What do global macros foretell for markets?

We live in a globalised world with innumerable linkages.

In FY21, India received a little more than 3 times the FPI flows into equities than the cumulative flows of the previous four years (FY16-20) combined! No doubt, this has a lot to do with the opening of the liquidity floodgates by global central banks, especially the Federal Reserve and European Central Bank (ECB) — driving key Indian indices well past previous peaks in terms of valuation levels across multiple metrics. US markets too are at historic highs.

The easy money could gradually stop, with tapering plans announced by the US Fed. Besides, with inflation in developed markets quite persistent, faster than estimated completion of tapering and earlier than expected increase in interest rates can rock global markets. Indian markets will not be immune to this.

In this context, BusinessLine caught up with Sven Henrich for his perspective on the fallout of central bank policies on markets and how the end game may play out. Excerpts:

Henrich is founder and lead market strategist for NorthmanTrader.com. He is a highly respected technical analyst and commentator on markets and the macro economic environment. He is the publisher of the Daily Market Brief keeping investors and traders abreast of the latest market critical technical and macro developments as well as market directional strategy

Henrich is popular in social media through his Twitter handle: @NorthmanTrader.

We had this big breakdown in the economy and the forced shutdowns and then we literally created trillions of dollars via both monetary and fiscal stimulus. Nobody has a clue what the end effect of throwing this much liquidity into global economy, markets, is. There is no precedent.

Central banks, in the past 12 years prior to Covid-19, had lamented about the lack of fiscal support and hence had resorted to printing (monetary stimulus). Now, there is fiscal support after Covid. But they are still printing and in larger amounts than during the depths of the financial crisis and also when the US GDP growth for CY21 is expected at around 6 per cent. We are creating this fantasy economy that is driven by overt stimulus.

So, the question is “Have we fundamentally changed the economy?” If not, you have got a huge reversion coming when this peak liquidity flooding the system moves out. With the US government adding $5 trillion in debt, the Federal Reserve adding almost $5 trillion to its balance sheet, we can have a hell of a party. Of course, corporate earnings are going to be great and consumers have cash to spend. But the fundamental question is, “What is the organic economy beneath all this?” Ultimately, that’s what we are going to have to deal with.

The danger is that if you look at the past several decades, whenever we create an environment of excess, be it 1999-2000 or 2007, we are creating bubbles and when it reverts, it brings about a recession and damage. And the concern is, we have learned to ignore all downsides because the magical central bank comes and removes downside from markets immediately. So, society never actually gets to know the consequences of anything. We don’t let business cycles run any more. There is no more process of creative destruction. We save everything, nothing gets renewed. I call it the ‘zombification of the economy’ that is entirely dependent on debt expansion and monetary intervention.

Corporate debt by far is at the highest level ever. Government debt is over the roof. The world has been able to mask pain over the last 20 years by continuing to expand debt. Debt growth has been higher than actual economic growth.

Jeffery Gundlach (referring to the founder of investment firm DoubleLine Capital) has been making a similar point based on the growth in nominal GDP and deficit spending — that without deficit spending, there would be no economic growth in the US. It has been possible because rates are at zero. As long as you have a deflationary environment where technology and demographics drive the deflationary environment, you can get away with that. But now we are seeing inflation well above levels that are comfortable. While it is termed to be transitory, the definition of ‘transitory’ is already changing. If that changes the equation, central banks will be forced to raise interest rates to cool things down. But in this environment, cooling things down means a recession.

My critical perspective is in terms of the negative side effects that the central banks don’t like to acknowledge at all, and their role in it. I have been watching the central bank show for the last 15 years, and markets don’t operate on their own or in a vacuum. A lot is driven by what the central banks do. What we are seeing now is a natural extension of what the central banks have been doing for the last 12 years, except that they have now made everything worse.

If you see from data points I have put out on my Twitter feed, wealth has never been so concentrated. According to a report, the wealthiest 10 per cent of Americans own 89 per cent of all stocks and the bottom 90 per cent own just 1 per cent. It is baffling when Jay Powell says “Fed policies absolutely don’t add to inequality’”. I am generally concerned for society and how fractured it is going to get. And central bank policies are contributing to this.

In the meantime the money printing has also resulted in highest inflation that we have seen for a long while and it is the bottom 50 per cent that gets hurt the most.

