September Fears And Polarizing Financial Markets Sentiment

By: Andrew_McKillop

Financial market operators and leading investment funds in several countries are now betting on two major trends: increasing risk aversion and fear of low asset performance, and increasing distrust of many types or classes of assets. These themes are sometimes opposed and sometimes linked, for example declining confidence in equity performance in theory could drive investors, perhaps only for a short while, to buy gold thus raising the profile of some types of reputedly secure assets.

Lower confidence in global equities performance has been paced by a retreat of funds from several leading commodities including oil for a short while, and possibly gold, and declining confidence regarding government bonds and debt, notably due to extreme low interest rates.

One measure of this is a trend towards bets that stock price volatility will increase, before equity markets either fall or perhaps crash, then start recovering. To be sure, almost all commodities are now close-linked with equities and would therefore "take the same ride".

Overall the betting is on a much more dangerous environment, especially for "mainstream" equity investors, but also for government and corporate bond market investors: either the bond market will make the big move, or the equity markets will make the big move because of rising instability and falling visibility for the global economy. Because any move to raise interest rates would be lethal for government debt and for the mainstream economy, the default choice for major movement is the equity markets.

Nassim Taleb, whose book “The Black Swan” is prescient on the role of unforeseen and underappreciated events causing markets to panic, has however since early August said he believes not only US bond markets, but also those in Europe and Japan could "collapse", but he does not advise that investors should automatically shift to equities. The underlying basic reason, he says, is that investors have not understood or do not want to accept the OECD economy's weakness. This has driven yields on two-year US Treasury notes as well as German 30-year and 10-year bonds to record lows recently, and the Yen to record highs in recent weeks, but this particular context is not at all sustainable.

Stocks in August had their worst month since May, and U.S. index futures tended to drop at easily predicted intervals as economic reports showed the recovery is flagging. Moves by US Fed chairman Ben Bernanke, at the end-August Jackson Hole meeting of central bank chiefs, to reassure investors have been weak and unconvincing. Conversely, the ECB's Jean-Claude Trichet has vaunted European economic recovery in a way that many judge exaggerated.

ASSET CORRELATION

As Nassim Taleb and others have noted, one major new danger is the convergence and correlation of so many, apparently different and unrelated assets, whose total traded volume and nominal value has massively increased and globalized since the 1990s. Both oil and gold are good examples. Despite their commodity status, at least for oil, their price movement is now increasingly correlated with general equities movement - except in special circumstances. Almost any day major equity indexes like the DJIA, Footsie, Dax or Nikkei move up, the oil price will also rise; if the equity indexes fall, oil will also fall - and despite the previous non-correlation or low correlation of gold price movement with equity prices, this now also tends to apply with gold.

Therefore, despite the extreme different fundamentals for gold and oil, their prices can move in quite tight band with equities, for some while. When there is breakout, this can signal major change in the real economy.

Asset correlation now extends to most other asset classes, including currencies and government paper, forming what we can call a kind of "undifferentiated global asset space". Quality and visibility in this space which is bigger than in all previous time are rather certainly in decline, and this factor can itself drive a loss of investor confidence at key moments.

As a general rule, highly correlated assets generate higher risks, and when volatility also increases the potential for radical and rapid decline of asset values is raised. Almost all experts agree the financial system is now much riskier than it was before the 2008 crisis, which triggered the US economy's worst contraction since the Great Depression. In turn the simple read-out is that another "double dip relapse" in the U.S. economy, or in Europe and Japan, would be far worse today than even 2 years ago in the previous or possibly continuing OECD recession.

As Bernanke and Trichet have many times pointed out, governments have injected huge amounts into the economy. US President Obama’s American Recovery and Reinvestment Act has spent US$ 814 billion trying to spur growth, and this effort has helped raise US public debt to US$ 13 400 billion, according to official data. In Europe, the sovereign national debt crisis, and the extreme high public debt of most European countries, is very well known - and continues. EU27 spending to fight recession and bail out financial institutions has probably been at least as high as in the USA, although this is denied. More important, the expected inflation impact has been low. Without a surge in "headline" inflation rates or a significant recovery of economic growth, asset value depression is very logical.

UNCORRELATED ASSETS

Despite real world factors making it uncertain, asset managers believe that growth in China and India will stay "decoupled" with the OECD economy. Both countries have engaged financial and economic “big bang”reforms giving foreign investors greater access to their capital markets. Their buying of gold in the recent past, and continued commodity buying starting with oil, are now basic drivers of price movement for commodities.

By Andrew McKillop

gsoassociates.com

Project Director, GSO Consulting Associates

Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

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