If you are a frequent city driver, you’ve learned to calculate traffic flows to obtain where you need to go. But imagine that the direction of all of the one-way streets was suddenly reversed, causing bottlenecks, even car accidents. It might be chaotic.
Eventually, however, commuters would adapt and a brand new steady state would form.
Like traffic patterns, financial markets are driven by movement as well – the movement of money. Actually, the path or flow of cash through markets is paramount. Sometimes, this flow gets blocked, pressure builds up in the system and eventually we need to visit a rewiring of the financial flows to reach a brand new steady state. This is what is going on now.
There isn’t any denying the violent repricing of financial markets in the month of January and the early a part of February. What’s been remarkable about the price action wasn’t just its relentless nature, but the insufficient a simple catalyst from either the micro or macro story. As such, the moves in financial markets were greatly divorced from the incremental news flow from the real economy.
Certainly, the global economy isn’t growing significantly, but the incremental data released during the period of early 2016 weren’t alarming and they were also consistent with the overall picture in November and December: a slowdown in the U.S. manufacturing sector because of strong currency headwinds, offset by a very healthy consumer sector; the prospect of slowing growth in the Chinese economy; and continued healing in Europe supported by accommodative monetary policy.
And the earnings picture, while not spectacular, was sufficient and would not seem to warrant the negative price action in equity markets.
It’s remember this that the finance industry is there only to serve the actual economy and should be controlled and affected by it. In a normal world, the financial markets do not drive real economic outcomes and lower oil costs are a good thing. Yes, there are winners and losers, however in an ordinary economy, the easiest way to increase value-added production would be to lower input costs. Hence, lower oil has to be good on balance for the greater real economy.
But we are not inside a normal world. In our current world, the tail wags the dog. The economic climate is becoming so large and so intertwined in most aspects of our activities, the markets drive real economic outcomes. As well as in the past 10 to 15 years, the financial system has evolved and grown with different key input – rising commodity prices. As a result, all of the financial flows and channels have been created based on money flows driven by commodity appreciation. Much like our example of traffic patterns, the system has been designed around specialized financial flows that have run in specific directions for years.
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The collapse of commodity prices is causing these financial flows to stop, change direction, or perhaps reverse. Rather than petrodollars being recycled into asset purchases, Middle East sovereign wealth funds have grown to be sellers of assets. Rather than China along with other emerging market countries accumulating reserves, they are sellers of reserves.
In 2008, people saw the amount of housing collateral in the system and understood the outcome on financial credit growth once the collateral fell in value. Many people do not appreciate the quantity of commodity-collateralized lending which has evaporated using the fall within the value of the collateral.
If you appear at financial markets with the lens of the real economy, markets look to be pricing inside a much higher probability of recession compared to economic data would warrant. The cost action to date this year was most likely a continued reaction to the fall in oil (and other commodity prices) along with a consequence of the unwinding of monetary flows derived from high commodity prices. Said bluntly, it had been a massive commodity margin call.
Whether you appear at the turnaround of petrodollar flows because the Middle East sovereign wealth funds sell financial assets rather than accumulating them or the recognition of pending write-downs in commodity-based lending and the attempt to hedge these illiquid claims via more liquid markets, all the flow in financial markets at this time seems associated with the outlook for oil.
It is essential to acknowledge that as powerful as these flow-driven repricings can be, they do not last forever, and ultimately the basic principles will win out.
It is important to recognize that as powerful because these flow-driven repricings could be, they don’t last forever, and eventually the fundamentals will win out
The knock-on effects in the turnaround of petrodollar flows is definitely an interesting one. Middle East sovereign wealth funds are big owners of European and U.S. stocks, with a very high weight towards the financial sector. Because these funds turn to raise cash to repatriate assets for domestic budget purposes, they offer the greater liquid holdings, which frequently means the large cap banks. The issue is, everybody knows this flow is originating, very few buyers are willing to part of to provide liquidity to facilitate these sales within an orderly fashion. So prices move sharply lower whenever a big forced seller involves the market.
Compounding this situation is the fact that, ever since the 2008 economic crisis, there has been lots of fear in financial markets. That crisis was centred on the near-collapse in the global banking system. Investors were irrevocably scarred by that experience, and collectively vowed to never let that happen again. Like generals preparing to fight the final war, all of us have focused on the banking system because the early danger signal for the following crisis, not appreciating the functional changes to the banking system (regulatory changes to the business design, much higher capital levels).
The weakness in financial stocks has triggered near panic round the state of the banking system and it has cascaded throughout the capital structure of banks, with weakness in everything from bank preferred shares to senior debt. We feel the marketplace is shooting first and aiming later. Yes, the threat of negative rates of interest is a cause for concern for banks’ earnings, however the market’s indiscriminate need to liquidate assets seems well past what one would expect.
At Gluskin Sheff we still believe global growth is stable which a resilient global financial system will prevent further market contagion. We do not think the worldwide economy is about to fall into a recession, despite the fact that certain assets seem to be pricing in such a result. The epicentre of the pain in financial markets has been around non-financial credit as well as in global bank equities. Instead of seeking to shed further risk, we are actually seeing some attractive opportunities across asset classes, which we’ll turn to take advantage of at much better prices than we would possess a couple of months ago.
George Young is vice-president of risk management and asset allocation at Gluskin Sheff + Associates.