China - staying out of the news

A tumble in stock prices gives rise to more worries about China but it is not deserving of the bad press

News about China often hits the front pages as its swift rise is both scary and a source of economic salvation.  Stock markets in China have been making news recent due to a sharp selloff in shares.  The media are quick to jump on any potential hiccup in China’s rapid expansion due to its growing importance as a global economic superpower.  Yet, the peculiarities of stock markets in China mean that the spill over effects are likely to be limited even though the financial sector will continue to be a source for headlines in the future.

New to this game

Picking the right stocks and when to buy them is never easy but it is even trickier with China being a relative newcomer to trading shares.  The shorter the period of time over which shares have been traded, the more difficult it is to pin down what should be paid for stocks.  Many of the companies themselves are also still young and are still fighting a fierce battle with rivals for survival.  On top of this, the bulk of the investors in the Chinese markets are locals and have less experience in trading stock. 

The government further muddies the picture with its plans for liberalising the financial markets.  While fewer restrictions would be welcomed, the reforms create jitters due to the potential pace of change depending on the whims of its leaders.  Yet, the government regulations in themselves are part of the problem.  One issue is limits on how much banks can pay out in interest on savings accounts.  Starved of other places to put any spare cash, too many Chinese look to make money in domestic share markets which are ill equip to deal with the inflows.

While many eager investors have managed to sidestep the barriers, heavy regulation of the financial markets keeps out many more Chinese.  This has the effect of limiting any losses when the inevitable selloffs hit the stock markets.  In this way, the government ensures that the underlying economy is sheltered from any volatility in the stock markets.  Neither is the stock market much of a reflection of what is going on in the actual economy.  Chinese stock prices had stagnated for a long time prior to the recent ups and downs so it is unlikely that any bad news in the stock markets will be a prelude to trouble with the economy.

Watch this space

All this would not make the headlines if happening in any other emerging market but China is a big deal these days.  Its importance as the main global driver for economic growth makes outsiders nervous.  Its haphazard mix of free market and government control means that pessimists are quick to spot its faults.  But, just like with the patchy rules governing financial markets, the government has adapted in the past to stay on top of problems before things get out of hand.

The fear of market turmoil spilling over to society at large will continue to keep the Chinese on a cautious path to freeing up financial markets.  Over this time, China will continue to be plagued by a jumpy stock market as its investors grow used to the ups and downs of share prices.  Considering that even Western investors have not fully mastered this, the trials and tribulations of Chinese share prices will likely to be hitting headlines again many times in the future.  But, with government policy helping to stem the spread of any losses, it is not something that needs to cause too much worry yet.

Global Economy - Half-time Report

It is game on in Brazil but many are hoping for less thrills in the financial markets in the second half of 2014

Just like in a football match, the half-way point (of 2014) is a good time to assess progress so far and look ahead to the second half.  The first six months have been relatively boring but in a good way, after participants and spectators of financial markets have been riding by the seat of their pants over the past few years.  The game plan so far has been an emphasis on defence with central banks in Europe and Japan providing more support for their economies while tapering by the Federal Reserve has been at a measured pace.  Investors are betting on a quiet second half to 2014 but this will depend on whether the markets can hold their nerve when confronted by the prospect of tighter monetary policy.

Tension is building

The start of 2014 could be considered a success on a number of fronts.  There are reasons for optimism in terms of the economic recovery such as swiftly falling unemployment in many countries.  Share markets are buoyant suggesting that investors are willing to take on risk.  Interest rates on government debt have dramatically fallen for most countries in Europe whose debt has previously been shunned by investors.  The focus of policy makers is no longer on dealing with the potential for crisis but instead on bolstering the economy recovery.

The only problem with this is that much of the progress has been built on loose monetary policy which is due to come to an end.  Investors will have to manoeuvre around the winding up of quantitative easing and higher interest rates.  This will be like a football team losing one player in defence – not the end of the world but it opens up the potential for calamity.  One consequence is that it is unclear how the second half of 2014 will play out.

May 2013 proves us with one example of what is likely to happen sometime soon .  In this month last year, financial markets went into spasms as the Federal Reserve signalled that it would cut back on its monthly bond purchases that constituted its quantitative easing program.  A repeat of what has since been labelled “taper tantrum” seems likely but with higher interest rates as the trigger (maybe prompting headlines of “rates rampage”).  Another popular phrase has been “fragile five” after countries who suffered at the hands of financial market who can turn nervy at any time.

When will things kick off?

The game plan from policy makers adopted so far this year is likely to stay in place considering the relative calm in the financial markets.  The aim will be to not let in any goals (especially any own goals) rather than pushing to score gains in economic growth.  As a result, it is tough to see any big changes in the economy itself.  Dramatic improvements in the economy are not likely with governments continuing to mend their finances.  Loose monetary policy may also not be as useful as hoped in boosting spending by consumers or investment by firms even as the economy shows sign of getting a second wind. 