Markets have become so large in relation to the economy. If your goal is full employment, to avoid a recession, you cannot afford a bear market. Markets are an expression of confidence and also an expression of discretionary spending. So, if markets go down, spending and confidence go down. It’s literally a vicious cycle. What I blame the central bank for is that none of them, from Alan Greenspan onwards, have had the courage to send a message to the markets that it needs to take some pain.

The big reveal came to me in 2018, which had the only brief period since 2009 when the Fed was non-accommodative in its language and Jay Powell had said Fed balance sheet reduction was on auto-pilot mode. During that period, the US 10-year treasury yield hit a critical level of 3.2 per cent, markets dropped and the balance sheet reduction on auto-pilot was just swept off the table.

And the reveal was that not only the world cannot handle higher rates, but also the Fed will immediately respond to markets.

Janet Yellen too paused after the first rate hike post financial crisis in December 2015 as this was not taken well by the markets and financial stocks were down over 20 per cent. The only time they were able raise rates slowly was between 2016 and 2018 when the ECB and BOJ (Bank of Japan) provided cover by printing in a big way and injected around $5.5 trillion in liquidity.

Asset price management should not be the Fed’s mandate, but it has morphed into that.

What has happened now is the much accelerated growth in central bank balance sheets. For example, in the case of the Fed, between 2009 and 2014, it increased its balance sheet by $3.7 trillion. This time, it increased it by almost $5 trillion in just 1.5 years. We have seen $10 trillion from just two central banks. Since November last year I have been tweeting charts that show every new high on the Fed balance sheet is followed by a new high on the S&P 500.

Another factor this time is that, with zero commission brokers and removal of entry barriers, we have got a new bunch of retail investors into the market.

History says that the current disconnect between valuations and economy is unsustainable. So, if you are bullish, you are betting on history not mattering. And the central bank intervention has given us the illusion that history does not matter.

The market cap to GDP in the US right now is at 205 per cent. There is absolutely zero precedence for this. People say, ‘well, we have the big tech and they are global’ but if you take the top five big tech companies out, you still have over 150 per cent market cap to GDP. In 2000, during the dotcom peak, it was at 150 per cent and crashed to around 50 per cent. And we had the recession subsequently.

Similarly, a market reversion bringing about a recession is becoming a threat now. With markets so large relative to the size of the economy now, they themselves are risking becoming a financial stability risk and threat to global economy as so much of money is tied up in them.

The liquidity curve that has propelled global stock markets is coming to an end in 2022. Markets will have to reconcile the historic valuation extension with a lot less incremental liquidity flowing in.

One has to be respectful of the strength and momentum in the market, but you also have to be highly attuned to changes in the market. We have seen it in past bubbles where they say markets are forward looking, but that turned out to be wrong. For example, Covid was already known in January 2020, but after a small pull-back, markets made new highs in February and then the crash happened.

Similarly, was market forward looking in 2007? No. Did the Fed give a heads-up warning? No. Ben Bernanke was out there saying sub-prime was contained and it was not going to impact the economy, and he was completely wrong. So my general view is, simply be careful to not get caught up in the hype. What we do is we look at technicals and that’s how we manage risk-reward.

QUOTES:

“We don’t let business cycles run anymore. There is no more process of creative destruction. We save everything, nothing gets renewed. I call it the ‘zombification of the economy’ that is entirely dependent on debt expansion and monetary intervention.”

"My general concern would be that not only are we witnessing the highest valuations relative to the size of the economy in history, but also the most aggressive long allocations in history. This means everybody is long the same stocks that are all priced to perfection, a perfection that may prove to be an illusion brought about by monetary and fiscal liquidity".

"Natural market discovery has been distorted by four central banks (Fed, BOE, ECB, BOJ) creating artificial money and buying $31 trillion in assets. The crazier the distortions and disconnect from economy, the more significant the damage as people throw all caution to the wind. They don’t even know what they are buying, they just know it goes up".

"Market technicals matter. This is one key message I want to pass on despite all of what I have said on central bank intervention. There is lot of algorithmic trading going on and all these play their part in the markets".

(This is a free article from the BusinessLine premium Portfolio segment. For more such content, please subscribe to The Hindu BusinessLine online. )

COMMENT NOW