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Stewart Cowley: shock & oarfish - 7 things that could rock your world
by Stewart Cowley on Nov 05, 2013 at 15:10
In a typically colourful blog, Old Mutual Global Investors' bond guru draws inspiration from the Pacific Ocean fish to illustrate the big threats in the financial system.
Seven financial oarfish
Oarfish have been washed up on the coast of California. Oarfish are comprised mainly of a mouth with a stomach at the end. They hang their snake-like bodies vertically in the very deepest parts of the Pacific Ocean in places where tectonic plates collide and earthquakes are born.
If they are washed up on the seashore the Japanese, who know a thing or two about earthquakes, believe a quake is imminent. Such superstitious tittle-tattle is being ushered away with a dismissive wave of the hand and a nervous laugh by officials in California right now.
So what are the oarfish in our lives? What are those seemingly unrelated pieces of evidence that, one day, we will look back on and say to ourselves, 'Why didn’t I listen to that?' In finance we are often accused of not giving people outside the markets due warning about what we can see but which is hidden from the general population until it happens.
So here are seven financial oarfish that could shock the system.
A twisted financial system
We work in a twisted financial system distorted by central bank actions all over the world: The Fed, the Bank of England, the ECB, the People’s Bank of China are all engaged in different types of policies for different reasons in order to prop up their societies.
Getting off these policies, and allowing free market price discovery to let rip through our society has never been needed more. Prolonging the situation increases the size of the eventual readjustment. Each day that passes and we tolerate these policies the bigger the bang when it comes.
Equity markets are increasingly being controlled by hot money. The build-up of deposits in the system has leaked out in the equity and corporate bond markets. Economic fundamentals and market movements have divorced themselves from each other. Deposit money is being lent via the repo market to buy equities at record levels and record prices. This won’t last.
The illusion of diversification
You have to be on the right side of everything all the time to make consistent returns. Diversification has become an illusion. This summer, if you wanted to optimise what I contend was the Fed’s failed attempt to communicate the end of quantitative easing, the best trade you could have done, from a sterling base, was short emerging market currencies and short long-dated US inflation-linked bonds.
No – that makes no sense to me either, as you would have thought that an improved outlook for the US would be ‘good’ for reflation assets such as inflation-linked bonds and emerging markets. Instead, everything gets put in one basket at moments like this and there is nowhere to hide. This is a sign of a system out of the control of logic.
QE doesn't hold down bond yields anymore
Looking back it’s clear the bond bear market in the US, at least, started in August 2012. Even though the Fed has continued its $85 billion a month purchases of mortgages and treasuries it has little or no effect on the markets any more. We don’t need the Fed to officially reduce its purchases for bond yields to rise– they are doing it themselves. Tapering talk is just a distraction.
Growing European contradictions
The contradictions within Europe are increasing not declining. Euroland aggregates have stabilised recently but there is a very different story inside of the numbers. Germany is increasingly propping up the periphery of Europe.
Over the summer the financial system contracted further and economic performance diverged. The Euroland capital account hit a record high – a signal that demand for the euro is peaking. Any re-ignition of problems in Europe will make the euro an ‘at risk’ currency again.
House prices are moving up but lending has hardly begun
A low-grade credit cycle has started in the US and UK. But there is little evidence that the traditional driver is at work yet. Mortgage lending in the US is actually declining whilst Help to Buy has barely begun in the UK. And yet the US Case Schiller house price index is increasing at over 12% a year and the UK Nationwide house price index is rising at nearly 6% a year.
London house prices rose 10% last month! Imagine what will happen if any real money starts leaking into our system. We should all become monetarists again to gauge when the interest rate cycle turns.
Market movements are now dictated as much by unseen agents as anything else. There is a deal of diversification going on among the holders of money.
Currency and bond markets such as Korea and Australia are as much the creatures of foreign reserves looking for a home away from the US dollar, the yen and the euro, as they are a function of fundamental economics. Don’t try and rationalise everything: the Australian dollar, for instance, can stay 25% over-valued for reasons other than the commodity cycle and its relationship to China.