What Coronavirus? Says the Market - My take on why central banks can still dictate the market and for how? long

‘Cognitive dissonance’ is the word the Guggenheim Partners Global CIO Minerd used when he described the disconnect between the economics and financial markets right now.  

For a long time now, financial markets have been living on ‘QE’. The program to buy up government debt using created money 1) has lowered the cost of borrowing for the economy 2) pushed investors to buy other financial assets as they are crowded out from government securities. Whether one liked it or not, the result has been clear. Central bank balance sheet expansion drives up market prices. Many have made comments similar to Minerd over the past 12 years and they were shrugged off. However, the coronavirus is making comments like this relevant again.

China, the world’s second largest economy at around 15% of global, has been devastated by the coronavirus, but the market still marches on. Many believe the disruption is temporary and things will go back to normal (V-shape recovery) so there is nothing to see.

Yet, behind the sanguine outlook lies the more important assumption, which is that central banks are always here to save the day. Therefore, bad coronavirus news is actually good news because it makes supportive central bank policies more likely. For instance, if the gets worse in China, perhaps China’s People’s Bank of China will cut interest rates to zero and do QE for the first time. To take it a step further, if the virus spreads to the US and it becomes a pandemic, then perhaps the Federal Reserve Bank will cut rates to zero and do QE for the fourth time. We, as people who may contract the virus and die, know that these certainly are not good outcomes, but if China does QE and US does QE4, you can bet the market will just rip up mechanically.

Given this outlandish, but perhaps probable, scenario, it is a good time to ask the big questions: why does QE still work, when would it stop working, and how long can this ‘cognitive dissonance’ last?  (working as in it drives up real asset prices)

Why does it still work?

1)      Globalization, Moore’s Law, aging demographics in the developed markets have kept inflation low. This allows central banks to use their powers without limits and push back.

Globalization allows goods, services, labor, and capital to flow so that things can be done as efficiently, if not as cheaply, as possible. Moore’s Law predicts that chips’ processing power doubles about every two years, this makes technology cheaper and more widely adopted. Aging demographics in the developed markets are the richest group. If they aren’t spending on goods to drive up prices, then who can move prices? In the end, central bank can keep on creating money to buy government securities, but as long as these factors are at full force, the consumer price index will stay low. This allows central banks to use their powers without limits and push back.

2)      High quality asset needs

There is a lot of wealth in the world ($240 tn in 2014), but not enough high quality assets (something that generates a return). Don’t blame it on the rich either, this is an everyday person problem. The rich actually can afford to buy risky assets since they have more than enough already. It is the middle class who are saving for their retirement/children’s education or relying on their insurance to help them that need high quality assets the most. When central banks are making prices go up, the ETFs, money managers, and insurance firms will follow, often times no questions asked.

3)      Asset holders cooperating supports paper profits

Even though trading is a zero-sum game, global investors have cooperated with each other. Instead of rushing to sell the asset to realize the paper profit at once, they understand that they are in it together. By taking turns to sell, nearly all existing investors can realize their profits over time.

4)      Wealth effect

The paper profits are not real until realized, but the asset holders’ spending on goods and services are real. The wealth effect, the increased spending from the financial asset market wealth, does improve conditions. As the economy improves from the spending, the high assets prices become a bit more justifiable.

How long can it last?

The short answer is when capitalism gets diluted, too many people get in on the QE secret, and when there are better things to invest in.

Based on the four reasons mentioned above, central banks’ easing would stop working when inflation increases and middle class savers get scared. Yet, these scenarios may only be temporary. For instance, inflation will pass as supply or demand adjusts, the market fear behind any asset dump will fade, and consumer sentiment will bottom out at some point. For things to really change, we may need to see fundamental changes in capitalism, investor behaviors, and market structures. 

1)      A global shift away from capitalism may lead to more sustained inflation. In other words, if the profit incentive goes away, it will take longer for producers to find cheaper, faster, and better ways to produce whatever that is in short supply. This will make it permanently more difficult for the central bank to respond to support the market.

2)      A spike in investor interest given the central bank support would drive prices into a bubble. If too many people get in on the QE secret, major stock indices will be driven up like Bitcoin or TESLA. This will lead to a bubble burst, before investors come back betting on central banks’ support. In the end, successive rounds of bubble burst will either lead to central banks or investors walking away. At that point, the stock market will still exist, but at levels much lower than the bubble period. 

3)      The invention of a new market could drive interest and capital away from the major stock markets today. In a world where lifestyle, culture, and technology have changed so quickly over the past decades, who is to say the middle class savers and wealthy’ investment preference wouldn’t’ change.

