QE powered markets have been motoring to new highs with all the abandon of teenage lovers. I've been promulgating the view for some time that markets are not pricing in the risk of a demand shock, of any scale, but it has had little resonance until recently. Yet a growing number of commentators are beginning to echo the thought and with a deal more intellectual weight. Upside from here is totally dependent on increasing economic confidence and momentum. Without demand that’s not going to coalesce. The pace of human worker replacement by machines is accelerating, the US consumer is still on the rack even before interest rates move, a reduction in Chinese GDP is self evident, Europe remains the mother of all time bombs and the UK is being flattered by selective house price moves and the auto manufacturing business in the West Midlands. There is an end to all this but a deflationary disruption in demand along the way will eventually rock equities.
So why are stock markets doing so well? One answer might be from a client who said, “I think governments everywhere are strangling their economies with regulation & taxes. It’s easier to put your money into the stock market than it is to build a business or a house on land that you own so equity markets go up and the real economy stagnates.”
Indeed, how many people do you know from the City or elsewhere who have retired to invest and or trade under their own steam rather than drag themselves out of bed at 5am in the morning? As we roll into bonus season for the banks another challenge is facing managers on trading floors. The near doubling and more of basic salaries in investment banks, rolled out 4-5 years ago to circumvent an expected clamp down on bonus’s after the crisis, has created other unintended but quite predictable consequences.
Unallocated and allocated costs have soared, (especially as other headcount like compliance has mushroomed). One head of a desk told me the “per head,” number to have a member of staff on his trading floor and I nearly fell over; it was more than twice the number we used when last I worked in a bank and even then my bank was at the top end of peer group. Despite this, most operations have been profitable. However, with structural change being imposed on the bond market by Dodd-Frank and the underwriting of markets by QE on the wane, there will be some tough decisions to make when the tide goes out.
Moreover, the CEO of another operation said to me, “Bonuses’ are not what they were and anyway, only a modest percentage is paid out in year 1. That though is stifling ambition because they feel they just have to turn up and do a good job to bank the pay cheque.” Even at Goldman they are ramping up basics even more in response to EU bonus caps. These are the business economics of the madhouse. It won’t end well and yet again the City is lining itself up for another great reckoning.
Talking of madhouse business principles, in these days of volatility suppression I’m reminded of another bugbear from my days in a bank. Trading books often have to take provisions against their positions. These provisions will be calculated against a number of metrics, mainly volatility but will include average daily volumes in the name, the average bid/offer spread and so on, and they are usually reweighted weekly. Unsurprisingly, when a bad thing happens volatility spikes and after a big fall for example, traders can expect risk control to wander over and say, “don’t forget, your provisions will rise on Friday.” Similarly, after a prolonged period of flatlining volatility, as we see now, provisions will be released back to the trading books and from their perspective, they’ve recovered hard earned P/L and can now walk the floor looking windswept and interesting rather than gaunt and persecuted. We see then, that after a bad thing the risk geeks decide that it would be sensible to take out an insurance policy in the form of provisioning but when we’re at all time highs with stretched valuations and low volatility they chuck the insurance policy in the bin.
Is that smart?