Yesterday we felt like a brief moment of gloating was deserved, when we noted that, based on the WSJ's reporting, the somber mood among Davos "prominent investors" and billionaires was "irritated, bordering on affronted, with what they say has been central-bank intervention that has gone on too long.... from this anecdotal sampling, at least, that has created growing distortions in nearly all asset prices—from stocks to bonds to real estate."
In other words, precisely what we have said all along. But there is much more work to do before the victory lap, most importantly in explaining what happens next.
Well, since it is now common knowledge that it is all about central bank and rigged markets, the next logical step is to predict what happens to markets when looking at "asset prices" from a purely central bank liquidity standpoint, aka the Austrian money flow perspective.
Here, we remind readers that in early 2013, just as the BOJ was preparing to unleash an epic QE episode in order to offset the lost liquidity injections which the Fed's upcoming taper would lead to, we explained that instead of looking at central banks as standalone entities operating within their own liquidity domains, one has to look at global liquidity as a coordinated whole, one in which every central bank is now an integral cog and where inside money liquidity is not only globally fungible, but transferable from point A to point B at the push of a buy or sell button.
And while for the longest time many, including us, were focused on DM central banks, over the past year a new market participant emerged: Emerging Markets, whose $7 trillion in reserve assets had become a source of reverse liquidity, or "quantitative tightening" as dubbed here over the summer, as numerous nations have been forced to liquidate USD-denominated assets to compensate for the loss of trade exports and oil revenue in the aftermath of the death of the Petrodollar which initially was noticed on this site alone and subsequently everywhere else.
Which brings us to the topic of this post, namely "why are markets all falling down?" and the answer by Citigroup's iconic, and one of Wall Street's very best, analyst Matt King who adds that "many investors have been struggling to explain the magnitude and violence of the recent sell-off. Why are EM and commodity price weakness proving such negatives for DM as a whole?"
The answer, hopefully not a surprise to our readers, is as follows:
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.
* * *
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.