“The market is broken.”
This sentiment has become more or less the received wisdom in the investing world over the last several years.
Nearly a decade of crisis-era monetary policy, coupled with political inaction across the developed markets, has led to underwhelming economic performance the world over.
Mohamed El-Erian’s book “The Only Game In Town,” published earlier this year, cleanly captured the thinking that obviously, something in markets and central bank policy isn’t working.
And yet amid underwhelming economic growth and frustrating central bank action, stock prices (at least in the US) are at record highs and bond yields are at record lows. To many in the market, none of this makes sense.
In a note to clients out over the weekend, Citi’s head of global credit strategy Matt King outlined seven reasons markets are “deeply dysfunctional.” But this seven-pronged dysfunction in markets really just comes down to monetary policy.
Monetary policy, in King’s view, has flattened markets. Everyone making the same bets because the market’s dominant force — central banks — are all going the same way: easier.
This has made markets, which are by definition two-sided, one-sided affairs.
Here’s King (emphasis mine):
A properly functioning market is a heterogeneous one: one where some investors are top-down, yet others are bottom-up; some invest long-term, others invest short-term; some look at fundamentals, others look at technical. That’s what makes for a two-way, continuous market. A market where all investors are forced to look at the same factor will inevitably be dysfunctional — grinding tighter today, yet prone to sudden reversals tomorrow when the inflows dry up. And yet anyone trying to hedge against such an eventuality inevitably underperforms.
King says that amid calls from investing luminaries like Bill Gross and Paul Singer — among many others — that markets are showing signs of being totally out of whack, it seems only central bankers are ok with the current state of play.
This, however, might be changing. King again (emphasis mine):
All that said, there do seem to be some cracks appearing. Central bank liquidity no longer refreshes all the parts it used to. There are inflows to credit, but not really to equities. € credit spreads are rallying sharply, but only because the ECB is buying them directly; the same applies in £. Both the Euro Stoxx (-9% YTD) and the Nikkei (-13%) are struggling, ongoing QE programmes notwithstanding. Inflation breakevens — the most direct reason for central banks buying risky assets — are falling further still.
Most doctors — and even patients — know that when a course of drugs seems not to be working, you don’t simply keep on doubling the dosage. This applies particularly when the patient, if no longer as sprightly as they used to be, is nevertheless doing more or less fine. The side effects of such a course are more likely to kill than to cure. Yet this is what central banks now seem intent on doing. They have too much invested in their models to consider changing them in our view.
If all goes well, this should produce more of the same: ever tighter spreads; ever more hand-wringing over a stagnating global economy; ever greater dysfunction in markets. That is indeed our forecast.
The problem, of course, is that King’s forecast for more dysfunction and more bull-headedness from central banks that think pumping markets with easy credit and low interest rates is not a great environment to make money.
The aforementioned Bill Gross has recently been advocating investors view cash — and a mindset of getting a return of capital rather than a return on capital — as a very viable option inside of a portfolio.
Depressing times indeed.
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