Saturday, 17 May 2014

Stumbling around in the dark....

What a wonderful day for a cup final! I spent part of this week in Paris, which was basking in the kind of spring sunshine that helped build its reputation. Shame about the dog mess, the taxi drivers and most of all, the lack of economic recovery, but that's for another day.

Back here in the UK, the FTSE has enjoyed it highest weekly close since 1999. Joy at the UK's spectacular recovery, a vote of confidence in the Chancellor's economic management, or a vote for the M&A boom? I'm no wiser about the outlook for equity markets than I am about anything else but the picture below is my small take on this. The FTSE peaked in 1999 shortly before the US Federal Reserve's main interest rate was increased for the last time in the boom. The FTSE reached its low as US rates were tumbling in 2002 and reached its 2007 high after the last of the US central bank's rate hikes in that cycle. And yup, UK equity markets have been rallying since US interest rates got to their current near-zero level in 2009. So, if you think that rising share prices are a 'good thing' and you want to thank someone, I reckon you should send a postcard to Ben Bernanke and Janet Yellen, rather than Mark Carney or George Osborne.

The same, by the way, is probably true of UK house prices.  Part of the UK house price 'problem' is that London's become a global city and house (or flat) building is lagging way behind the migration into the city. Sure, there's a problem with a handful of billionaires who have decided to buy Mayfair in a game of monopoly for the super-rich. But the attention the press pay those folks is far greater than they deserve. Just as the focus on the 'wrong kind' of immigrant is greater than it deserves. Most of the people who arrive in London, whether from the suburbs of London or the suburbs of Paris, Milan or Budapest are young, educated and hungry for success. And the reason they pay too much to buy or rent somewhere to live, is not because a few properties are empty but because there aren't enough of them.

But the second reason they pay too much is that the cost of money is too low. Not just low in the UK, but low everywhere where the US Federal Reserve's influence is felt. And that's where the similarity with share prices is greatest. Low global interest rates push investors into shares rates than government bonds. They encourage large companies to borrow cheap money to buy back their equity, or to buy their competitors in the name of efficiency. And when share prices lose touch with the economy, it is only temporary, because a company can only ever be worth the discounted value of future dividends. If there are more people who want to live in London than there are rooms for them, prices can stay high for a long time. But no-one is that desperate to win the shares of any company if it doesn't make much money.  

In recent weeks however, the cost of money has been coming back down. This time last year, American central bankers started to warn that it was only a mater of time before they stopped pumping ever more money into the economy by buying government bonds. And only a matter of time after that before they started to push interest rates up. That warning caused a huge re-think by people involved in markets about where interest rates would be, not in the next few months but in the next few years. A year ago today, an American bank could borrow or lend money for one year, starting in 5 years' time, at a rate of 2 1/2%. That is roughly the same as saying that the best guess of the financial markets in five years' time, the Federal Reserve would have increased its interest rates to about 2%. Too low. Collectively, markets had a rethink and by September that 1-year interest rate starting in 5 years was priced at 4.2%. So the new best guess was that the Fed would raise rates over 5 years to around 4%.

That was a better guess. Right or wrong, time will tell. But from the central bank's perspective this was healthy. Everyone had woken up to the fact that we wouldn't really have such low rates for ever. Markets cooled and in some cases fell. But recently, egged-on by low inflation and a lack of wage growth, central bankers have been downplaying the risk of interest rates going up soon, or far. And so, here we are, pricing in 1 year rates in 5 years' time at 3.4%. So we thought rates would be 2% in 5 years's time, re-thought and decided the answer was 4% and now we think it's a touch above 3%.  Investors, borrowers and lenders are stumbling around in the dark because they don't understand how central bankers decide the level of interest rates any more.

Markets need guidance. I thought the Federal Reserve did a good job last summer. I think they're in danger of undoing their good work. We were in the dark and we thought the Fed was showing leadership. But now, we're stumbling again.

As we stumble, two things happen. The first is that investors drive the price of houses, shares and all sorts of assets up. To levels which will be unsustainable when interest rates finally go up. And the second is that we treat all assets as being the same, so that I can dram pretty pictures of all sorts of asset prices, and they look eerily similar.

So, here we are with a  14-year high in the FTSE. We've also got a the recovery of the Brazilian real, also at it strongest levels since last summer just in time for the World Cup. That picture's below. If you do get the chance to go to Brazil you can experience at first hand what such a strong currency does to the cost of coffee, or beer, or any of the other things football-watchers need to buy.

And it's not just the Brazilian real. The Indian rupee picture looks similar.  Completely different underlying economic story.  And political uncertainty removed. But the way the real and rupee are tracking each other speaks of a world where investors are once again simply looking for yield, rather than differentiating between these different economic stories. And that's a very unhealthy consequence of central banks which don't just leave markets wandering around in the dark, but give the impression that's what they're doing, too.

Enjoy it while it lasts...