Markets unmoved by turbulence

Donald Trump delivers another broadside. Pic: AP

One of the peculiar aspects of this post-Trump environment is how calm, indeed buoyant, markets have been despite the turbulence and threats to stability around them.

There was a little tremor overnight after the latest bout of sabre-rattling between North Korea and the US, with North Korea declaring that President Trump had declared war on it and threatened to shoot down US warplanes regardless of whether they were in its airspace or not.

After an initial sell-off, however, the US market closed only about 0.2 per cent lower and remained just below the record levels reached earlier this month and still on track to achieve one of the longest winning streaks in history.

A piece of research from Goldman Sachs’ international equity strategists issued yesterday puts the current bull market in context. The analysts said the S & P 500 is currently in the fifth-longest period in history without a five per cent correction. Should it continue, by December it would be the longest such streak in history.

Volatility, not just in equity markets but across most asset classes, is at all-time lows despite the volatility in the external environment. That’s not necessarily a good signal, given that prolonged periods of exceptionally low levels of market volatility have tended to end with a bang.

Nevertheless, it is perplexing that the US equity market, which started the year on a Trump-inspired pro-growth tear, hasn’t responded to his inability to implement any of the key initiatives that were supposed to generate above-normal growth in the US economy.

A Wall Street trader. Volatility in equity markets is at all-time lows. Pic: AFP

It is equally surprising that even though the long-anticipated start of the US Federal Reserve Board’s program to shrink its financial crisis-inflated balance sheet is imminent, the markets — once thrown into a “taper tantrum’’ by the prospect that the Fed would trim the scale of its bond-buying — have been unmoved.

From next month the Fed will stop reinvesting $US10 billion of maturing securities. After that each quarter the Fed will increase by $US10 billion the level of non-reinvestment until it reaches $US50 billion a month in about a year’s time. Within two years the Fed will have shrunk its $US4.5 trillion balance sheet by more than $US1 trillion.

While the European Central Bank and Bank of Japan are still deploying unconventional monetary policies, the ECB has already started to taper its buying, reducing its from €80 billion to €60 billion a month, and is expected to reduce the scale of its interventions further.

While not yet synchronised, the two key central banks are moving broadly in the same direction and the beginning of the end of an era of extraordinary era for monetary policy is underway against a backdrop of stronger developed world economic growth.

The US markets, both equity and credit markets, don’t appear to be fussed by the shift in central bank thinking and actions nor by the prospect, reflected in the “dot plot’’ provided by the members of the Fed’s Open Market Committee, of another US rate rise this year and three more next year.

Traditionally, rising interest rates are a negative for markets. It is possible, of course, that the markets are betting that the normalisation of US monetary policy and interest rates in particular will be more gradual and gentle that the Fed seems to believe.

While the market has been right in the past in predicting the Fed would move more cautiously than its projections might have suggested, the looming changes to the composition of the board — Trump will have the ability to appoint a majority of its members — may make it less predictable.

Inevitably all bullmarkets end. While this post-crisis bull market has been fuelled by uniquely unconventional and aggressive monetary policies that have remained in place for nearly a decade at some point there will be a correction, if not the bursting of a bubble.

The warmongering between Trump and North Korea, the prospect of more of the Trump agenda being blocked within Congress, the potential for trade friction and the shrinking of the size of the pool of liquidity as the Fed starts to normalise US policy are all potential friction points, if not flash points, for US markets.

For some reason this time of year is often associated with significant market turmoil — the 1929 and 1987 crashes occurred in October while the big moment at the start of the global financial crisis occurred in mid-September 2008 when Lehman Bros collapsed. (One behavioural finance theory is that in the lead-up to the summer holidays in the northern hemisphere investors are cheery and optimistic — but are more realistic once they return to their desks in September).

It is conceivable that the markets, which price in expectations of the future, have got it right. The Fed might be normalising its monetary policy but actual normality is still a long way off. In the meantime the other two key central banks are still pumping ultra-cheap liquidity into the global system.

Federal Reserve Board chair Janet Yellen. The Fed will soon start shrinking assets.

Trump’s inability to get anything meaningful through Congress at a time when the US economy is growing at a reasonable rate without igniting inflation might actually be a positive for financial markets, given the erratic nature of the administration.

Certainly, a Trump-inspired surge in US growth if the administration were able to implement its agenda could force the Fed to act pre-emptively against inflation and raise rates faster and further than it now envisages which, given the level of household and corporate debt and leverage, might be quite destabilising.

It might appear irrational that financial markets are not pricing in any material level of risk in an environment where there are some obvious risks emerging and swelling. Central banks, however, have been underwriting that risk since the GFC and will probably continue to do so, albeit perhaps at a reducing rate, for some time — years — to come.

That doesn’t mean there couldn’t be another markets meltdown, but it perhaps explains why the markets aren’t pricing the possibility of one in.