A blessing in disguise?

By Buttonwood

WHEN Winston Churchill, having led Britain to victory in the second world war, was defeated in the 1945 general election, his wife Clementine remarked that it might be "a blessing in disguise". If so, the great man replied grumpily, it was "very well disguised."

Could the same be true of yesterday's market sell-off? Some investors were arguing the case yesterday. Eric Lonergan of M&G, an investment firm, tweeted that

Falling yields and oil price (are) far more of a stimulus than recent data is negative. Expect growth momentum to improve.

Certainly, lower oil prices are a tax cut for western consumers. Although, of course, the result is an income loss for oil producers, the marginal propensity to consume of consumers (as it were) is higher and this helps demand. Rising oil prices have been a harbinger of recession, whether in 1973-1974, 1979-1980 or 2007. Lower government bond yields are a help, to the extent that they also bring down corporate borrowing costs. This effect is limited, however, by a rise in spreads; high-yield US bonds now yield 500 basis points above Treasuries of the same maturity or 6.3%. And of course, if companies are worried about the strength of the global economy, they will not borrow, whatever the rate level (as the Japanese example illustrates). Then there is the fear that risk aversion may be reigniting the euro zone crisis, with Greek yields soaring and Spanish and Italian markets being affected.

In part, this may be a question of lags. To the extent that falling bond yields and lower oil prices reflect concerns about global growth, how long will it be before the self-correcting mechanism works?The process may be speeded up to the extent that investors (or companies) were worried about the prospect of a tightening in monetary policy; after yesterday, the first Fed rate rise is not fully priced in till March 2016, as opposed to some time next year.

But another issue is whether the recent market falls are detached from reality, and do not reflect the economic news? Perhaps they are the result of a hedge fund liquidation, as some were suggesting yesterday. Mr Lonergan tweeted that

the 4wk moving average of (American) job claims lowest since 00. And 2yr ylds collapse! Nothing to do with facts.

This opens an interesting argument. Many people used financial measures such as the stockmarket, or the yield curve, as leading indicators. But that is based on the assumption that markets are rational and have some prescience of the future. People like me argue that markets can be irrational and get into bubbles. Are we guilty of confirmation bias, in believing that the markets are wrong when they go up and right when they fall?

It is easy to find gloomy news in recent weeks; the trio of poor August reports from Germany, for example, the downgrade of trade forecasts by the World Trade Organisation and of growth forecasts by the IMF and of global oil demand by the International Energy Agency. But some believe the August data were distorted by unusual factors and that September will see a rebound. Andrew Cates of UBS, a bank, writes that

Leading indicators of growth are not—at present—consistent with any major slowdown in the world economy. Some of these indicators moreover suggest that global growth will strengthen, albeit modestly, in the period immediately ahead.

In particular, he cites the fact that the global composite purchasing managers' index is at 55, well above the 50 level that indicates stagnation; bank lending growth is picking up in the United States; and capital goods orders have also picked up. Mind you, it is not all good news; his global growth surprise index (whether economic data beat expectations) has turned negative.

There might be a problem, Mr Cates admits, on deflation.

Excess capacity in most of the world's large economies, including China..., could further undermine globally traded goods prices in the period ahead. Structural issues in the meantime concerning ageing demographics and new technologies are posing additional challenges for some of the normal cyclical mechanisms that might sour global inflation.

Here is where your blogger's long-term pessimism kicks in. Many developed countries face a future with stagnant or falling workforces. We could deal with that by increasing the participation rate but the trend is in the opposite direction; in America, participation is at a 36-year low. We really do not know what's going on with employment; the choice seems to be between creating low wage jobs in Britain and America nor no jobs at all in continental Europe. We could overcome the workforce drag with a sharp jump in productivity, but that has also been weak; and technological change may be displacing workers and adding to inequality, in any case. This is creating a political backlash.

In other words, the normal economic cycle may not apply this time (and I have not even mentioned the lingering effect of high debt levels yet). Markets have been depending on central banks to offset all these risks. But as Dhaval Joshi of BCA Research, a consultancy, wrote after yesterday's events

Financial markets have begun to question a long-held dogma; namely, that when it comes to underpinning the economy and asset prices, central banks are omniscient and omnipotent. The trust is they are not. In the major economies, monetary policy is approaching the limits of what they can do.

He adds that central banks have two levers; the level of rates and the amount of base money (banking liquidity). Both are operating on full. He adds that

arguably, a central bank has a third lever; the commitment to keep its two main levers fully open for longer and longer. But this has diminishing power because the longer the promise, the less believable it is. After all, how can a central bank make a credible long-term commitment when its policy committee will have different voting members a year from now, and completely different voting members several years from now?

What about central banks' influence on asset prices? When interest rates are at zero, the future returns expected from competing assets must also come down—in other words, current asset prices must rise. But this re-rating is not limitless.

This is at the heart of the matter. Even if the Fed does not increase rates next year, it will surely take a big economic shock to make it resume QE. The markets have relied on the central banks for so long, like a small child holding his dad's hand when learning to ride the bike. It is time to let go of the hand now, but there will be a few bumps and bruises along the way.

UPDATE: Markets may take heart from today's industral production numbers but it's the rest of the world, not the US, that's really worrying