Detailed analysis of economic data is a dying art.
As Bloomberg's Mark Cudmore notes, confirming the detailed and depressing reality of Citi's Matt King, all that investors seem to care about is the performance of financial assets and the related reaction of central banks.
The past seven year bull-market has largely justified the logic of such an approach, but the frenzied panic of the last month raises the question of whether investors will know how to adapt if the framework changes again.
It’s worth debating whether recent market ructions offer the first evidence that central banks may be near the limit of their ability, or their willingness, to keep pumping up asset prices. An affirmative answer to either would be scary for investors.
The scale of stimulus from the Bank of Japan is already unprecedented, yet an increasing number of analysts are crying out for even more. Many are hoping the Fed will support markets by acknowledging their rate-hiking plans have been overly aggressive.
There’s a lot of raucous concern about a correction that is focused around "Wall Street." However, on "Main Street," unemployment isn't rocketing, house prices aren’t collapsing and even a small recession looks unlikely in any Group of 10 economy.
Some emerging-market economies are suffering greatly, but they’ve been doing so for a couple of years, and it didn’t seem a major concern when the S&P 500 was making record highs.
To be sure, the real economy isn’t in a wonderful place. Main Street’s still feeling the hangover from the pre-crisis boom years. The war against deflation is far from over. And financial market chaos won’t help.
But let’s not confuse a drop in asset prices with a real- economy meltdown. It was global central-bank policies that significantly reduced the correlation between the two during the last seven years –- and the link won’t immediately revert the moment speculators don’t get their way.
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As Matt King so eloquently opined previously,
Ever since markets seemed to stop following fundamental relationships back in 2011, we have sought to discover what has been driving them instead. For a long time, developed markets QE seemed to provide the answer: correlations between changes in credit spreads or equities and global QE were, although not perfect, still much stronger than might have been expected for such a purely technical indicator, implemented largely not through equities and credit themselves but through government bond markets. The factor seemed to seep from one market to another: even from a US perspective, the global aggregate did a better job than looking at Fed QE alone.
But in March last year, the correlation which had been almost the sole guide to our positioning recommendations broke down: the ECB and BoJ were continuing to make the equivalent of over $300bn of asset purchases per quarter, yet rather than rallying 10% – as had been the relationship in the past for both credit and equities – markets sold off (figure 11).
One way the correlation could be made to work again was to expand the metric from pure QE to include all central bank liquidity injections – including emerging markets (Figure 12). The expansion of FX reserves previously was, after all, both another form of price-insensitive buying of DM government bonds, and (since it was financed almost entirely by an expansion of the EM domestic monetary bases) a form of global money printing.
We were initially, and remain, somewhat cautious as to whether this is the ‘right’ metric, especially in € where the QE is actually taking place. Now, of course, EMFX reserves are contracting rather than expanding (even when adjusted for exchangerate movements), and the exact mechanism by which this affects risky assets in developed markets is not entirely clear. And yet the quality of the correlation over the last few data points would seem to argue in this direction (Figure 13 & Figure 14).
Not only does including EMFX reserve changes help explain the sell-off in markets in the second half of last year; more powerfully, the temporary recovery in October and renewed relapse seem also to coincide, both in credit and in equities.
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As we have argued for a while, it is not that we are straight bearish, and that these developments can only be resolved in a new crisis. Rather, it is the profound uncertainty, which comes in part from the potential for a regime change, and in part from the circular feedback loops at work in markets, which we have found it so hard to reflect in point forecasts and yet argued should be the central feature of investors’ portfolio positioning. What is concerning at present is that some policymakers still seem in denial about how interlinked everything is.
We hope that after they see the following chart, which shows not only DM net liquidity injections (i.e., q-easing), but also EM net liquidity outflows (i.e., quantitative tightening) and which explains not only the recent selloff, but also shows how to trade global central bank and sovereign wealth fund and reserve manager flows, all confusion and denial will end.
Or perhaps not. As King himself pessimistically concludes, "Perhaps if this sell-off fizzles out by itself, as it did last October, central banks will again be spared the need to face up to the distortive effect they have had upon markets, and can continue the pretence that markets are still following fundamentals. After all, for many of them, this has been the sell-off which ‘isn’t supposed to be happening’."
We couldn't have said it better ourselves.