A way of considering the financial system in the post QE era has been to understand that everything has become increasingly dependent on confidence in central bankers. So long as markets believed that debt levels no longer mattered, and that countries could grow their outstanding debt without consequence, the show could be kept on the road. Government bonds, despite being valued at yields that didn’t even compensate for inflation, were somehow a worthwhile investment. The same could be said of the equity markets, earnings could grow on the back of ever lower interest burdens, enabling companies to assume debt and buy back shares with seemingly little risk. On the back of ultra-low bond yields, growth companies could assume huge valuations.
This whole edifice is ultimately dependent on confidence that central bankers have the tools to smooth any bumps on the road. When things are going well in the economy, or for a business, debt levels appear not to matter but ultimately they create fixed liabilities such that when problems arise unexpectedly, things can start going wrong very fast. This is where confidence in central bankers comes in, when the market was having its end of year meltdown, it took only a few soothing words from Fed Chairman Powell to send the markets back onto their upward trajectory. The same can be said of individual businesses, so long as investors believe a highly indebted automaker, making operating losses, with a currently insignificant market share, run by, shall we say, an interesting head, will be a future market leader, the valuation can be justified. Confidence is a most intangible thing, a small change can cause a one-time respectable financial institution to be subject to a bank run, or a glamour stock to evaporate over a short space of time.
The question investors face right now is whether we are emerging from a prolonged period of excess confidence into a period where the cynics are in the driving seat once again. Evidence is increasingly emerging that buyers are no longer prepared to trust the future growth prospects of individual companies. The recent revision of the terms of WeWork’s latest financing round suggests that a degree of realism is emerging. This can also be seen in the market’s recent attitude to certain new bond and loan issues.
We are also at a critical juncture when it comes to confidence in central banks. Through an ever more complex array of measures, they have been able to safely steer the global economy through the bumps of the last decade without a recession in a major economy, despite the unprecedented levels of debt. The big question now is whether central bankers have the tools to alleviate the impact on the US economy of the slowdown in China, while Chinese companies and consumers are evidently avoiding US products. It would seem something of a big ask for central bankers to solve a problem in the real economy with financial measures, particularly when interest rates are already so low.
As a consequence, we feel that the financial markets might well be emerging from a prolonged period of complacency into one where reality looks a little less rosy than before. While it is not altogether clear whether we are in the grand reset so many commentators have for so long expected, it is also not obvious how monetary measures can offset the impact of a trade war. For this reason, we are not chasing the current rally aggressively and are in wait and see mode to get better clarity over the coming weeks. Announcements from companies and central banks and importantly how the market responds to them will set the future tone.
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