As for these fundamental changes, things are already gradually happening. First, the world is moving away from the raw form of capitalism. There is now growing scrutiny over businesses’ environmental, social, governance, moral, and cultural standards. It is possible that all these forces contribute to future inflation from a supply standpoint. As for the second point, there may never be too many who get in on the QE secret. It has already been mainstream for 12 years and inequality makes it hard for everyone to participate in the market. Third, while a new market seems unlikely, weirder things have happened. Bitcoin's market cap is $130 bn because enough people said so. The difficulty is for a new market to get to a sufficient size. In 2014, there was about $240 tn of wealth in the world (Marginal Revolution). Today, global equity markets add up to $50 tn (BofA), global debt markets is about $135 tn (150% of global GDP), and US and China’s housing market is about $75 tn (Economist, Goldman Sachs). Unless there is a credible new market that rivals major equity market, middle class savers' money will still flow there. 

Ultimately, for those wondering whether the ‘cognitive dissonance’ of the market can last, watch how the market is treating the producers and whether a new asset market is on the horizon.

 

Disclaimer: risks such as political checks on central bank powers, financial stability concerns, and any end of the world scenarios are all possible, but are excluded for the sake of this thought exercise.

Why Everyone Should be a Fed Watcher

Heading into Jackson Hole, many financial market participants are eagerly watching Fed Chairwoman Yellen’s every move. As if they are not already, they will be glued to their smartphones and tablets, watching out for any pop up news of Yellen’s speech. They want to know if September is a go.

This go means Fed hikes rates. To profit and loss minded investors, this will be huge news. The rate hike will determine whether the dollar will resume its appreciation, the equity and bond market will deflate, and international markets will slow down. To casual followers of capital markets and the economy, this means that the government believes in the strength of the US economy and maybe their mortgage rates will go up. However, to most people, this means nothing. Whether young or old, they will look up at their TV, stare across at their computers, or swipe away on their smartphones, thinking “I don’t care and this is boring.”

I do not blame them, but I believe everyone should be paying attention to the Fed and this is to their own benefit. The anticipated 25 basis point interest rate hike, when and if it comes, has a butterfly effect on everyone and those who predict it well has the best chance of survival and prosperity. You may think I am exaggerating, but hear me out.

Just like farmers rely on the weather, modern workers rely on the economy. A farmer can be diligent and resourceful with seeds, but if the weather and conditions are bad, the farmer’s crops will go nowhere. Similarly, a modern worker can be hard working and endowed with money or education, but if the economy trajectory and economy are bad, the workers will have very limited success. A new home buyer couple, a college graduate and a middle management dad during the 2008 financial crisis all suffered. The couple ended up overpaying for a house and are stuck paying mortgage for the next 30 years. The student who did everything right, but still fell short of finding a job after school. The dad, who helped the company throughout the year, got laid off because the corporate said so.

As a result, it is easy to see that the weather and economy have a great impact on the farmer and worker. The difference is that good farmers try their best to predict the weather and adapt to different conditions while good workers generally have little understanding of the economy and allow the economy to batter them around without any adjustment or a clue. At this point, one may have two burning questions: what can workers do and how can they predict the economy?

For the first question, it is no different from the farmer. Just like the farmer who foresaw the poor rains this season and decided to plant a less water intensive crop, one should evaluate conditions before making a big purchase or investment. Whether it is buying a house or going to school, people should make sure their plans (crop) fit the economy (weather). If their plans do not fit, then they should be open, if not eager, to change. The ever growing students at coding schools are a perfect example of this change. Perhaps interested by tech or discouraged by their current field, people adapt to learn skills that seemingly will fit the economy. There is no way for sure to know whether this will work out, but it beats the odds of the stubborn farmer who refuses to leave his barren land.

As for the second question, I say watch the Fed. The Fed is not only stacked with brilliant economists and researchers, but also it is tasked with changing the economy (weather). To understand what I mean here, imagine how farmers observe and predict the weather. The Fed is more than just a wise and experienced farmer who watches the clouds, feel the wind, and observe seasonal patterns to predict the weather. The Fed is an Elon Musk like disrupter who will play god to change the weather and economy. The Elon Musk reference is to his proposal to nuke Mars to induce create a sun and warm up the planet for future inhabitants. Well, unless one thinks Fed’s QE is on the level of Elon Musk’s idea, one should just think of the Fed as a modern day engineer who cloud seeds for rain and build dams and levers to control water. (I will stop here because this is not a blog on Fed’s monetary policy channels, communication, and impact) Therefore, by following the Fed, one should be able to understand the current and future trajectory of the economy. Before people were treated as robots and shuffled inside giant factories or office buildings, they paid attention to and adapted to weather. Today, people should take back this skill and pay attention to and adapt to the economy.

Just like sailors do not set sail without checking for storms, people should not live their lives without paying attention to the economy. The captain and crew can pray to their gods all they want and wish for smooth sailing, but the storm will find them if they do not check and prepare for the weather. People can find “the economy” boring all they want, but the economy will find them if they act like it has no relevance to their lives. Fast forward a few 100 years, it is now easy to find any weather information that is timely and accurate. However, information and accurate views on the economy is more difficult. Given there is no app that will tell you everything you need to know about this week’s weather with just a quick swipe, just do your homework and study the Fed.

So is Murph’s brother Tom a good farmer? He is on a doomed planet, but he does switch around his crops…