Whether the benign economic conditions continue into the next six months depends on the fickle nature of investors.  Like an erratic football striker who often gets stroppy, investors need to get their way in order to be kept happy.  Central banks will likely take a cautious approach so investors don’t retreat to the side-lines.  This is likely to result in the first hike in interest rates by the Bank of England, which is ahead of its peers in this regard, being pushed back to at least next year.  Further reasons for delay include other policy options being available to the UK central bank and a likely negative effect on the pound from any rise in interest rates.  Others such as the European Central Bank and the Bank of Japan likely have even more to offer in terms of loose monetary policy to play ball with investors.

The football world cup in Brazil has been notable for its outstanding goals and nail-biting action.  In contrast, many will be hoping that the financial markets in the second half of 2014 will be as exciting as a nil-all draw. But just like a game going into extra time and penalty, some excitement is inevitable as monetary policy tightens and it is something that the financial markets will have to cope with this year or next.

Stock Markets – Calm for now

Following a rising stock market is an easy way to make money but share prices can only defy gravity for so long

Something strange is in the air among investors – a pervading sense of calm.  Volatility in financial markets has dropped off while stock prices are near record highs.  These conditions seem out of place at a time when there are a number of reasons to be jittery - the economic recovery is far from assured and central banks are set to raise interest rates.  The buoyancy of the financial markets says more about the habits of investors than the actual state of the economy. 

One defining feature of investing is that it can be easier to make money by following trends rather than fighting against market momentum.  The only problem is that the trends become a force in themselves and can push prices too far either up or down.  This effect can only be temporary as markets must revert back to normality at some point.  This leaves investors caught between making money when times are good and making a getaway before profits are wiped out.  This day is drawing closer.  Your Neighbourhood Economist can’t predict when it might happen, only that a reckoning is likely to be just around the corner.

It’s complicated

Financial markets are notoriously hard to read.  Theory tells us that the prices of shares are based on a combination of all available relevant information.  Yet one of the most pertinent reasons for buying or selling is the past price movements.  Financial assets are one of the few things that we buy more of as the price rises and are more likely to sell when the price falls.  This can often override other considerations such as whether a company is expected to see its profits grow in the future.  Base instincts such as greed and fear can also take over and distort our investment decisions.

The tech boom and bust just over a decade ago was a classic example of this.  Investors threw money into start-ups whose ability to generate revenue was questionable.  You did not even have to believe that the Internet would revolutionize business, just that others would and that these others would keep buying so that you could make a tidy profit and sell up.  Thus, prices often deviate from what shares in a company might actually be worth depending on the likelihood that someone else might be willing to pay more for the shares sometime in the future. 

This is not to say that money cannot be made by holding onto shares in profitable and well-managed firms.  Yet such an investment policy will only work out in the long term with the timing of when to buy and sell also being crucial.  The bulk of investors, however, are not trading in shares over the long term.  Professional investors looking after other peoples’ money tend to actively buy and sell to take advantage of short-term trends.  This proactive approach is also used justify (and amplify) their considerable fees despite often being unable to outperform market benchmarks.

Actually, it's even more complicated

Gauging where shares might be heading is further complicated by the current expansive monetary policy.  An abundance of cash in the financial system means that people wanting to buy financial assets are never far away.  Pushing share prices to unrealistic values is just one example of how monetary policy is creating problems.  Policy makers need consumers in an optimistic mood to get spending up and creating extra wealth through the stock market is one of the few ways of getting us in a more cheerful mood.  It can only provide a short-term boost and might work in the opposite direction when this policy is reversed.  The jolt from the inevitable interest rate hike which is likely to disrupt the market calm may result in more than just some investors losing their easy gains.

US Monetary Policy – Investors face stormy future

US investors have been blessed with calm seas of late but their good luck is unlikely to last

Monetary Policy has entered a period of calm after enduring something of a turbulent passage through the global financial crisis.  The unprecedented tempest which buffeted the banking sector led central banks to trial a number of measures never seen before.  Yet, since tapering of quantitative easing was launched at the end of 2013, it has been relatively smooth sailing.  Tapering has been implemented in steady waves so as to not shake the delicate stomachs of investors.  However, rather than signalling the end of the choppy weather in the financial markets, the current lull could just be the eye of the storm.

