The Dog Days

Terrifically well crafted piece on summer markets by friend, Stephen Lewis:

The day-by-day countdown to the hundredth anniversary of the outbreak of the First World War should serve to remind us there is no firm historical foundation for the common assumption that nothing significant ever happens in the dog days of August.  The markets’ old-timers will recall it was in August 1990 that Saddam Hussein invaded Kuwait, beginning the train of events that led to the Gulf War.  More recently, it was BNP Paribas’s halting of withdrawals from three funds it managed, in August 2007, that first alerted investors to the global scale of the fall-out from the US subprime mortgage crisis.  We would be yielding to superstition if we adopted a fearful view of the next few weeks simply because they will constitute another August month.  After all, while the war in 1914 began for the UK in August, hostilities had broken out between Austria-Hungary and Serbia on 28 July. Similarly, in 2007, Bear Stearns’ revelation on 16 July that two of its subprime hedge funds had lost almost all their value was warning enough that much was amiss in the US capital markets.  Troubles rarely come out of the blue.  Usually, the signs of impending disaster are long visible before the debacle occurs.  It is tempting, during the period of denial before the final cataclysm, when markets seem calm, to believe that the negative aspects of the situation must already be fully discounted.  But there is a world of difference between a notional catastrophe and a real one, and the full dimensions of a real catastrophe are seldom imagined beforehand.

Rarely in the writer’s experience, stretching back forty-five years, have the world’s capital markets been afflicted by so pervasive a sense of unfocused foreboding.  This is not reflected in the behaviour of securities prices which continue to be well underpinned, too well maybe.  Rather, the mood is evident from the volume of comment drawing attention to a host of extreme market values seeming to betoken an unsustainable stability.  In bond markets, ultra-low yields appear to deny the chances of the economic recovery that forecasters are standardly projecting. In equities, parallels are widely drawn with the metrics that prevailed in 2000 or 2007.  But, whereas on those previous occasions when equities stood on the brink of collapse, investors had an idea from which direction the destructive flame would come, there is now no consensus on what should be most feared.  What is universally agreed is that markets would not be where they are today if central banks had not spent the past five years so energetically rigging them.  Where they might be standing if central banks had not had recourse to unconventional policies, while pushing their conventional policies beyond their historic limits, is anyone’s guess.  What makes market sentiment sensitive to this question now, as it was not a year ago, is the expressed resolve of the US Federal Reserve and Bank of England at least to reduce the degree of accommodation they will provide, without indicating when this process will begin.  The malaise runs deeper than this, though.  It is not merely a case of market uncertainty that could be dispelled by some clear ‘forward guidance’.  For beneath the surface of day-to-day transactions lies the suspicion that the global crisis and the measures the authorities have taken to prevent a recurrence have wrought permanent damage to market structures.  In short, the market mechanism may now be even less well able to cope with sudden changes in sentiment than it was pre-crisis.  If this should be revealed to be the case, the shock to business confidence when sentiment does turn in capital markets could well be deeper and more long-lasting than after the 2007-09 meltdown.

There is no shortage of threats to market stability.  They have been accumulating while central banks have applied their anaesthetic.  Politically, the state of the world is much more menacing than it was five years ago, when bond and equity valuations were lower than today.  Successive rounds of sanctions against Russia have set the seal on that country’s exclusion from ‘the international community’.  But it seems very unlikely that China will allow its BRICS fellow-member to succumb to Western pressure.  In the past, China would not have had the resources to defy the West, even had it a mind to do so, but now it does.  The Beijing authorities may shrewdly judge they will never be subject to sanctions.  Western nations have consumed ‘a peace dividend’ they may now feel they must regurgitate.  That could impose a severe handicap on their future economic performance as resources that might have supported debt reduction or capital investment are diverted to defence spending.  Then there is the growing instability in the mid-East.  Though disruption of energy supplies from that region may seem a less serious threat to the world economy in light of shale developments, there have been few signs that shale producers, most notably the USA, are willing to share their bounty with those countries dependent on imported energy.  If the US ban on crude oil exports were to persist in the face of disruption in the global crude market, Western political unity might not survive long.  Alongside these risks, we need hardly labour the point that the EU and the euro zone look far less cohesive than they did five years ago.  Fresh strains are likely to affect the euro as the region’s economy appears headed for renewed weakness.

The most dangerous forces, though, may be those generated within the markets themselves.  As in the past, market excesses may bring disorderly correction.  Arguably, the very levels of market prices represent excess.  But in judging where excesses lie, it has always been most useful to examine where market activity has been growing most rapidly.  Thus, it seems unlikely that trouble will arise, at least in the first instance, from bank lending to non-financial corporate customers because, for years past, demand for such loans has been weak and the banks have been careful in granting credit.  The BIS, in its annual report, identified the massive substitution of bond finance for bank borrowing and the growth of non-bank asset management funds in recent years as potentially problematic.   It also warned against the concentration of risk in some ETFs.