Equity markets live and die on several well-established conventions, according to ConvergEx's Nick Colas, noting that these are the rules that investors use as the bedrock of their fundamental analysis. The volatility of the last few weeks shows that some of these paradigms are now under attack. Chief among the question marks: “Do central banks always have the power to tip the balance between growth and recession?” Another rising concern: “Can stocks constantly shrug off recessionary signals from commodity and fixed income markets?” Lastly, “How many exogenous, if largely unpredictable, global events can equities ignore before their collective weight halts a bull market?” Bottom line: the debate on these topics isn’t over for October or the balance of the year.
Via ConvergEx's Nick Colas,
The last Mitford sister, Deborah, died late last month at the age of 94. If you are unfamiliar with this storied British family, think of them as a 20th century version of the Kardashian brood with posh British accents and infinitely more drama and controversy. Deborah was many ways the calmest of the six sisters, devoted to her enormous country estate, named Chatsworth, and a noted patron of the arts. Her obituary in The Art Newspaper featured a Lucien Freud portrait done in 1957, and he was just one of the boldfaced names from the art world to call the Duchess a good friend.
The other Mitford sisters tended to be far less conventional. Indeed, their lives of +50 years ago make modern reality TV seem tame by comparison. They did things that may seem commonplace today, but remember that they lived in the middle of the last century:
Nancy, the oldest, was a successful novelist and had a longstanding affair with a married French diplomat. Her novels tended to the semi-autobiographical, so this was not exactly a secret in British society. Or anyone else.
Pamela, #2, married and divorced a famous jockey of the time. After that, she was the longtime companion of an Italian horsewoman.
Diana, #3, left brewery magnate Bryan Guinness for a British fascist and spent World War II in prison.
Unity, #4, was also enamored of the German cause in the 1930s and tried to kill herself at the start of the war.
Jessica, #5, was a groundbreaking investigative journalist in the U.S. and her 1963 book “The American Way of Death” is still influential in the funeral industry to this day.
Flouting convention is all well and good for free-spirited British nobles, but when it comes to more conservative institutions like the world of investments breaking the rules leads to more than just scandalous headlines. When I read of the Deborah Mitford’s passing, I got to thinking about the unwritten rules to which we all subscribe – knowingly or not – when we analyze the value of financial assets generally and equities specifically. The recent volatility in global stock markets – something I am sure will last for a while longer – stems from more than simple twitchiness over U.S. earnings or whether Germany is technically in recession. Rather, it seems as if investors are questioning some of the most fundamental narratives by which they allocate capital and consider risk and return.
Consider the role of central banking in managing the U.S. and European economies. Since these institutions do not link their currencies to precious metals like gold or silver, their credibility comes solely from policy actions that achieve their mandates of social goals such as economic growth, managing inflation, and employment. The old chestnut of “Don’t fight the Fed” is an implicit endorsement of the notion that the U.S. central bank controls – or at least guides with a very heavy hand – the American economy and capital markets. Two Fed Chairs – Paul Volcker and Ben Bernanke – can claim the most credit for burnishing that reputation. The first tamed long-standing inflation, and the second dragged a near-dead financial system back from the brink.
But – and this is a big “But” – there are clearly rising concerns over how much central banks can really do to engender secular economic growth. In the U.S., equity market valuations of 16-17x current earnings imply further expansion with little chance for recession. At the same time, the Fed desperately needs to normalize short-term rates at something closer to 1-2% from today’s 0-0.25%. That’s essentially like taking a still-weak patient off life support and hoping they can breath on their own. The recent Fed minutes, with their worries over a strong dollar and weakening global economy, don’t read like a promising diagnosis in that regard.
In Europe, the problems are deeper. The U.S. central bank has +100 year track record of responses (good and bad) to financial crises; the European Central Bank is still working through its first. Germany’s unemployment rate of 4.9% is less than half of the EU’s 11.5%, creating a notable rift in how the continent’s largest economy views appropriate monetary policy versus the rest of Europe. If central banks need one thing to maintain a sense of control – a necessary convention to achieve long-term social goals – it is for investors to feel that policy is predictable and correct to the current economic conditions. Right now, belief in that convention is eroding when it comes to the ECB.
Another maxim of capital markets – one that the well-dressed Mitford sisters would have appreciated – is that everything should largely match. If stock markets believe in economic growth, then fixed income and commodity markets should share that belief. Global bond yields have been in decline all year, but equity markets (until recently) shrugged that off as fears of localized deflation in Europe. Now, commodity prices like crude oil are following suite with near-dated contracts for West Texas Intermediate at $86, down from $104/barrel in July. With continuing threats from ISIS to the stability of oil-producing parts of the Middle East, you’d think we’d be talking about geopolitical risk premiums in the market. Not deflation.
That drop in oil prices brings us to our third and last broken convention: that markets generally ignore all but the largest and most immediate exogenous shocks. ISIS militants are close to Baghdad and threatening border towns near Turkey, but that group has been terrorizing the region for over a year. Ebola is just the latest in threatened global pandemics – recall concerns over avian influenza or several SARS outbreaks over the last decade. The California drought’s effect on food prices doesn’t get much press at the moment, but beef prices are near all time highs in the U.S. In isolation, all these catalysts would typically be manageable concerns. However, we’ve seen U.S. markets respond negatively to Ebola headlines in the past week, signaling that perhaps the weight of several currently “Smaller” crises can have the same damaging effect as one large one.
In the end, the most central convention of investing – that asset prices move in quasi-predictable cycles – is the one investors seem to be questioning most closely at the moment. After a damaging Financial Crisis and difficult balance sheet recession, owners of financial assets have been ready and willing to believe in a long slow upswing for global economic growth and – correspondingly – the price of stocks. The underpinnings of that belief – central bank policy, corroborating evidence from bond and commodity markets, and a lack of geopolitical challenges – now seem shaky.
