstated in this recent phase. The main function of much of Central Banks action of the last few years has been the provision of liquidity – however, as many are now recognising, the relationship between these actions and growth outcomes is limited at best.
Central Banks have clearly been able to influence the yield curve and bond prices, but the real economies around the world have been driven by the same factors as they always have: ‘animal spirits,’ productivity, and incentive structures. We feel that stimulating growth is best achieved by government through fiscal policy i.e. spending and/or tax cuts. Many countries have not begun to make a concerted effort in this area.
However, if the concern today is generally about liquidity provision in the financial sector (which as we note above could well be overstated) then the Central Banks can continue to act just as they have done to prevent a freezing up of the financial system. Low or negative interest rates are no constraint to this function.
What do you believe?
Many claim to be long term investors, who can be more emotionally resilient than the market and pick up opportunities when they arise. The reality is that for this to work for some, then most will have to find it too hard to do in practice. Investment approaches are truly tested in periods such as this so, by definition, they cannot feel comfortable.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.