Evolving Markets

Major “events” in markets have been caused by wrong assumptions over mathematical relationships. The Long Term Capital Management Debacle (LTCMD) in 1998 was primarily the result of the incorrect assumption of perfect markets by a cluster of Nobel Laureates. The naïve and wrong assumptions over correlations proved to be the spectacular undoing of the mortgage markets in 2007-8.

Currently, the US economy is stuttering. Headline growth during the latter half of 2023 was extremely rapid – GDP growth averaged more than twice the economy’s 20-year average - but this strong activity was led by the public sector, either directly through government investment or indirectly via the authorities’ support for household incomes.

In my experience, there is nothing so powerful for asset markets as an “unquantifiable positive story and a tonne of liquidity”. Russell Napier’s Library of Mistakes in Edinburgh looks brilliantly at some of the madness that has taken hold of financial markets over the centuries (well worth a visit if you are ever nearby), and of course Edward Chancellor’s Devil take the Hindmost is the seminal text on the subject of credit-financed investment madness, but I have seen my fair share of mad booms firsthand.

Much like this report in 2023, global conditions will remain unique and defy a confident overall summary; thus, here are ten predictions on some particularly noteworthy factors.

Whether for year-end management reasons, or as a result of political considerations, it is a fact that the US Federal Reserve has allowed effective monetary conditions to ease over the last month. The public sector has injected more than $200 billion of liquidity into the financial system. It therefore comes as no surprise that financial markets are booming, yields are tumbling and the dollar is weak, a situation that we expect to continue into year end.

It has been a wild few weeks within debt markets – sharp sell-offs, even sharper rallies, and then a renewed sell off. Movements in equity markets have looked tame by comparison. Bond markets are certainly having to process a lot of conflicting information – inflation, deflation, politics and a mountain of potential issuance next year following what was an amazingly quiet year for debt issuance in 2023.

Over the recent years, there has been a tendency amongst politicians and the media to target the CPI rather than inflation itself, or at least the inflation process. Too often have we heard from policymakers that inflation can be brought down through direct government subsidies or price controls. Subsidies may well have a justifiable social purpose, particularly during times of externalities such as wars but they have no role in controlling inflation. We have even heard that interest rates should not be increased “because they affect mortgage rates and mortgage costs are in the CPI”.

The media is abuzz with stories about the demise of the US Dollar as a reserve currency and the rise of alternatives, such as the proposed new “BRICs” currency. From our perspective, we cannot think of a worse monetary idea than a pan-BRIC currency. It is difficult to conceive a less optimal currency area i.e. one worse than the Euro Area, which has certainly had (and continues to have) its problems.

There was quite simply nothing not to like about the latest US consumer price index data; not only was the headline a good number but so too were most of the internals.

One cannot turn on a financial news programme at present without hearing some talking-head or other discussing the outlook for interest rates, almost as though they are the only thing that matters to markets or the economy. We suspect that the matter to a degree to the latter, and much less to the former than is generally accepted.