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LGT Investorama: Mood swings following an artificial equilibrium

April 26, 2018

Everyone is familiar to some extent with the way our moods can change. It is part of human life. Only when mood swings become unusually frequent and/or pronounced can they be considered pathological and therefore medically significant, making therapeutic measures necessary. In a bipolar affective disorder in the extreme form, the sufferer cycles between phases of deep depression and disproportionate euphoria. The same applies to the “emotional state” of the economy in general and the psychology of the financial markets in particular. What can investors learn from this?

Fluctuations in economic activity across a certain range are in the nature of a market economy. They come about through imbalances in overall economic demand and aggregated supply arising from different causes, which leads to cycles in the utilization rate of production potential. Still more pronounced – even in normal periods – are the price fluctuations or changing moods of the stock markets, known in trade jargon as “volatility.” Generally, market sentiment varies to a stronger degree than the related economic figures, because the former is ruled by flighty expectations and the latter are never known exactly or only with a delay. Furthermore, external, non-economic factors also play a role. So much about the everyday workings of the markets, for which stabilization policy measures are neither necessary nor practicable.

That was different a good ten years ago, when in the worst financial crisis since World War II, one pillar of the economy after another threatened to collapse. At that time, government had to pull out all the stops in order to rescue the financial system and revive the real economy. To prevent the much-feared nightmare scenario of a deflationary depression, a high dose of monetary antidepressants was prescribed prophylactically, and as the repertoire of conventional remedies was soon exhausted, a growing number of unorthodox, largely untested treatments were applied.

The outcome was a collective change in behavior of the financial market players, with price fluctuations and market mechanisms that were almost completely disabled. The price charts could essentially be mapped with the straight edge of a simple ruler: almost all equity indices pointed diagonally upwards, with so little variation that even a thin ruler could cover the entire range of the price development! Unfortunately, however, the equilibrium artificially created on the side of long-term interest rates is still far away from the natural equilibrium. This “stable instability” glaringly contradicts the old economic wisdom that the ten-year yield reflects the expectations of capital market participants for economic development – i.e. real growth plus inflation – over the next ten years. Because as long as yields are inconsistent with these expectations, it pays to shift assets away from government bonds into the private sector and vice versa. The somewhat simplified basic conclusion of economic equilibrium models is thus violated in a drastic way – a side-effect of the monetary shock therapy. Even given conservative forecasts of the economic outlook, yields are too low by between almost 150 basis points (US) and 300 basis points (German bunds)! Here at home, we seem to be essentially trapped in a zero-interest world!

Equally as serious as these market distortions – and the price to pay for artificial stabilization of the economy and financial system – is the dependency the markets have developed on monetary tranquilizers. The fact that the process of exiting from the ultra-loose monetary policy could not possibly be a painless one was either overlooked by the central banks’ crisis doctors at the time, or it was deliberately concealed. Since the so-called “taper tantrum” (portmanteau of the words temper tantrum and tapering) in 2013, fear of a similar “withdrawal fit” occurring is omnipresent. This term was used to describe the financial markets’ acute shock reaction to Fed Chairman Ben Bernanke’s initial announcement that the US Federal Reserve would begin cutting back its bond purchases. Since then, investors and markets have been conditioned to behave contrary to their inherent natures – they have developed a bipolar disorder with phases abruptly alternating between “risk on” and “risk off.” In a schizophrenic-like manner, negative economic data might exert a calming influence or even inspire a manic state, while overly positive news triggered downright panic attacks.

How will the long-overdue withdrawal process be achieved: by getting back to, or at least closer to, a natural equilibrium? Janet Yellen has more or less shown the way, starting a rehabilitation that has so far been successful, and Jerome Powell and Mario Draghi would be wise to follow her lead. Like in psychopharmacology, this means gradually reducing the dose of “monetary medicine” over a longer period until the “patient” can, ideally, do without it altogether. Even so, some adjustment shocks are inevitable. As in a clinical context, to prevent nasty episodes like the “taper tantrum,” carefully executed communication and forward guidance are essential.

The moral for investors is thus not unlike that for psychiatric patients. First of all, asking oneself “what if...” achieves nothing; the controversial debates still going on about the usefulness of or even the lack of alternatives to quantitative easing are purely academic in nature. Secondly, it is better to look optimistically into the foreseeable future, as monetary authorities –and along with them, the markets – inch their way in the right direction back towards the old normality, as far as and for as long as it is possible. One must be satisfied with modest progress and not be too put off by temporary setbacks. One should also be careful not to accept a diagnosis of “irrational exuberance” prematurely. Such a diagnosis should not be made years too early, as was the case under Dr Alan Greenspan, but only if there is a final outbreak of manic excessiveness in the form of exuberant carelessness. And last but not least: if the psychological strain of doing this is too great for you, you should not consult a psychiatrist, but rather place your portfolio in the hands of a trusted financial professional.

Dr. Alex Durrer
Chief Economist

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