Skies clear following predictable monetary policy

Investors prefer favourable conditions in the same way as sailors.  A view far ahead to the horizon is prized in the financial markets as well as by mariners.  One element that helps investors to better plan a course for the future is having a predictable monetary policy as a guide.  Investors had come to rely too much on the Federal Reserve as a steady hand at the helm using quantitative easing to put some wind back in the sails of the US economy.  Problems thus arose when the Federal Reserve first floated the idea of trimming back its expansive monetary policy in the middle of 2013.

What was a stiff breeze for the US hit many emerging markets like a financial hurricane.  This is because a considerable portion of the money printed in the US had travelled the globe in search of more bountiful returns.  Some developing countries had become a haven for the extra cash but the money left in a whirlwind once the prospects for returns in the US picked up.  The resulting market turbulence pushed some countries to the brink of going under, but investors eventually settled down again after adjusting to the new forecasts.

The outlook for US monetary policy has brightened considerably with the steady progression of tapering.  The Federal Reserve has cut back its purchasing of bonds by US$10 billion at each of its meetings, which happen almost every month.  As a result, bond purchases have been reduced a few times already in 2014 and fell from US$85 billion in late 2013 to US$45 billion at the most recent meeting at the end of April.  The predictability of US monetary policy also survived the potential shipwreck that was the change in skipper from Ben Bernanke to Janet Yellen at the beginning of the year.

Forecast for storms ahead

All is well for now.  However, there may be trouble on the horizon as tapering is just the start of the Federal Reserve relinquishing its role of propping up the economy.  A bigger storm may be coming next year as interest rates have to be raised from their current record low levels.  The Federal Reserve has pledged not to change interest rates for a while as it monitors the economic recovery.  Interest rate hikes must happen sometime in the next year or so especially in light of the surprising improvements in the US job market.

The end of quantitative easing and higher interest rates are all part of a voyage back to normality.  It has been a strange new world in terms of both the financial markets and monetary policy following the waves of financial havoc over the past several years.  The recent squalls that hit emerging markets can be seen as a necessary part of this journey.  Nevertheless, other rough patches may still lie ahead considering that it is far from normal for US stocks to be pushing on record highs despite slow economic growth. 

While it is tough to gauge what normal should look like in terms of the financial markets, the signs indicate that rough seas lie ahead.  Emerging markets have already taken a beating which makes it likely that the next storm may strike US investors closer to home.  

Uncertainty is still the only certainty

Sometimes you come across data that seems to capture the current mood.  This was the case with a survey by an investment firm showing that 32% of wealthy investors plan to increase their holdings of cash over the next 12 months.  This change in asset allocation toward cash is strange considering some investments such as stocks are having a stellar year while returns from leaving money in the bank have been dismal.  This high level of caution shown by investors, who typically have advisers telling them where to put their money, highlights the level of uncertainty faced by those trying to invest their money.  Yet with a number of possible hiccups on the horizon, cash seems to be the least bad of a poor range of options. 

The key concern for many investors is the upcoming reduction (so-called tapering) of bond purchases by the Federal Reserve.  Improvements in the US job market are expected to see the Federal Reserve cut back its monthly purchases of US$85 billion worth of bonds in the next few months.  One of the side-effects of this monetary policy has been to push investors away from bonds and into riskier assets such as stocks which has helped to lift the S&P 500 up 26% so far this year to record highs.  The actions of the Federal Reserve have grown to be the dominant factor in the direction of share prices with investors placing more stock in announcements from the central bank than data on the strength of the underlying economy. 

There has been a debate raging over the extent of the influence of the Federal Reserve with some degree of distortion inevitable considering the scale of the bond buying operations.  Share prices could be overinflated and a sharp fall might be necessary to find their correct value.  Alternatively, any changes from the bond buying end may be minimal and it may just be worries about what might happen that is scaring off investors.  Some experts argue that it is good news that investors are holding a lot of cash as it suggests that shares are not yet overpriced and this cash may still flow into the stock market over the next year.  However, in this scenario, the smart money would already be invested in stocks. 

The uncertainty is such that investors are shunning higher returns from stocks for much lower pay-outs from leaving money in their bank (the best efforts of Your Neighbourhood Economist resulted in yours truly being locked into cash for two years to eke out a miserly interest rate of 2.0% through a UK savings account).  Among the few certainties for investments over the next year or so is that a considerable amount of volatility is likely as investors try to figure out what the Federal Reserve will do next and how other investors will react.  Great if you like investing to be like a roller coaster ride, but the rest of us may be better off settling for meagre returns from our banks.  

Federal Reserve – preparing to taper

With crunch time coming up, the Federal Reserve puts in the groundwork for a key change in policy

In the long march of dealing with the aftermath of the global financial crisis, the recent baby steps taken by the Federal Reserve may be one of the most crucial parts of the journey.  The Federal Reserve is considering lowering the interest rate on reserves it holds for banks as part of a move to offset upcoming reductions (tapering) in its bond purchases which currently amount to US$85 billion each month.  This tapering is perhaps the most important policy change in the past 12 months with the health of the global economy in the balance, so the Federal Reserve is anxious to ensure all goes well.

