Two days of chaos

Market update

A more chaotic tinge to the bond market’s retreat pushed interest rates sharply higher at most maturities this week. This less permissive interest rate environment seemed to force a reassessment of value elsewhere in the capital market’s complex. Gold and Bitcoin suffered amidst that stiffer competition from higher real interest rates. Some long out of favour parts of the stock market relatively prospered at the expense of some of the more recently shiny bits. Diversified commodities, with the exception of precious metals, continued their barnstorming start to the year.

The context for all of this apparent dyspepsia was a marked re-assessment of the prospects for global growth and inflation, particularly the former judging by the anatomy of the global government bond sell-off. Infection rates have dropped far more sharply globally than can be explained by vaccination rates or indeed estimates of pre-existing herd immunity. What continues to leaves the experts a little perplexed has proved a source of cheer for economic forecasters. This, alongside evolving expectations for the incoming US stimulus package, as well as the infrastructure effort in its slipstream, have forced investors to reappraise the expected path of global growth, and therefore interest rates.

CIO view

This week’s action raises plenty of important questions for investors to try and grapple with. Worries about the global economy overheating may seem remote in the context of the year just gone, however this is likely one of the key debates of the year ahead. Incoming economic data are likely of very little use for now. Inflation data are noisy at the best of times, right now there is barely any meaningful signal at all.

In an analogy that would horrify most serious economists (and car enthusiasts), we might think of the global economy as a car. Like most cars, the global economy has an optimal speed. In the car, if we go too fast for too long, the engine will overheat and steam will erupt from the bonnet. If it goes too slow, it stalls. In this analogy, you can think of sharply rising prices or problematic inflation as the steam. It is potentially a signal that the economy is running beyond its potential. The stall corresponds to a recession. In a sense central bankers have a measure of influence on the accelerator and brakes through their ability to affect interest rates. However, we should be wary of overstating this influence – central banks are just part of a complex web of forces driving and responding to interest rates. We should also remember that they have the same problem as everyone else – namely that the optimal speed of travel for the global economy is always changing, sometimes subtly, sometimes less so. The fact that this potential growth rate is also unobservable in real time further complicates our ability to see what the ‘right’ interest rate is. To flog the car analogy to its final death, it is like driving a car where the size and detail of the engine is constantly in flux.

The point of all of this is that the interaction between growth, inflation, interest rates and stock market valuations is significantly more complex than many talking heads let on. This last year may well have changed the pace at which the economy can happily grow. The policy decisions of the next year could also have a significant influence. One of the many problems with making this judgement now is the outlook for the labour market around the world. We simply do not know to what degree the nature and number of jobs available has been changed by this pandemic and our response to it. To know this, we need a better idea of what our lives will look like when we have this latest coronavirus in meaningful retreat.

Regular readers will know that we have long been wary of the idea that the recent past contains all the information we need to predict the investment winners of the future. The socio-political, macro-economic, regulatory and other contributing influences to one period rarely remain stationary. The capital markets winner and loser board changes, sometimes suddenly and most unpredictably, as a result. This is why we devote so much of our time and resource to mathematically imagining hundreds of thousands of viable futures and finding the mix of assets that sits most robustly in amongst them. This process does sample from the past of course, but is careful not to overstate the signal you can get from the last decade. Those that would offer a compelling singular vision of what is to come in the months and years ahead, as well as the perfect investment(s) to profit, should be ignored. 

From the perspective of this week, it is likely the pace of the decline in bond markets (and accompanying rise in interest rates) that inflicted the bout of stock market dyspepsia rather than the level of interest rates. Borrowing costs remain low both in nominal and inflation-adjusted terms. We are also sceptical of the idea that the incoming US stimulus will force the economy to overheat. Much of the package contains measures that are either one-off (e.g. $1,400 tax rebates) or that will taper off as the economy recovers (unemployment benefits). Besides which, the size of the hole punched by this pandemic is conceivably larger than some imagine. Policy maker efforts to continue to try and fill that hole should be very welcome. 

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