FinancialGuy Writes!

Is Disaster The New Normal?

Where has the volatility gone in financial markets? Why is the current political situation not causing mayhem?

Over the last few weeks I have been developing a theory about the current state of financial markets. The theory isn’t fully fleshed out, despite my efforts, but I hope that by explaining my thinking here I can stimulate thoughts in others and hopefully some comments.

The background to my thinking is rooted in the common wisdom of markets and economics. For example, when there is a lot of bad news around markets fall. When there is lots of uncertainty volatility increases. When money creation rises so does inflation.

Just a quick mention of a few things ought to be enough to have spooked financial markets but it seems to have failed. In the eurozone there is huge problem after huge problem in Spain, wide ranging economic problems in Italy, Greece, Portugal, Ireland and on and on. There has been the postponement of the fiscal cliff in the United States. Are we entering a new era of currency wars? Is this a race to the bottom? Who might “win”?

Any of these things ought to have been enough to spook markets and force significant turbulence, but no, not this time. For several months I have been wondering the same question day after day, “How bad does the news have to be?”

I ought to out myself. In financial terms I am a perma-bear, always expecting the worst. This latest round of equity gains has had me staggered – are markets, economics and politics really that unrelated???

I have begun to wonder whether markets have simply come to the conclusion that the near collapse of the European currency and economies is the “new normal” and nothing to worry about. Have they decided that the ability of politicians to postpone the inevitable indefinitely is unlimited and therefore there is nothing to worry about?

Perhaps they are right? We will lurch from problem to problem with none being quite insurmountable enough to bring the house of cards to ground.

If we cast our minds back to 2007/8 it was unthinkable that the financial system could emerge unscathed from the sub-prime crisis. It did not, but the world continued to turn. Then it became unthinkable that Greece could stay in the euro. It has. As sovereign balance sheets expanded to mind bending levels it was unthinkable that we could escape higher inflation. We have. Each potential catastrophe that has been faced and somehow passed at the eleventh hour (or later) has not compounded onto one another.

It has crossed my mind several times that the exceptionally high rates of unemployment are the reason. Typically when wage inflation is low, corporate profits rise and so do equity markets. With young people out of work on such an enormous scale it is difficult to imagine that there is much negotiation over rates of pay.

Surely this cannot be enough though. Can it?

At some point sovereign balance sheets are just going to fall over. Well, one would have presumed that might have happened already, but it has not.

Perhaps we have simply entered a new era of economics and politics of crisis management.

If this is the case, then most troubling of all, equity markets look cheap and we should all be rushing to buy assets at almost any price. Normal thinking would suggest that the “dumb money” rushes in at the top, which would seem to be now while the “smart money” continues to sell. I discussed this here a few months ago, and I am just as confused now about the levels of risk to potential return as I was then.

Normal theory falls down again because there is traditionally a link between equity markets and property markets (residential property, for example, is pro-cyclical). In the countries that are really struggling (Spain for example), it is clear that both the stock market and property market are in deep doo-doo. The banks have been less than willing to fully write down their property holdings, mortgages and non-performing loans. In other words, there is much more to come.

In the UK for example, the London property market seems to be about level in the last year but much of the rest of the country has seen gentle falls for several years – but the FTSE keeps powering onwards and upwards – all while the national economy seems to be struggling on.

Have some stock markets therefore become decoupled from property markets? Or their national economies? From reality?

As I said, I am struggling to link all of this together, so if you have any thoughts or insights to add – whether I am right or wrong – please do so.

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