“To prove that Wall Street is an early omen of movements still to come in GNP, commentators quote economic studies alleging that market downturns predicted four out of the last five recessions. That is an understatement. Wall Street indexes predicted nine out of the last five recessions! And its mistakes were beauties.” –Paul Samuelson
It is somewhat ironic that the economist whose most famous quote leads this article was also (at least partially) responsible for much of the malarkey preceding the last major global boom that was driven (again, at least partially) by an over-reliance on mathematical models that helped market practitioners to believe that theirs was a science of sorts rather than informed guesswork masquerading as a science. Samuelson after all pioneered the use of rigorous mathematical models to analyse and explain economic outcomes.
Whilst his work helped to understand various flow-through mechanisms and was in the category of “mostly accurate,” in this case that description was also prone to substantial random errors much as Douglas Adams’ description of Earth as “mostly harmless.”
Rigorous math works in very contained spaces, where parameters can be defined to a high degree of accuracy. Economics and by extension market movements, simply do not fit such parametric descriptions. As the redoubtable Tim Price noted in his blog entry a couple of weeks ago:
“Here is a “lesson” from history. In October 1973, OPEC initiated an oil embargo in response to US involvement in the Yom Kippur War. Within five months, the oil price quadrupled. By the end of 1974, US stocks had fallen by over 45%. The US got off lightly. UK stocks fell by almost 75% during the same period. Oil up, stocks down. Now the oil price is down sharply, and many stock markets are down sharply. Since they fall when the oil price goes up, and when it goes down, perhaps stock markets will also collapse if the oil price goes sideways. Or if it enters some alternative dimension not wholly perceptible by human consciousness.
Or perhaps stock markets are complex systems, markets and investors are not entirely rational, and correlation is not the same as causality. In Britain in 1974, the oil shock was compounded by a property and banking crisis. This time round, the “reverse oil shock” has been compounded by clear deterioration in China’s economic prospects, uncertainty over its currency, and the conspicuous overvaluation of many stock markets, aided by years of Quantitative Easing.”
The point is that any economic “models” predicated upon higher commodity prices having causal relationships to higher (or lower) economic growth would also need to incorporate other variables, the least of which should include
- Prevailing (nominal) interest rates
- Incipient inflation expectations
- Employment levels
- Demographic factors
- Monetary supply and its dynamics
- Fiscal balance of government(s)
- Ability and willingness of banks to advance credit
- Asset valuation(s)
- Prevailing market liquidity
A cursory glance at all of the above suggests that it is virtually impossible to determine either the number or the direction of many of these variables. For example, if nominal interest rates are already at zero, is it plausible for monetary policy to ease further? This question would have yielded a ‘textbook’ answer of No in the 1980s, but the opposite answer twenty years later.
In much the same way, demographic factors are difficult to predict and estimate as ‘steady state’ economics would simply use the net birth rate to determine this; but may completely exclude immigration. For example, the German population declined from the beginning of this century until 2010 when it suddenly reversed course; this was because other European economies had become basket cases by then, driving populations to take up jobs in Germany.
In a country of under 90 million people, how does the immigration of 1.1 million people (largely from Syria) in 2015 change that picture? What does it mean for economic growth and inflation expectations over the next 20 years as these people and their children are absorbed into the workforce? If there is any cogent economic and market analysis of this out there, I certainly haven’t read it yet.
Into this maelstrom
Given the sheer complexity of factors involved, it has always surprised me that financial media reports on market movements are so grossly simplified as to suggest single-factor models at work. You will all have read over the past few years some version of either poor jobs report or good jobs report driving markets either lower or higher. Actually, scratch that – you will have read all four possible headlines on those two variables – direction of employment and its impact on markets.
If we are to take a very honest look at global market valuations at the beginning of the year, here’s what we would have concluded:
- Asset valuations were incredibly high
- Central banks wanted to exit the easing trend
- To sustain valuations, markets needed stronger growth numbers in general
- Growth expectations were highly dependent on two big economies – US and China
- Corporate earnings could no longer be propelled by cost savings
- Credit spreads had become incredibly tight (i.e. very little reward for risk)
- New regulations made it impossible for banks to buffer volatile markets
Given the above, as well as other unmentioned risks (Russian actions in Syria for example), there was always the potential for negative market surprises far away from the single-factor model explanations favoured by the financial media. Sure enough, you suddenly had a raft of news, much of which was unexpected:
- Growth expectations from China took a tumble as recent macro data remained unhelpful to any story involving a turnaround. Stories of a potential devaluation ruled the roost, prompting “me-too” devaluations across other emerging markets, pushing foreign investors to sell stocks to avoid further losses from local currency movements.
- Credit related stories from China also turned worse with more defaults, and perhaps inevitably, more scandals emerging from the woodwork such as bank employees being arrested after issuing fake bank acceptances; having stolen the original proceeds to invest in the cratering stock market.
- Saudi Arabia’s apparent intransigence on cutting oil production helped to push oil prices to below $30 a barrel, pummelling in turn credit markets as the US high yield market had over $250 billion of bonds exposed to shale gas and oil. Mull that number for a second – two hundred and fifty billion dollars.
- An unexplained spike in bank borrowing rates against riskless government bonds (in the jargon, the TED spread) in December suggested liquidity strains. While this index has since reverted to more normal levels, the damage had been done – banks were a target.
- European banks hit the skids as fears of lower economic growth, higher credit losses and inept government efforts helped to pummel the sector by 30% in January alone. The malaise quickly spread to American banks as well.
- A number of companies reported weak sales and more importantly guided down their revenue expectations for the year. The market’s favourite stock, Apple was amongst the decliners after expecting lower sales of its devices in key markets including China.
- Global banks have new rules including the Volcker policies and Dodd-Frank regulations that restrict the size of their balance sheets exposed to securities. Thus, there is no cushion for absorbing short-term volatility anywhere.
Savvy traders recognize a market meltdown when they see one; and especially when others including central banks do not. Paraphrasing Warren Buffett’s famous maxim that ‘when the tide goes out you get to see the people not wearing shorts’, in this case as the tide went out you did see the traders making a killing with their market shorts.
Reading the liquidity tea-leaves, they had figured out that there was too much fatigue across markets, and way too many overpriced and over-owned assets that they only needed to pick a few choice shorts to make a decent amount of money and rather quickly at that. Against that momentum, the feeble and fragile construct of global monetary policy was only ever going to fail.
To answer the question posed at the beginning, market movements and the real economy haven’t been this divorced for a while now. Declining markets may not presage a global recession; they could well be merely reflecting more earthly valuations for the mediocre times ahead.
The opinions expressed in this column are the author’s own and do not necessarily reflect the view of Asia Times.
(Copyright 2016 Asia Times Holdings Limited, a duly registered Hong Kong company. All rights reserved. Please contact us about sales, syndication and republishing.)