Doh! This year… We all sensed a crisis was coming. The Russian invasion of Ukraine has suddenly crystalised what it is: insecurity in Energy, Food and Commodity markets, the very building blocks of the real global economy. These are real things – unlike the concepts behind bond yields or equity returns.
Fasten your seat belts… this ride has only just begun
Inflation has now established a firm grip across the global economy, and whatever teenage scribblers and bank analysts say about it peaking… it feels like it is here for the long term. As we demonstrated in 2008, you can pretty much fix a financial problem overnight by throwing money at it. What we are learning today is you can’t fix Germany’s shortage of gas until we build new infrastructure, which will take upwards of two years. You can throw money at broken health services, but you will only fix them by fundamental reform. Money is not a solution.
The financial world and the real world are very different places. The problem is financial models written to explain the complex workings and underpinnings of the financial and monetary economy… we are now discovering they have absolutely nothing in common with how the real economy actually works.
Ukraine was the wake-up-and-smell-the-coffee shock to energy, food and commodity prices that broke the model. The consequences have overturned everything we thought. We were kidding ourselves about how the global economy works. Sophisticated and terribly clever algorithmic financial models predicting financial outcomes have utterly failed to understand the complexity of the real economy, and just how suddenly cascading consequences ripple-like tsunamis through markets, labour and commerce.
Consequences, consequences…
Even now, I don’t think Central bankers really understand just how overturned the apple cart of monetary stability has become! The triggers for new real inflation impacting the global economy in terms of energy, food and commodity prices, and the consequences of higher wage demands are all clear, but the underlying fuel that has now caught fire is less well understood.
Inflation – which I recently described as “the apex predator of the bond market” – is now very real. Balancing rising interest rates as central banks finally acknowledge it’s a problem while putting in place an inflation aware investment strategy to generate returns while balancing the risks of equity markets versus the security of bonds… well, it’s a tricky optimisation game where you can’t know the actual parameters.
One critical point about energy and commodity inflation is how it hit markets as “no-see-ums”. For readers unfamiliar with my market blog, the Morning Porridge commentary,
a No-see-um is something so blindingly obvious and dangerous your mind refuses to acknowledge the likelihood until it’s actually happening. Also important is the concept of how an SEP (Someone Else’s Problem) makes us blind to the consequences of what’s occurring around us.
Central bankers and economists tell us they watch the whole economy. In reality, they all wear blinkers.
Traditionally, a monetarist economist will tell you: “inflation is everywhere a monetary phenomenon”, blaming excessive government debt and monetary creation for the current inflationary woe and sense of crisis. They point to the massive monetary creation since 2012 – when we began QE – and ultra-low interest rates as the drivers of inflation. Until recently, however, we didn’t see any real-world inflation… all the inflation generated by QE was locked up in financial assets, driving bond and equity rallies.
Here’s just part of the problem… As soon as you spot a no-see-um, its effects become very real.
Inflation started to spiral from financial assets into the real world during the pandemic. Suddenly real events – like the container ship, the Evergiven, blocking the Suez Canal highlighted supply chain crises. Today we have Walmart paying truck drivers $100k salaries to ensure supplies – triggering wage inflation across the retail sector. Consequences beget consequences.
The “Monetary Experimentation” we’ve seen since the global financial crisis of 2007-2008 in the form of sustained criminally low-interest rates and Quantitative Easing did little to boost growth, but it created extreme financial asset inflation - driving inflation into the bond and equity bull-markets of the last 12 years.
Now that inflation is transferring into the real economy, going back to simple monetary tenets: if the money supply rises, inflation follows. All you need to do is light the blue touch paper to trigger an inflationary explosion. What is now driving inflation is the massive amount of liquidity created by low rates and QE. It’s now fuelling the fires of massive real economic commodity and energy inflation. It proves excessive liquidity creates non-monetary real-world inflationary risks.
And all it took was a trigger. Ukraine and Energy Insecurity. Suddenly Europe woke up to the frightening reality of dependency on Russia for power. And, as the world woke up to the reality that Russia and Ukraine are dominant agricultural suppliers… ouch.