The actions of the Federal Reserve have been keenly felt across the globe with stock markets everywhere buoyed by the extra cash sloshing around the international financial system.  This abnormal state of affairs where central bank policy dictates the movement of stock prices is increasingly creating distortions through excessive gains in stock prices.  A pickup in the US economy would mean that the extra stimulus is no longer needed, but a smooth transition as the Federal Reserve changes tack will be key to sustaining any economic recovery in the United States and elsewhere.

As such, the Federal Reserve has been keen to soften the blow to the stock markets with policies that act as a stimulus as it cuts back on the bond buying which has been the main focus of its expansionary policy.  The mere rumour that the Federal Reserve would buy fewer bonds resulted in the interest rates on 10-year US government bonds jumping from around 1.7% in May to almost 3.0% in September.  Forward guidance, with future hikes in interest rates linked to unemployment, was tried as a means to signal the intent to help the economy but investors did not buy it (see prior blog for more).  

Changes to interest rates on banks’ reserves which are under consideration will only probably have a minimal effect but it is the signalling by the Federal Reserve that may be more important.  By showing a willingness to continue to support the economy, the Federal Reserve eases concerns that its actions will trample over the nascent economic recovery.  Some of the best successes of monetary policy have taken effect through nothing more than the suggestion of future action, such as the promise by the European Central Bank to do “whatever it takes” to save the euro.  This convinced enough people that it put paid to the Eurozone crisis without a single bond being purchased or interest rate being changed.  

Your Neighbourhood Economist was previously critical of the Federal Reserve for not taking the opportunity to begin tapering in October but the extra couple of months have been put to good use in ensuring that the change in policy goes smoothly.  All eyes will now look to the next meeting of the Federal Reserve (17th to 18th December) when tapering may be announced especially if US job data released on the first Friday in December is seen as positive.  The Federal Reserve is taking a cautious line but it is worth ensuring that there are no stumbles in the finishing stretch.

So what’s the rush?

Having vanquished the threat of economic disaster, the Federal Reserve sets its sights on a return to normality.  

It would seem to be anyone’s fantasy to have the power to influence the direction of the global economy and have investors hanging off your every word.  But it is more of a nightmare for Ben Bernanke, the chairman of the Federal Reserve.  Despite concerns over the strength of the economic recovery in the US, the Federal Reserve is already planning to shed its guise of defender of the economy.  But why the rush?

The Federal Reserve has been thrust into the role of hero with monetary policy deemed to have mythical power to heal the ailing economy.  The limited resources at the hands of central banks have required the use of heavy firepower to stave off economic disaster.  But it is a victory that has come at a heavy price with central banks now deeply involved in the management of the global economy which is proving a difficult position to retreat from (for more, see The perils of doing too much).  Statements by Bernanke in the previous weeks which suggested that the day had been saved and further actions could be tapered off prompted investors to run screaming (refer to Monetary Policy in the Real World). 

The haste at which the Federal Reserve is keen to head for the exit despite concerns that the risk of economic meltdown has not been put to rest is mostly due to the perceived consequences of monetary policy.  Economists who run central banks typically have the personality of the bookish and reserved Clark Kent rather than that of a caped superhero.  Rather than believing in their own powers, economists have a faith in the ability of the markets to generate optimal outcomes.  So any actions taken from the top down which are not governed by market forces will generally result in distortions in the natural order of things.  The extent to which the Federal Reserve has had to ride to the rescue – slashing interest rates to close to zero and buying US$85 billion in bonds each month – has created forces that if left unchecked could result in the Federal Reserve being cast as the villain.

The Federal Reserve has been caught out in the past when led by Alan Greenspan for setting interest rates too low for too long.  The cheap rate of borrowing helped to fuel growth but this proved to be unsustainable when the global financial crisis kicked in, as the amount of debt had become too much to bear.  Low interest rates have not yet had anywhere near the same effect this time round as firms and consumers have been so worried about the future that they have been paying back their loans instead.  The key concerns regarding distortion at the moment is in the prices for stocks and bonds which have benefited from the Federal Reserve’s efforts to keep the economy moving (see Doing more harm than good).  Inflating an asset bubble at this time would be like fighting off one crisis only to plant the seeds of another.  And the Federal Reserve not only has to worry about the reactions of investors but also about the value of its own investments considering the US$3.5 trillion in assets already on its books. 

