Markets waiting for Janet Yellen to show the white flag

If the Fed chair blinks and postpones future rate hikes, there could be a change in markets—the dollar would fall and commodities and emerging markets may shine again


US Federal Reserve chair Janet Yellen. Photo: Bloomberg
US Federal Reserve chair Janet Yellen. Photo: Bloomberg

This isn’t the first time that Mario Draghi, the president of the European Central Bank (ECB), has brought the markets back from the brink.

From his “whatever it takes” speech to preserve the embattled euro in 2012 to his recent statement that there are “no limits” to how far the ECB is ready to go to achieve its objectives, he has provided firm support to equities.

During a time when the markets badly needed reassurance after conflicting signals from the US Federal Reserve, Draghi has once more stepped into the breach. It’s no wonder he has been dubbed ‘Super Mario’.

Investors have been relying on central bankers to provide a floor to equities, as they embraced policies of quantitative easing explicitly designed to boost the wealth effect, right from the days of the infamous ‘Greenspan put’.

To be sure, they have had periodic bouts of jitters, but central bankers have stepped in whenever the panic threatened a rout. Over the past few years, investors have learnt it doesn’t pay to fight central banks.

Is the bout of volatility in early 2016 any different?

Well, for one, even ‘Super Mario’ is not invincible. Early last December, he over-promised and under-delivered and the markets threw a tantrum. That was a warning that markets will not be denied their fix.

Second, another bout of yuan depreciation and a ham-handed application of a market circuit-breaker indicate there’s a lot the Chinese authorities do not know about markets and bouts of stomach-churning volatility will continue.

Belief in the ability of the Chinese authorities to manage shocks to their economy is fast eroding. One only has to look at Japan to realize that transitions from an investment-driven model to a consumption-driven one are far from easy. Add to this the geopolitical tensions in West Asia that have affected the price of oil and it’s clear that global markets continue to be very fragile.

There is also a more fundamental concern, one that will become increasingly important the longer it takes for growth to come back—whether the unconventional monetary policies such as quantitative easing and negative interest rates adopted by the central banks of the advanced economies can turn around their economies.

Economist William White, who warned so presciently of the financial crisis, has been writing about this. In a presentation titled The Ultra-Easing Money Experiment in October last year, he pointed out, “a lower discount rate works primarily by bringing spending forward from the future to today.

In this process, debts are accumulated which constitute claims reducing future spending. As time passes, and the future becomes the present, the weight of these claims grows ever greater. In short, easy monetary policies are likely to lose their effectiveness over time—and seven years seems rather a long time by anyone’s standards”. If White is correct, volatility will become much worse, as the central bank “fixes” lose their potency.

There could also be another contradiction. In seeking to revive their economies, governments seem to be relying on central banks, which, in turn, are trying to stoke the wealth effect. But the nature of the wealth effect is such that it exacerbates inequality.

And since the rich have a lower propensity to consume than the masses, the wealth effect may not be strong enough to deliver robust growth. More importantly for the market, if the health of the economy becomes dependent on asset bubbles, booms and busts will also become more frequent.

That said, investors would not want to be on the wrong side of central bank action. Looking ahead, if Federal Reserve chair Janet Yellen blinks and decides to postpone future rate hikes, there could well be a complete change in the markets—the dollar would fall and commodities and emerging markets may shine again.

The Bank of America-Merrill Lynch (BofA-ML) January 2016 survey of global fund managers, carried out in 8-14 January, showed very high cash levels with investors, cash that easily fuel a rally. But in spite of the recent carnage, BofA-ML believes we haven’t seen bear market capitulation. That’s because although allocation to equities has fallen sharply, investors are still overweight stocks and current allocation is a mere 0.3 standard deviation below the long-term average.

What then will mean that the bottom has been reached? The BofA-ML report says true capitulation would involve a lower US dollar, while redemptions lead to forced selling of favourite long plays such as the FANG (Facebook, Amazon, Netflix and Google) stocks.

The survey also points out investors remain “stubbornly long tech, euro zone and Japanese stocks (assets now most vulnerable to a redemption/recession shakedown)”. While being long, the US dollar is still the most crowded trade, conviction in the trade is falling. The survey showed that dollar bulls are now a net 44% compared with a net 87% in November 2014.

BofA-ML’s recommendation: “Sell bounces until the 4Cs (China, Commodities, Consumer, Credit) improve.”

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