Nothing makes you so aware of reality as a sharp punch in the face. It opens our eyes to finally see the blindingly obvious financial connections hidden in the complexity of the Global financial ecosystem! Commodities, Food, and Energy – the building blocks of everything in the global economy – have become as much distorted by the last 12 years of monetary experimentation as every other kind of asset….
Here’s just part of the problem… As soon as you spot a no-see-um, its effects become very real. As soon as you realise a “someone else’s problem” is also yours, the consequences magnify and become reinforcing. That’s why the moment you spot a crisis is when it gets more dangerous. That moment has occurred. When market commentators start to compare what is happening today to 2008 – pay close attention. There are parallels – but that one was about a financial collapse. This one is about a real economic crisis.
Abundant liquidity distorts not just rates, but the real economy also. As the prices of labour, shipping, and logistics change due to inflation you need to understand the whys and hows to anticipate their effects. Wages will rise because that’s how wage inflation rises. Logistics will get more expensive because fuel costs have risen. Food prices will rise because fertiliser costs are up and supply is limited. Real-world consequences… trigger further consequences.
The current risks are immense. If central banks get it wrong – and they usually do; policy mistakes cause most recessions - then removing the easy liquidity which has driven the commodities market could trigger a real-world economic crash.
19th October marks the 30th anniversary of Black Monday, when in October 1987 stock markets around the world experienced a flash crash. The FTSE 100 fell 11% on the day, and then fell a further 12% the next day, wiping out more than a fifth of the value of the UK stock market in just two trading sessions.
As terrifying as these sharp falls were, hindsight tells us that for investors who didn’t panic, even a badly timed investment made money in the long run.
Laith Khalaf, Senior Analyst, Hargreaves Lansdown: “Stock market crashes are a bit like the Spanish Inquisition- no-one expects them. The 1987 crash is renowned for the speed and severity of the market decline, and undoubtedly when markets are plunging so sharply, it’s hard to keep a cool head.
“Hindsight clearly shows that the best strategy in these scenarios is to sit tight and not engage in panic selling. Time has a tremendous healing power when it comes to the stock market, and price falls are typically a buying opportunity. The stock market is an unusual trading venue, in that buyers tend to stay away when there’s a sale on.
“The Footsie has recently reached a new record high, which prompts the question of whether it’s heading for a fall. There are always reasons to worry about the stock market and now is no exception. The Chinese credit bubble is front and centre of concern, along with increasing global protectionism, and the disturbing prospect of World War Three being started on Twitter.
“However there are also reasons to be positive, with the global economy moving up a gear, borrowing costs remaining low, and stocks facing little competition from bonds and cash when it comes to offering a decent return.
“The market will of course take a tumble at some point, and it’s impossible to predict when. This makes being bearish an easy game, because you only have to wait so long before you are eventually proved right. The big question though, is how much you have lost out on in the meantime by sitting on your hands.
“It’s important to bear in mind that investing isn’t a one-time deal, savers typically invest at different times throughout their lives, and at different market levels, and sometimes they will be luckier with their timing than at others. To this end, a monthly savings plan takes the sting out of any market falls by buying shares at lower prices when the inevitable happens.
“The golden rule, of course, is to make sure you are investing money for the long term. In the short term the stock market is a capricious beast and can move sharply in either direction, but in the long run, it’s surprisingly consistent.”
After the crash
The table below shows stock market returns following the three big stock market falls of the last thirty years: 1987, 1999-2003 and 2007-2009.
The first column shows what you would have got by investing £10,000 on the eve of the crash, and pulling your money out at the bottom of the market. The remaining columns show what would have happened to your investment if you had held on to it. These numbers should be viewed as examples of what stock market returns have been if your timing is really pretty stinky, and you only happen to invest £10k once in your entire life, on the eve of a dramatic downdraft in the market.
In 1987 investors would have seen £10,000 reduced to £6,610 in a matter of weeks. However, if they had waited 5 years, their investment would have fully recovered, and 10 years later would be worth £32,690, with dividends reinvested. Today that investment would be worth £104,340.
Stock prices recovered pretty promptly after the 1987 crash, in contrast to the bursting of the tech bubble in 1999, which was compounded by the Enron scandal and the World Trade Centre attack, leading to a deep and prolonged bear market lasting until 2003. £10k invested in the stock market in 1999 would be worth £23,210 today, an annualised return of just over 5%.