But it is perhaps the psychology of those running the Federal Reserve that is the overriding reason behind a desire to retreat into the shadows.  The Federal Reserve is not comfortable in the spotlight and prefers to operate in the background as a steady hand on the wheel rather than a dashing hero.  The improving economy in the US provides an escape route while other central banks are still on call ready to fight off economic stagnation.  The decision to move first out of the central banks and put down the big guns of monetary policy is bold but it is also prompted by a fear that further actions will require even more of a superhuman effort to tidy up the resulting potential mess.  

Where to next for central banks?

Saving the global economy might have been the easy bit – now central banks have to find a way to get out of the limelight.

The outlook for the world economy is far from sunny but talk of impending doom regarding the fiscal cliff in the US or the collapse of the Eurozone seems to have passed.  Central banks have been called on like never before to save us from economic catastrophe and have developed new strategies to deal with the unique problems thrown up by the global financial crisis.  But the deeper the central banks get involved, the more difficult it will be for them to extract themselves from their new dominant roles in propping up the global economy.  Signs of economic recovery mean that this tricky task is at hand but the way out will not be easy.

The first to have to come up with an exit strategy is the Federal Reserve in the US due to a relatively robust economy with the US economy expected to expand by 1.9% in 2013 and growth of 3.0% forecast for 2014.  The third round of quantitative easing means that the Federal Reserve is currently purchasing bonds worth US$85 billion each month with a promise to continue this until there is substantial improvement in the labour market.  With the unemployment rate having edged downward from 8.1% in August to 7.6% in June, the chairman of the Federal Reserve, Ben Bernanke has begun to talk of tapering off its bond buying which will be the beginning of the a long process of winding up the aggressive loosening of monetary policy.

The loose monetary policy has not only involved central banks becoming considerable buyers in the bond market but also interest rates being set at record lows.  It is fair to assume that these policies have helped ease the pain stemming from the global financial crisis, if not having staved off economic meltdown.  Yet, the flipside of the dominant role taken by the central banks is that the reversing of these policies brings its own problems.  Central banks have typically been supported for their actions in the face of possible disaster especially considering the squabbling of politicians.  While policies that boost the economy during slowdowns will always be welcomed, measures that add headwinds to an economic recovery (tightening of monetary policy) are unlikely to make central banks popular.  Yet, the bond buying and record low interest rates distort the economy and may create problems in the future. 

So a return to normality in terms of monetary policy is inevitable but it will be a protracted process with purchases of bonds by central banks being pared back followed by interest rates being nudged upwards all depending on the state of the economic recovery.  This chain of events may start this year in the US, maybe in the summer but probably later in the year or in early 2014, and will take at least a few years.  The decision making of the Federal Reserve will face even more intense scrutiny in the media considering the influence that its actions have over the markets for bonds and stocks (see Caution - windy road ahead for explanation).  The glare of the media will make it difficult to keep the majority onside as even the much-revered former chairman of the Federal Reserve, Alan Greenspan, discovered after falling from grace due to having been seen in hindsight to have left interest rates too low for too long.

The other major central banks will have the luxury of following behind the Federal Reserve.  The European Central Bank cut interest rates in May 2013 in a mainly symbolic sign of its continued intentions to bolster the Eurozone where the economy is expected to weaken by 0.3% in 2013 according to the IMF.  The real possibility of a breakup of the Eurozone was almost single-handily put to rest by the European Central Bank’s willingness to do “whatever it takes” to save the euro (for more, refer to "Whatever it takes"). Yet, the lack of a recovery has left the European Central Bank on red alert – everything is on hold in case another crisis breaks out.  The central bank in Japan is heading in the opposite direction to its US counterpart and is ramping up its monetary policy in the hope of kick-starting an economy which has been stagnating for the past two decades (for the details, see All bets are ON).

So trying times lay ahead for central banks and the rest of us left trailing in the wake of their actions.  Not only will the direction of prices for stocks and bonds depend on developments in monetary policy but gauging the suitable tempo of change by central banks will be crucial in encouraging the nascent recovery in the global economy.  It may be the beginning of the end in terms of central banks saving the world but there is still a long way to go to get to safety.

Caution – Windy Road Ahead

Trends in the stock market are hard to spot at the best of times but upcoming changes to monetary policy will add a few extra twists and turns.

Trying to work out the right time to buy or sell shares is like driving at night with a busted headlight – only some of the road ahead is visible and it is best to proceed with caution.  Evidence suggests that even the so-called experts struggle to negotiate the markets better than anyone else.  Everything from nutty dictators in North Korea to the latest iPhone can throw the markets into disarray.  The task of investing in stocks has been made even more difficult due to extra funds in the financial system stemming from central banks everywhere printing money.  The actions of the central banks has given shares an extra boost but the resulting gains are expected to fade with more cash likely to be less forthcoming as the global economy improves.  With monetary policy now dominating movements in the stock market, the prospect of changes by central banks are likely to leave investors hanging on the edge of their seats.

