Aeroplane analogies have become prevalent in markets commentary over the past year, generally focused on the extent to which Jay Powell, pilot of the US Federal Reserve, can glide to a nice soft landing in the economy. Can he engineer a slowdown in inflation without causing a crash?
The passengers are getting nervous, it seems. “Stand by for sudden pressure loss,” Matt King, a global markets strategist at Citi, wrote this week. In a note to clients, he said the undeniably decent performance in key markets so far this year — the S&P 500 and the MSCI World index are up around 8 per cent — is often attributed to “genuine improvements” in the economic outlook.
Don’t believe it, he said, instead suggesting asset prices are once again behaving as if central banks are indulging in quantitative easing — bond purchases that supplement interest rate cuts in an effort to support the economy.
“Market moves this year have had a decidedly QE-like feel to them, don’t you think?” he wrote. “Mysteriously low equity volatility . . . real yields grinding back to the low end of recent ranges. Valuations in both bonds and equities that no one seems quite able to square with either central bank rhetoric or underlying [fundamentals].”
Even bitcoin has been rallying, he pointed out. If you think that is because the crypto token has demonstrated a meaningful new utility, I have an NFT of a bridge to sell you. In the metaverse. Instead, the one useful function that bitcoin does serve is to tell the world that something peculiar is running through the financial system.
In this case, King said, it’s a build-up in reserves. “On the measure that counts for markets — namely reserves — central banks have added $1tn in global liquidity, or de facto QE.” He reckons that has added 10 per cent to global equities.
The first big injection came from the Bank of Japan. Towards the end of last year, it added more than $200bn in reserves to defend its longstanding policy of holding down bond yields. At the time, most fund managers I spoke to laughed off the suggestion this was helping global asset prices, even on the margins. Now it is broadly accepted as a fact.
The thick layer of icing on the cake came from the Fed, which stepped in to relieve the pressure after Silicon Valley Bank failed in March. That amounted to a reversal of around two-thirds of the US central bank’s balance sheet reduction that had previously taken place.
“But while the individual drivers are varied and complex, we now expect almost all of them to stall or go into outright reverse,” said King. “We think this could subtract $600bn-$800bn in global liquidity in coming weeks . . . Keep watching the liquidity data — and buckle up.”
It certainly looks like investors are popping on their seat belts, just in case. The latest monthly fund managers’ survey from Bank of America this week highlighted a deeply bearish mood. A chunky 63 per cent of investors surveyed now expect the economy to weaken, up 13 percentage points on the month.
Perhaps most ominously, allocations to bonds had shot up to the biggest overweight position since March 2009. Some of that comes from investors buying in to the enormous dip in government bond prices over the course of last year. But fund managers’ underweight position in equities relative to bonds has extended to the most extreme level since the financial crisis, BofA pointed out.
Does this level of alarm make sense? Markets are incredibly resilient given the list of things we have been told to worry about of late. A recession? No particular sign of that. A banking crisis? Again, no. “[The failure of SVB] could have been an Archduke Ferdinand moment that lights a fire,” says Fahad Kamal, chief investment officer at private bank SG Kleinwort Hambros. “But it does not look like it was.”
For Kamal, sure, a draining of liquidity from central banks could be the straw that breaks the camel’s back. But none of the other reasons to run to the hills has really bitten. “Pessimists are pessimists,” he says, but he has nonetheless upgraded his risk tolerance to neutral over the past few months, in part because of the sheer resilience markets have shown so far in 2023.
Stéphane Monier, chief investment officer at Lombard Odier Private Bank, is among those who are unnerved by the mismatch between the rather anxious mood among fund managers and the apparently rude health of stock markets. “Nobody is particularly bullish,” he says. “The rally is moving by itself, everybody is a bit surprised.”
He is trying to stay neutral, and relatively optimistic, but to do this, he needs what he calls “crutches” such as derivatives he has bought to protect his portfolio in the event of a meaningful hit to US stocks. If the S&P 500 index falls 15 per cent or so, 10 per cent of his US equities exposure is protected.
Nervous flyers are clearly not running out of new stuff to fret about. Citi’s warning is certainly worth taking seriously. But it feels like pessimists are shouting into a void. As one banker told me recently, “I am tired on their behalf.”