Looking at these figures, it’s hard to dodge the conclusion that this was the worst of all three periods for stock market investors. It also contributed to the already declining fortunes of defined benefit schemes in the UK, and did huge reputational damage to insurance companies as the dreaded MVR (Market Value Reduction) became common parlance amongst hitherto happy With Profits policyholders.
The value of rolling up dividends shines through in the numbers below. Since the peak of the market in June 2007, £10,000 would only have grown to £11,890 based on stock price movements alone. But once dividends are counted and reinvested, that rises to £17,230, not a bad result given this money was invested at the peak of the market just before the global financial crisis took hold.
Is the Footsie about to crash?
The FTSE 100 reaching a new record high recently has of course prompted questions about whether it’s heading for a fall. However the level of the Footsie is not a measure of the value in UK stocks, seeing as it doesn’t take account of the level of earnings of companies in the index.
Below are two related measures of value of the UK stock market which take company earnings into account, but each give a slightly different picture of valuations in the UK stock market right now.
The headline historic P/E is elevated compared to its historic average, though still well short of the level seen in 1999.
The Cyclically Adjusted P/E Ratio, a valuation method championed by Nobel prize-winning economist Robert Shiller, takes a longer term view of earnings by looking over the last 10 year, which smooths out volatility in the one year P/E number.
On the cyclically adjusted measure, the UK stock market is trading below its historical average, and well below levels seen in both 1987 and 1999.
So which of these two measures should we believe? Well, we assign more weight to the Cyclically Adjusted P/E because it takes a longer term, more rounded view of stock market valuation. But if we simply take both measures into account in combination, together they suggest the market is somewhere in the middle of its historic range.
When thinking about the valuation of the stock market, it’s also worthwhile considering the valuation of alternative assets. The 10-year gilt is currently yielding 1.3%, and cash is yielding next to nothing with base rate at 0.25%. This contrasts sharply with 1987 when base rate was 9.9% and the 10-year gilt was yielding around 10%. So if you think the UK stock market’s expensive right now, then you have to take a really dim view of the value provided by bonds and cash.
(Source: Hargreaves Lansdown)
The German stock market crash is a timely reminder of the need to broadly invest, affirms one of the world’s largest independent financial services organisations.
The comment from Tom Elliott, deVere Group’s International Investment Strategist, comes as the DAX, Germany’s top stock index, was nearing the red after shares in the country’s largest car makers dropped over a fresh probe into the diesel emission scandal.
Mr Elliott observes: “Eurozone stock markets have felt the pain of a strong currency in recent weeks, as investors think that improving economic data will force the ECB to curtail its bond-buying program prematurely and - if inflation picks up - lead to interest rate hikes.
“But the DAX 30, the key German stock market index, now has an additional problem that has contributed to recent falls. Its motor sector – led by BMW, Daimler and Volkswagen- is under a cloud as more jurisdictions line up to fine the companies over diesel emissions. Last week, the Mayor of London announced plans to seek compensation from Volkswagen after the true scale of the company’s diesel-fuelled cars’ contribution to the city’s air pollution became known. The sector is at risk of punitive fines across the world.”
He continues: “A further risk is that the ‘Made in Germany’ brand suffers more generally.
“However, while this is embarrassing for the German auto sector, and for German exporters more generally, it is likely to be a passing phase. The fines will be absorbed by shareholders, and meanwhile the German auto sector will return to the real long-term battle: is there a durable market for high quality, driver-driven, private cars?
Mr Elliott goes on to say: “German - and European autos’ biggest threat comes from technology from the US – in the form of driverless cars and battery cells, amongst other factors – as well as changing social habits, which include car pooling and young adults driving less in developed economies.
“The German stock market crash is a timely reminder of the need to broadly invest so that portfolios will have exposure to the young companies likely to benefit from driverless cars for example.”
He concludes: “Diversification of portfolios across sectors, asset classes and regions will ensure investors are best-placed to take full advantage of the present and future opportunities and to mitigate the risks.”
(Source: deVere Group)