The basic premise of shares in a company is that it entitles the owner to a portion of the profits in that company.  The value of shares will rise or fall depending on the company’s ability to generate profits in the future.  While profits also rely on circumstances at each individual company, it is the state of the economy in which companies operates that tends to dictate the direction of the stock market.  So it may seem like somewhat of an anomaly that some stock markets such as in the US are hitting record highs at a time when the outlook for the global economy is so dismal.  The reason behind all this is monetary policy. 

Central banks were quick to slash interest rates to close to zero with the onset of the global financial crisis, but when the low interest rates were having little effect in terms of the prescribed goal of boosting lending, a new policy of quantitative easing was adopted.  Central banks started to print money and use this to buy bonds with the hope of making borrowing even cheaper.  Yet in spite of all of these efforts, consumers and companies have been stuck in a cautious mood and loathe to part with their cash which they have stashed away instead. 

The surplus funds end up being invested in assets such as bonds and stocks.  Bonds would be the preferred investment due to being a safer bet amid these turbulent times, but with central banks spending billions buying up bonds (which increases prices and reduces returns), the meagre pay-out from bonds has seen funds flow instead into the stock market.  The extent of these cash flows is such that it is vagaries of monetary policy that have come to dominate the direction of share prices.  The underlying health of the economy only registers to the extent to which it has an effect on the bond buying of central banks and has created a paradoxical situation where bad news regarding the economy is good for shares as weak economic growth translates to continued action by central banks.

The return of growth in the global economy may help to cushion any weakness in share prices as the central banks wind down their operations.  In theory, steady economic growth ensures that corporate profits increase over time, and thus, the value of stocks is typically on an upward trend.  But with the possibility of ups and downs in the global economy, shares may end up being overpriced depending on the extent of a potential correction in the market due to the change in monetary policy.  The potential for a correction in the stock markets makes it tricky to call whether it is a good time to buy or sell with the added uncertainty likely to make for a bumpy ride if you have the stomach for it. 

Close your eyes and hope for the best

Some advice for how to ride out the upcoming twists and turns in the markets.

Your Neighbourhood Economist tries to remain impartial when writing, but like many people, has a certain amount invested in the topics that are mentioned on this blog.  For most of us, it is our employment which can make us vulnerable to the ups and downs of the global economy.  But for some who have a bit stashed away here and there, putting any extra cash to good use is a tricky predicament at this time.  It seems to be like riding a roller coaster in the dark – hence the title of this article – is the best investment advice that Your Neighbourhood Economist could come up with and here is why.

Investment options can be categorised into two types (or a mixture of both) – safe or risky.  With many countries in the developed world still suffering a hangover from the aftermath of the global financial crisis, it would seem as if the clever move would be to go down the safe route.  But the safe option - bonds - has been jumped on by so many investors that returns from bonds have hit record lows in many places, such as debt from countries like Germany or the UK, which are seen as refuges from the turmoil elsewhere. Even the banks with their own problems are paying out higher interest rates than the more prudent options in the bond market.

With such a meagre pay-off from playing it safe, money has been migrating to riskier options with higher returns with shares being the obvious example of a riskier investment.  As such, some of the indices for the big stock markets such as the Dow Jones in the US have hit record highs.  This may seem a bit strange considering the doom and gloom surrounding the outlook for the global economy but it is a phenomenon which has been engineered by central banks across the globe.  Their policy of printing loads of cash has been targeting increased lending and a boost to the prices of assets that you and I might hold such as real estate or stocks.  This increase in asset prices is meant to help us open up our wallets and be more willing to spend (a phenomenon referred to as the “wealth effect”) despite the lingering possibility of job losses and sluggish increases in wages. 

There is a fatal flaw in this scenario that makes investing in this seemingly booming market for stocks even more of a risk.  Central banks will have to shut off the flow of cash sometime.  The main concern for central banks is inflation and keeping it at a sufficiently low level.  But more money, when people actually spend it, leads to higher prices which will be the result of the central bank policies once economic growth returns in earnest.  So the flow of extra cash from central banks which has pumped up share prices will end at some point in time over the next few years.

The timing all depends on the state of the economy in different countries with the Federal Reserve in the US already signalling that it will soon taper off its buying of bonds depending on a continued fall in unemployment.  The European Central Bank has its monetary policy on hold for the moment as the economic situation in Europe gradually improves but may act if another crisis kicks off, while the central bank in Japan has ramped up its monetary policy with the stagnating economy seemingly impervious to previous bouts of monetary stimuli.

