Complacency Still Reigns
Given current market volatility and the increasing amount of evidence showing that the global central bank money printing orgy of recent years has utterly failed to produce a so-called “self-sustaining” recovery, it is quite odd how nonchalant investors remain about the outlook for “risk assets” such as stocks.
Image via glennllopis.com
In this context, we wanted to show our readers a chart a friend has recently sent us. This chart depicts the MSCI Global Index and contrasts it with a “macro confidence” indicator (“global risk sentiment”). This indicator does not take sentiment surveys into account – instead it is purely based on a variety of market prices and positioning data that are held to reflect investor sentiment. Not surprisingly, this indicator often has contrarian implications. It is quite stunning to what extent it is currently diverging from stock prices. Apparently, investor confidence not only hasn’t suffered, it has actually soared to a new high for the year:
Global risk sentiment (red) vs. global stock prices (black) – a huge gap has opened up between reality and perceptions
Our friend also pointed to a publicly available article by Sentix, a German company that analyzes sentiment data and is widely acknowledged to be the go-to expert in this particular field. The article can be found here. Here is the decisive excerpt:
“The latest sentix data set reveals an alarming discrepancy: investors’ fundamental belief in equity prices is still rising despite falling economic expectations. Potential risks are especially lurking in the US market. Investors are turning a blind eye on possible adverse effects for equities as economic optimism fades.[…]
Discrepancies of such magnitude reflect serious risks. Though, rising skepticism about economic expectations has not raised investors’ awareness regarding equity price developments – investors still perceive an engagement in equities as an investment without alternative. Moreover, investors’ blind trust in the power of central bank interventionism is threatening. Would behavior be consistent with expectations should reactions follow suit – with negative consequences for equity price developments.
(emphasis in original, with exception of the sentence about “blind trust in the power of central bank interventionism”)
Sentix provides the following chart that juxtaposes economic expectations with the “strategic bias” of investors toward the US stock market according to its surveys:
Strategic bias toward US stocks vs. economic expectations – yet another huge gap
Naturally, we believe that the most important sentence in the accompanying article is the one about unbridled faith in the “central bank put”. To this it should be noted that investors in the US stock market can no longer rely on the Federal Reserve having their back – at least not before stock prices are a lot lower. The Fed isn’t even contemplating additional monetary pumping at the current juncture – instead, it is agonizing over whether or not to implement its first baby step rate hike.
An Aside – The Fed’s Modus Operandi
We should interpose here that the Fed’s new modus operandi since the 2008 crisis actually enables it to hike rates and run a loose monetary policy at the same time. How so? Consider how the imposition of the federal funds target rate works. In the pre-crisis world, the Fed would simply add to or drain reserves from the interbank lending market in order to manipulate the FF rate to its desired target. Whenever commercial banks were expanding credit and were demanding more reserves than were offered by other banks, the effective FF rate would be pushed up. In order to prevent it from being pushed beyond the administered “target rate”, the Fed would jump into the breach as the enabler of credit expansion and provide additional reserves from thin air (conversely it would drain reserves if the supply of reserves offered by commercial banks threatened to push the FF rate below target – a very rare event indeed). This was done by the Fed either purchasing assets from the banks, or selling assets to them (usually on a temporary basis via repos, but occasionally also via “coupon passes” that enlarge the money supply permanently).
But how does this work during or after “QE”? The answer is, it cannot possibly be done in this manner anymore. Hence the introduction of “IOR” – interest on reserves. By setting the interest it pays on excess reserves at the upper boundary of the FF rate corridor, the Fed can prevent banks from offering large amounts of reserves in the overnight interbank lending market, since they can earn more interest for them from the Fed directly. It can conversely also stoke the supply of reserves from the banking system by paying less on bank reserves. Most importantly though, IOR has decoupled assets held by the Federal Reserve system from the FF rate. Thus the Fed can actively expand the money supply at any time, even while it hikes rates! It is important to be aware of this fact.
Why Faith in the Central Bank Put is Misguided
It is perhaps not surprising that investors have such faith in central banks saving their bacon – after all, it is common knowledge that unbridled money printing has been the main driving force behind asset price inflation. When central banks (or commercial banks with central bank assistance) are expanding the money supply, it is an apodictic certainty that some prices in the economy will rise. Given the manner in which new money enters the economy, it is quite normal that securities prices are among the first prices to rise, and clearly they are also among the prices affected the most by an expansion of the money supply.
US money supply TMS-2: The tinder for the party on Wall Street – US money supply expansion – click to enlarge.
However, the rate of change in US money supply expansion has slowed considerably, from annualized peak growth rates close to 17%, resp. 16% in late 2009 resp. late 2011, to 8.34% as of July 2015. Concurrently, stock prices (based on the S&P 500 Index) have risen by nearly 230% between their 2009 low and their 2015 peak, and the increase since early 2012 alone has amounted to over 70%. It is doubtful whether stock prices can rise much further unless money supply growth re-accelerates. This seems unlikely to happen in the near term.
It is clear though that the Fed is going to resume monetary pumping if the pressure from declining asset prices becomes big enough. A point investors seem to be forgetting though is this: Once risk aversion increases and the market begins to decline, central banks are reactive, and they only react once there is considerable market upheaval. Investors are then faced with the fact that whatever actions a central bank takes to pump up money supply growth again, the effect will only arrive with a considerable lag. Indeed, the market’s rally between 2012 and 2015 was largely the lagged effect from the peak in money supply growth rates recorded in late 2011. We know this inter alia because the rally consisted of little but “multiple expansion”. It wasn’t a reflection of a big increase in corporate earnings.
In short, the Federal Reserve will be unable to prevent a crash or a bear market. It has always been unable to prevent bear markets from unfolding. Obviously, if it were otherwise, stocks would never have declined between 2000 and 2002 or 2007 and 2009 (or at any other time for that matter).
One more interesting data point in connection with “economic reality and perception” is provided by Citigroup’s Economic Surprise Index. This indicator shows whether the expectations of economists regarding economic data points are exceeded or undercut on average. What is interesting about it is how sluggish this indicator’s most recent recovery has been. Normally it tends to fluctuate quite quickly within its historical range, but recently it has recovered only very reluctantly, has remained in negative territory since January and seems to be turning back down already after merely recovering half of its previous decline:
Citigroup’s Economic Surprise Index – lower highs, lower lows and a reluctant bounce that hasn’t managed to push it out of negative territory thus far – click to enlarge.
While the recent string of weaker-than-expected economic data is not yet indicating an imminent US recession, it is getting ever closer to doing so. The stock market isn’t going to fare particularly well if a recession is in the offing (the average decline from the peak during recessions is 30%). The danger of a very large denouement is quite elevated in light of extant leverage (record high margin debt) and excessive valuations.
The market has delivered a warning shot in August, but it seems investors aren’t taking it seriously yet. This could turn out to be a costly mistake. If (or rather when) faith in the omnipotence of central banks crumbles, we could see an unusually severe market dislocation.
Charts by: Sentix, SentimenTrader, St. Louis Federal Rserve Research