It can be useful to step back from the day-to-day noise of specific markets and focus on the big picture.
The price of any financial asset is determined by the marginal buyer or seller. A price deemed cheap will attract buyers and consequently the price will rise. The opposite is also true; expensive assets will be sold to secure excess profits and prices will fall.
But in the real world financial markets have a nasty habit of operating somewhat differently, with a tendency to overshoot and then ‘mean revert’. Certain financial asset markets today are probably as far away from their theoretical equilibrium as they have ever been.
The root cause of this is manifest: having allowed the global financial community to run riot multiple times in the past two decades, the gatekeepers of the system have subsequently acted on each occasion to save the reckless participants from themselves. But, by doing so, they have distorted the next cycle.
Today, six years after the latest systemic shock, we are again confronted by multiple distortions. The price of money (as measured by interest rates) and monetary policy have probably been too accommodative for too long. As a result, the current situation is substantially different from anything that investors have experienced before.
Investor behaviour is also different – for example, ‘reaching for yield’ at all costs has become a common practice. But now, the most significant monetary spigot of all – that controlled by the Federal Reserve – is gradually being closed. At the time of writing, it would appear that it will be shut completely by late autumn.
Whether it is or not, there is no reason to expect the future to revert to ‘normality’ until that excess liquidity has receded. Once the liquidity flow drops to zero, the next logical step for markets to focus on is its withdrawal and a rising interest rate environment.
Why is the US reducing stimulus now? The official answer would surely be: ‘The job is done, it’s no longer required.’ The slightly cynical realist may propose: ‘They’ve overdone it, and they know it.’ Either way, the US economy currently appears healthy enough to support itself.
If one asked the new Chinese leadership the same question, we suspect that of the two answers given earlier, the latter is far more realistic. China is an aberration – a command economy concurrently pursuing a capitalist, market philosophy, and as such they have an ability to solve problems of excess like no other nation.
China may, therefore, be able to avoid much of the direct fallout from its past excesses.
China is to today’s global economy what the US was in past cycles – the marginal buyer – therefore the price setter of many commodities. As China weans itself away from fixed asset investment dependency towards a more consumer-driven economy, commodity prices should adjust accordingly. This could prove be to another huge fillip for the consumer-dominated US economy, as lower commodity prices suppress inflation.
Nonetheless, as stimulus is withdrawn, certain areas of bond markets appear to be vulnerable to correction, while equity markets remain mixed. At this juncture, it is critical to remain alive to the factors, be imaginative and to act accordingly.
John Chatfeild-Roberts is chief investment officer at Jupiter Asset Management