This puts potential investors on a scary part of the metaphorical roller coaster ride of investing in the stock market.  There has been a big drop in the market with the financial crisis and the upward turn as share prices bottomed out, but where to next?  To complicate matters, it is the cash coming out of the central banks more than the actual state of the economy that seems to dictate share prices.  This has led to a paradoxical situation where the stock market can fall due to positive news on the economy as robust economic growth would prompt central banks to shut off the flow of cash.  

The result is a lot of twists and turns ahead as the market players try to assess the future of monetary policy, the direction of the global economy, and how other investors will react amongst all of this.  What is bound to ensue is a lot of screaming over both the good and bad.  But with few other easy investment options available, there may be little else to do but invest in stocks, close your eyes and hope for the best.

The danger of positive thinking

With global stock markets in the midst of a major mood swing at the beginning of 2013, a new found optimism brings its own perils.

It is as if the market as a whole decided to focus on the positives as its New Year’s resolution.  Global stock markets have taken off in January 2013 as investors have shrugged off the worries that had weighed down on stock prices in 2012.  But while chronic pessimism has plagued markets over the past few years, the opposite has been the case in the New Year as stock prices have rebounded to levels which are tough to justify amid weak growth in the global economy.  So even though too much negativity has wreaked havoc in the markets, unfounded optimism can bring its own problems.

The prices of shares had been due for a rebound.  Investors had been on a knife edge with the potential for disaster seemingly around every corner as leaders in Europe dithered during the Eurozone crisis, politicians stepped up to the edge of the fiscal cliff in the United States, and the economy in China slowing during changes at the top of the Communist Party.  But along with Mayan predictions of the end of the world, all major catastrophes were averted in 2012 and this prompted a change of heart after investors returned from their holidays. 

Bonds are the typical haven for investors in times of woe and the past few years followed this pattern with investors having snapped up the bonds of prudent countries that have manageable debt levels even though interest rates have been below two percent.  Yet, bond prices have risen so high that further gains are not likely, but there were few other attractive investments at the time. And, as 2012 drew to a close, investors aching for higher returns had already shifted from the safer government bonds into the bonds of previously shunned countries such as Spain and Italy as well as corporate bonds. 

The new signs of life in the stock market tempted many into believing that the time was right to take on more risk and cash in their bonds to place a bet that improvements in the global economy would pick up pace in 2013.  This scenario has prompted talk of a “great rotation” as a swing in sentiment prompts investors into moving money from bonds in stocks.  The continued printing of money by central banks to shore up ailing economies has also helped to buoy the spirits of investors.  This all suggests an abundance of cash which will be heading into the stock market.  Yet, although it makes for a nice story to help prop up share prices, it may just turn out to be a fairy tale.

One of the main sticking points is that, while share prices have rebounded, the outlook for the global economy is still grim.  Higher share prices need to be backed up by companies generating larger profits and this cannot happen until the global economy has regained more vigour.  While an economic armageddon has seemingly been avoided in 2012, growth in the global economy will remain sluggish as high levels of government debt in many countries are trimmed back over years of austerity (for more details about Europe in this context, see Both Good and Bad News for Europe).  

Despite the holes in the story of the “great rotation”, many investors have been keen to believe in a new beginning.  Even the temptation of dubious scenarios can draw buyers back to the market due to concerns about being left behind if the market rebounds.  Investors also buy on expectations of what will happen in the future rather than based on the here and now so a dramatic improvement in economic growth in the following 12 months could prove that now is the right time to buy.  But with many having suffered heavy losses as share prices plummeted during the global financial crisis, a false dawn will do little to reassure investors that it is safe to return to the market.  An overly inflated stock market will also create a conundrum for central bankers and may prompt them to tighten up monetary policy while the economic recovery is still tenuous.  So here’s hoping that investors wake up from the pipe dream of soaring share prices before it turns into a nightmare.  

Where is all the money going?

Central banks in the world’s largest economies, the European Central Bank and the Federal Reserve in the United States, have recently announced plans for creating an unlimited amount of money.  A third central bank, the Bank of Japan, also has announced its intent to pump even more cash into the Japanese economy.  The funds from the central banks are used to buy bonds with the goal of pushing down interest rates (for details – see The Demand and Supply of Money).  The money received by those selling the bonds has to go somewhere.  But it is not always clear where the money will go.  Image pumping more and more jam into a donut – some of the jam will go where it is supposed to but the jam will at some point spurt out in unintended directions and make a bit of a mess.

The buying of bonds by the central banks will increase the prices of bonds and decrease the interest rates which mean that bonds will be a less attractive investment.  The shift of funds away from the bonds being brought by the central banks to other sectors of the economy is seen as an added benefit along with the lower interest rates.  It will help to reduce the borrowing costs of companies which would make them more likely to invest.  But the anaemic state of the economy suggests that such investment is still muted. 

