The death of markets

The investment bank, Macquarie recently posted a note describing how the shifts in financial markets of all kinds are no longer based on fundamentals, but instead are driven by an over reliance on central bank intervention. The result is that, in Maquarie’s view this makes macroeconomic calls much more difficult to call.

The last several weeks witnessed one of the strongest reversals since the GFC. Following Brexit, the virtual implosion of the Italian banking sector and May poor payrolls, investors had to absorb a jump in Jun payroll and full panic mode by CBs, including: (a) flagged BoE easing; (b) a potential Japanese “helicopter drop”; (c) growing calls for public recapitalization of Euro banks; (d) easing by a plethora of countries; and (e) acceptance that Fed cannot tighten.

The result was a jump in asset price correlations, with both risk-on and risk-off assets delivering strong returns: (a) equities re-captured pre-Brexit highs on the perception that CBs would panic sufficiently not to worry about asset bubbles, and hence if corporates can squeeze some EPS, the stage would be set for a rally: (b) global bond yields collapsed across the entire term structure for both DMs and some EMs. Term premiums collapsed as investors accepted that risk of tightening is zero whilst there are very few signs of any inflationary shocks; and (c) gold rallied, driven by understanding that current policies would ultimately lead to either deflation or stagflation or hyperinflation. …can one make sense of these erratic changes? No

This has important implications for commodity markets. In theory higher prices should indicate to producers and consumer that there is higher demand and/or lower supply. Futures markets have always diverged from underlying fundamentals. But if markets are no longer providing signals based on these fundamentals then the trust in them as a ‘signal’ is broken.

We believe that global economy and investors are residing in the twilight zone between an era of relatively free market capitalist economies (with its own set of signals) and a new environment which is likely to be completely dominated by the state. Although most market signals (such as spreads) have already been degrading for a decade, we maintain that over the next year or two, free market signals would finally perish to be replaced by state-driven credit, spending and capital formation funded by CBs (what we call “nationalization of credit”). It would take the form of state-sponsored stimulation of consumption, investment, R&D and rescuing what essentially is a bankrupt financial super structure (i.e. banks, insurance, life and pensions). Whilst similar to FDR’s New Deal, it would be a far more distorted world than either the 1930s or the 1960s-70s, with brand new investment signals.

How do we know whether we have arrived at this state-driven paradise of public sector money and demand multiplication? As highlighted in our notes, we have four doorstep conditions for such a dramatic public sector shift, with high volatility and discontinuities being the most important. We don’t believe these conditions are yet satisfied, but the chances are high that they would be over the next 12-18 months. In the meantime, we still expect half-hearted “stop and go projects”. Japan is likely to be the first to ‘jump’ and wholeheartedly embrace this merger of fiscal, income support and monetary policies but others would eventually follow. It is just a matter of time. How does one invest? Ignore noise & stick to fundamentals.

I think what this implies is that investors and physical agents in commodity markets need to adopt a much longer term view of how fundamentals could play out, i.e. the longer term impact of population growth, environmental degradation, rather than more short term factors. But this is no use for a farmer wanting to hedge next season’s crop or a manufacturer wanting to know a what price to buy aluminium for an upcoming order.

We maintain that conventional mean reversion strategies cannot work in the world of no conventional business/capital market cycles and broken market signals. At the same time, we maintain that macro calls are no longer possible (as cross-currents are too unpredictable) and would not come back until the new world of direct state sponsored growth arrives.

Originally posted on Macrobusiness

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