Global financial markets are still adjusting to the last 14 years of extraordinary monetary policies. These extraordinary policies were instigated by the world’s central banks in 2008 to combat the Global Financial Crisis (GFC).
And we are now having to deal with the resulting inflation shocks and policy normalization. This is a real challenge as markets and economic behaviours have fundamentally changed as a result of these distortions.
Markets are looking at a significant possibility of global conflict, broken supply chains, not only of food but also energy supplies, and the resulting increased possibility (certainty?) of a global recession.
At their core, capital markets allocate capital. They assess the risk and price the risk of putting money to work within an economy.
When markets are allowed to work, capital is allocated efficiently. At the right price for that particular risk.
When markets are not allowed to function efficiently, for whatever reason, say deliberate distortions caused by government regulations, there will be distortions in the allocation of capital as well as the price associated with that allocation and thus consequences.
Let’s have a look at how we got here.
The monetary expansion caused by central banks and the government distorted pandemic over the last 30 months have seen interest rates come down to artificially low levels. This has utterly distorted the basic but vitally important signalling mechanism of the market economy and resulted in mispricing of all financial assets.
The consequences have been extraordinary. Evidenced by the markets’ movements over the last few months. And yet, I would argue that many of the consequences have yet to reveal themselves.
Simply put, despite good intentions (something I would argue with but let’s leave that for now) when central banks and governments start messing with the cost of capital and the efficient allocation of capital, things will go wrong.
Every. Time.
It’s as if central banks want to prove right the old saying, “If it’s one thing we should learn from history, it’s that we don't learn from history!”
An additional problem is the fact that once central banks and/or governments step in to “correct” the market, market participants expect them to do it again next time there is a small sign of an issue. And again. And again. And again…
You get the point.
Consider another salient point. Of the people working in financial markets today, 60% joined post 2008. Think about this. None of these people have ever experienced normal markets. Which includes a significant bear market!
Even fewer remember what an 18% mortgage looks like. Or double digit Treasury yields. And most definitely have never experienced a stagflationary market.
This is not to imply that the present generation of financial market participants are stupid. They most definitely are not. But they lack the experience that comes from dealing with normal markets. They only know the artificial markets created by the central bank distortions. Buy the dip being at the forefront of this.
It bears repeating, bull markets make even stupid people look smart.
It should not come as a surprise that when stock markets soar and bond yields fall to record lows, anyone managing money looks like a genius.
Incredibly cheap capital triggers wild speculation in financial assets. Risk is mispriced. And the investment strategies employed are less than optimal. Think corporates increasing their borrowings to buy back shares. This pushes up the share price and makes shareholders, obviously including the management, happy. In the short term. But it actually reduces corporate profits. Especially if the cost of borrowing rises. Like it does now.
When industrial companies play the financial markets rather than investing in new production facilities to improve the company’s long term prospects, there will be consequences. And they affect more than just the shareholders.
I think we’ve been there before. Does anyone remember the movie “Wall Street”?
In real, non-central bank distorted life, there is an optimal price for capital. The rate at which market participants invest for growth. For at least the last 14 years, everyone has focused on financial assets. And not the “real” economy.
As these assets got more expensive, people looked for alternative ways to get rich. With the least amount of effort. I guess this may account for some of the increase in the price of crypto and related assets like NFTs.
And now the markets have realised that most market participants are swimming naked, to paraphrase Warren Buffet.
Risk in the markets cannot be magically disappeared. It can only be transformed.
There are no solutions. Only trade-offs.
Central banks did not “solve” the GFC of 2008. They only kicked the can down the road. And that’s where we are now.
Keep in mind, generals are always prepared to fight the last war. Central banks are the same. This current crisis is unlike any of the previous ones though. And using existing weapons will not work.
We most certainly live in exciting times.
The good news though is that the good times will return. They always do! And this time will be no different. We shall manage.
We always do, don’t we?