Money has also moved from the bond market into shares.  This also has an upside due to what is known as the wealth effect – consumers will spend more when they perceive themselves to be wealthier (when their shares are worth more).  But any gains in the stock market due to this can only be temporary as the underlying value of the shares which depends on the profitability of the companies can only improve along with the economy.  This had not stopped the stock markets reacting vigorously to the perceived intentions of the central banks.

Considering the global nature of finance, the money does not only stay within the same country but spans the globe looking for the highest return.  However, the bond buying policies add to the colossal amount of funds that can potentially cause havoc in the economies which are their final destinations.  A flood of money surging into a country will increase the value of its currency while putting downward pressure on the currency in the country where the bond buying is taking place.  This dents the exports of the former while boosting the exports of the latter and the bond buying has been labelled as a protectionist policy at a time when sluggish economies make most countries desperate to boost exports.

A previous victim has been Brazil where the value of its currency, the real, climbed to above R$1.6 against the US dollar in July 2011 after having dropped briefly to below R$2.4 against the US dollar at the end of 2008.  The volume of its exports has suffered as a result and the Brazilian economy has slowed.  A strong currency is also a problem in Japan where the central bank followed the lead of central banks in Europe and the United States with its own bond buying plans with one eye on its currency.  The Japanese yen is still close to its record high of around Y76 against the US dollar which was reached in October 2011. 

In the old economic textbooks, the value of currencies would be dictated by the relative competitiveness of different economies.  More competitive economies would be able to export more and the funds drawn in from overseas as a result would increase the value of the currency.  The opposite would hold true for less competitive economies and the system of global trade would trend toward equilibrium as a higher currency would make more competitive economies less so and vice versa.  However, the flow of money across borders now overwhelms the flow of goods and it is the cash that is sloshing around in the global financial system which dictates movements in the currency markets. 

These funds are often completely separated from the reality of the underlying economy and the same forces that push the overall system to equilibrium are not at work as would be the case when trade in goods dominates.  This combined with the ability for cash to be moved almost instantaneously has profound and often chaotic effects on the global economy and our understanding of the economy still lags behind these new circumstances – a humbling reality for any economist.

Stocks Up Despite Doom and Gloom

After all the doom and gloom in my last posting, I noticed a strange headline in the newspaper. The negative outlook for 2012 would suggest that stock prices would not be doing so well, but instead, stocks are the highest they have been since the plunge in the markets amid the financial crisis. So while economists typically like to stay clear of talking about stocks, hopefully I can provide some insight into what seems to be a bit of an anomaly.

Stock prices often move in directions that are different to what is actually happening in the economy. One explanation is that investors will purchase stocks not only based on what has occurred in the past but also what is predicted to happen in the future. This means that the stock market is dominated by whether investors are feeling optimistic about the future or are downbeat on the prospects for companies making profits. The forward-looking nature of investors means that stock prices are typically seen as a leading indicator – a measure that points to an upturn or downturn in the economy before this is registered in the actual growth data. This may be the case here but it is unlikely considering, for example, the Federal Reserve in the US is planning to keep interest rates at close to zero as mentioned in the previous posting.

Instead, market sentiment has been buoyed by the outlook for interest rates that was released recently by the Federal Reserve. Weak prospects for growth in the US economy have prompted the central bank to state that it expects to hold interest rates down until late 2104. This implies a negative outlook for the economy but it is taken as being positive for stocks. The reason for this is because low interest rates mean that the return from bonds will typically be low and investors who are looking for a better return will be tempted to invest money in stocks instead. Stocks in the US have already bounced back strongly after a massive sell off when the Dow Jones Industrial Average plunged from around 14,000 in October 2007 to below 7,000 in March 2009. The Dow Jones index has since climbed back up to near 13,000 by the beginning of February 2011 which is the highest since May 2008.

The stance taken by the Federal Reserve is positive for stocks in other ways. Consumers and firms will be more likely to borrow if interest rates are low. Also, the commitment to keep interest rates low further suggests that the central bankers in the US will take less aggressive policies against inflation and this is a positive sign for some companies. Higher inflation means that firms such as electricity and gas providers as well as other companies which sell energy products would have more scope to increase prices and this would help boost profits.

Of course, this is not the only reason for the recent gains in the stock market. Data out last week showed that employment is on the rise with 243,000 jobs created in January in the non-farm sector. But the central bank’s policy does provide a background whereby the attractiveness of stocks is increased compared to other investments which means more money will flow into stocks along with any improvements in the economy.

Not any great investment advice, but hopefully, the world may make a little bit more sense.