An alternative perspective
14 August 2015
In Praise of the Augean Stables: The Fear of Growth
“Augean stables are not to be cleansed with a spray of rose-water.”
Gabriel Setoun, Robert Burns
In conventional theory, economic growth is a strong driver of financial markets.
That is a fallacy. History tells us that the correlation between the economy and asset prices is tenuous at best, often diverging and tending to one only at turning points as good or bad news catch up to sentiment, sparking euphoria or a rout respectively.
The last few years are a case in point. For almost all asset classes (with the exception of commodities), this has been an exceptional and occasionally unparalleled bull market. Since the lows of March 2009, to take a few examples, US stocks are up almost 260 per cent, US investment grade corporate bonds are up 167 per cent and European high yield bonds have near trebled (see Figure 1).
Even the oft unexciting government bond market has sparkled, with the bulk of credit market returns coming from the salve of falling interest rates. Despite recent volatility, the two-year German Bund sits at -0.25 per cent while the five-year hovers barely above zero, for example. These levels are comparable to those seen centuries ago in a medieval Europe governed by the uncontrolled ebb and flow of gold supplies and prone to long bouts of deflation. And lest one thinks that this is only true for the strongest economies, even ailing Spain and Italy have yields that sit at multi-century lows.
A Twilight Rally
It is a remarkable rally in assets, all the more so for having occurred during a period when growth has been lacklustre or non-existent, to say the least. The current US recovery is one of the weakest on record, with average growth of 1.8 per cent – far below the levels one might expect after a recession. Others such as Europe and Japan lag far behind.
The culprit is not hard to pinpoint, as illustrated in Figure 1 earlier. Huge doses of monetary stimulus from central banks have flooded the financial system with liquidity and driven rates down to unprecedented multi-century lows. The US Federal Reserve’s (the ‘Fed’) balance sheet is now 26 per cent of US GDP while the ECB’s balance sheet is approaching 30 per cent of Eurozone GDP.
Against this tsunami, markets have had little choice but to acquiesce. In the absence of monetary velocity and a functioning real economy, all the money has ended up instead in asset price inflation. Alongside, it has also destroyed any notion of what the fundamentals might be. Consequently, investors have been lured into a desperate search for yield, particularly pension funds and insurance companies, which have found the liability side of their balance sheets hammered by falling interest rates.
Throw in a growing belief that central bankers will provide a financial put in all circumstances, and this hunt for yield becomes a vicious crush as investors become happy to pay almost any price for return in a low growth world. The same pattern is repeated elsewhere, whether it is Europe post ‘Draghinomics’, Japan post ‘Abenomics’ or China post recent rate cuts and central injections.
The result has been a strange twilight zone. As long as growth is tepid or under threat, markets are buoyant. But throw in talk of normalisation or rising rates and immediately the markets rush into panicked fits of volatility. The taper tantrums unleashed in June 2013 by Ben Bernanke were an early precursor, as the US prematurely announced the withdrawal of stimulus. More recently, we saw the bloodbath in the Swiss franc as the Swiss National Bank withdrew support for a stated exchange rate, and the paroxysms of volatility in May and June as Bund yields went up ten-fold to one per cent in six weeks, spreads widened and stocks began to wobble.
The markets clearly fear growth. Normalised rates imply growth, but rather than being a harbinger of good times to come, they are viewed with fear today. Bernanke’s taper tantrums subsided when the Fed reaffirmed its commitment to lower rates for longer. European fears were driven by signs of improvement in the economy. The Swiss episode was triggered by a central bank actually taking away the sop it has proffered for so long.
The reasons are simple, not irrational. Most central banks have refused to consider the possibility of an asset bubble seriously, preferring instead to focus on low inflation and getting back to full employment. Therefore, under these circumstances, there is little likelihood of rates being raised or the cup of stimulus being withdrawn.
What Polite Company Leaves Unsaid
Restore growth, however, and you risk uncovering the detritus beneath the surface.
Underneath all that quantitative easing flood water, there still lurks a gigantic iceberg of debt, which has only grown further since 2008. Much like Japan in the lost decades, there has been little appetite or attempt to address this. Globally, the public debt markets have grown more than ten-fold over the last quarter century from $10 trillion in 1990 to nearly $100 trillion today. They have also grown more interconnected than ever and fragile. Corporate bond liquidity, for example, has fallen by nearly three quarters since we exited the last crisis.
Normalise rates and you risk exposing all the corporate and consumer zombies, currently kept a heartbeat away from bankruptcy by ultra-low interest rates and the mantra of ‘extend and pretend’. You risk increasing the interest rates that sovereigns currently pay to crippling levels and exposing the fragility of their balance sheets. The US, for example, would see interest payments more than double from $229 billion today to nearly $550 billion per annum as the environment normalises, based on official projections alone (see Figure 2). Restore interest payments to their historical average as a percentage of total federal outlays and that number rises further to nearer $700 billion.
Move the analysis to weaker nations such as the Mediterranean European economies and emerging markets, and the problem compounds, as they become more reliant on the currency whims of others.
Most importantly, you risk repairing the broken pricing mechanism of the markets and allowing investors to compare risks and returns more dispassionately. This would expose the misallocation of capital that has taken place over the last few years on an unprecedented scale and risks a conflagration of creative destruction, whose economic and socio-political spillover effects are, at best, unknown and, at worst, too terrifying to ponder.
Cleaning the Stables
The situation is reminiscent of the cleaning of the Augean Stables, one of the Twelve Labours of Hercules. The stables had never been cleaned before and contained a prodigious amount of dirt. The problem was only compounded further by the copious amounts of dung produced daily by the immortal cattle that lived there.
Markets and investors are little different today, with the detritus building up day by day. Restore growth and you will likely cleanse these Augean Stables. No wonder markets are scared. It may be the right thing for the world economy, but unfortunately it also exposes a lot of the dirt beneath the surface and will leave a trail of destruction in its wake.
For now, investors choose to extrapolate the recent past into the infinite future, drawing a simple correlation between monetary accommodativeness and rising asset prices. But there is no mathematical or economic relationship between the two, merely a psychological link based on perception and faith.
Like all bubbles, both will come under strain and buckle in time as facts overcome the fantasy of forward guidance. Today, we see perhaps the beginnings of those in China and Japan, as policymakers move towards more direction and overt control of markets in an aggressive effort to prop them up.
In these dislocations and their cousins elsewhere lie the opportunities for those prepared to be patient and wait.
Bob Swarup is the Founder of Camdor Global, an advisory firm focused on macro trends, investment strategy, risk management and regulation. He is a Fellow at the Institute of Economic Affairs and author of the critically acclaimed book ‘Money Mania’, which examines 25 centuries of financial crises