An independent professional's take on the latest news and trends in global financial markets

Strange and wondrous times

In my latest Financial Times column, I argue that current market conditions are fascinating, but inherently unstable, because the Federal Reserve’s monetary policies have removed the traditional anchors on which investment decisions are traditionally made.  By chance I notice that Bill Mott of Psigma Investment Management, who has been managing equities even longer than I have been following the markets, has come out with a similar line of argument.

You can read all my FT columns and Spectator articles in an archive on the Independent Investor website. Here is a short extract from the latest one, which starts by recalling that even golden decades like the 1990s were punctuated by a succession of crises. I am also attaching a copy of Bill’s latest comments, which should be read in the light of the current fascinating stand-off between Ireland and the EU over how best to resolve its deepening banking problems, which I imagine will continue to weigh heavily on market performance for a while.

The striking thing about recalling these past episodes is that it is possible to make a plausible case that we could see an imitation rerun of nearly all of them in due course.  That the euro is ultimately vulnerable to fragmentation needs no elaboration, given the market’s run at Greek and now Irish debt. Some form of 1994-style rout in the bond market seems unavoidable in the next few years. The risk of a fresh market-induced disruption in emerging markets too, although it is almost certainly some way away, is also growing by the day.

The problem for investors is not that these risks are in any way concealed from view – in fact the more visible they are, the less of a concern – but that some tried and tested tools to analyse the right course through them are lacking. The consequence of the deliberate monetary stimulus now being masterminded by the Federal Reserve, and imitated in other places, is not just that it is distorting asset prices, but that it is also rendering useless the traditional anchors on which valuations and investment choices are based.

When interest rates all the way along the yield curve are being targeted for manipulation on an unprecedented scale, few market prices can be trusted. What today is the risk-free rate? You won’t find it by looking in the traditional places. It is no accident that one of the star performers in the markets over the last few years has been gold, the one asset that cannot be valued by conventional means. Its lustre will remain as long as large parts of the world economy continue to be force-fed negative real interest rates.

The massive injection of zero-interest rate funds into the US and other economies has been likened, memorably, by the strategist Don Coxe to the battlefield use of heroin for wounded soldiers. Essential in the short term, the challenge for the doctors is to wean the patients off the pain-killer before they become addicts, unfit for either military or civilian life.  If interest rate futures are right, it means that Mr Obama could be the first American President in history to complete a whole term within a zero interest rate environment. “There is no historic precedent for such sustained stimulus”, notes Mr Coxe, “which means no one can predict what longer-term damage it will inflict”.

Bill Mott Update – Biggest Financial Experiment in History – 17 November 2010.

Written by Jonathan Davis

November 17, 2010 at 4:45 PM