Crisis of confidence in central banks’ omniscience emerging as sell-off driver

22 January 2016

During last Friday’s frantic market action, which bore first signs of ‘capitulation’, I had hoped not having to write about depressed market conditions for a 3rd week. However, as I wrote last week once a sell-off gets going, the ensuing rush for the exit by short term investors and liquidity squeezes amongst leveraged investors creates a dynamic of its own which is very hard to gauge and even harder to rationalise from an economic perspective. The kick-off to the annual World Economic Forum in Davos was therefore somewhat welcome distraction from what has become the worst start to the year in 4 decades. Davos also matters this year because many reputable economists and institutions present and discuss their economic expectations for the year ahead. This has been helpful, because most stated that they still expect a continuation of the path of gradual economic expansion and see a low likelihood of an economic crash scenario, which the market action of the past 3 weeks appears to suggest. Having been burnt in the past, however, most of them also hedged their views with the warning that extreme market action can negatively influence economic decision making. Regardless, markets initially continued their roller-coaster ride and hit intraweek lows which in most cases where below last September’s lows (which are now referred to as the ‘China-Flash-Crash’). In a marked change compared to the previous week, however, it has been possible to identify a distinctive pattern in the turbulent action which may prove very useful for our investment decision making. This is that whenever there was any inkling that central banks might understand the market concern after all and will not simply ignore them as a bad tempered tantrum, markets staged relief rallies. This first happened on Tuesday after lacklustre Chinese Q4/2015 economic data and press releases suggested that the Chinese authorities are very well aware of the formidable challenge to rebalance their economy ahead of them and that they are determined to address the issues. Monetary and fiscal stimulus programs are only a small step from here. The second time it happened was following the monthly press conference of the European Central Bank’s Mario Draghi. He hinted that his institution would expand their monetary easing program in March if market actions led to a deterioration of the economic and monetary stability outlook. At the time of writing the relief rally triggered by his statement is still ongoing and has resulted in the first week of the year in which most stock markets have closed higher than then they opened on Monday (2-3%). This decisive reaction indicates that the main concern of capital markets appears to be that central banks may be misjudging the continued fragility of the economic expansion and tighten monetary conditions prematurely. The three 2016 headwinds I described in last week’s Tatton Weekly, namely the deflation of the ‘Commodity Super Bubble’, the ‘EM credit stress’ following rate rise induced US$ strength and the ‘China slow down’ as a natural consequence of the Chinese economic and credit rebalancing will all require measured responses. Reassurances by central banks that they will manage monetary policy with close regard of these recalibrations of capital flows or even better improve their coordination, as in our view what is required to end this New Year’s tantrum. The last sell-off bout on Wednesday had distinct signs of capitulation and many technical buy indicators jumped to ‘strong buy’, indicating to those who hold cash for opportunistic bargain hunting that it may be a good time to inject their liquid funds into the liquidity squeezed market. Looking at our own inflows this past week it would seem that it was not just speculative investors who could sense a bargain. With record inflows of £40 million into Tatton managed portfolios last week a number of our own investors must have likewise seen the bad market start to 2016 as somewhat of a ‘January Sales’ opportunity to deploy additional cash. While they certainly succeeded in buying into their long term investments with far more upside than was available in 2015, I do not yet want to go as far as saying that this is likely to be the end of this correction. However, the changed ‘pulse’ we saw in the markets over the past week, makes me confident enough to say that I believe we are now closer to the end of this market upset episode than the start.