Category Archives: Financial Markets

Crowd Psychology and the Stock Market

Anatole Kaletsky wrote an article in Gavekal Research – ‘Five Features Of Market Madness’ – (Ideas June 16 2020) in which he talked about ‘Nominative determinism’. Two examples:

  1. Chinese property company called Fangdd Network where its value jumped from US$800mn to US$10bn in four hours of trading. Fangdd Network made it sound like a cheap ETF (ETFs give you a way to buy and sell a basket of assets without having to buy all the components individually) for the FAANG technology giants.
  2. Nikola, an aspiring electric vehicle manufacturer with no revenues that launched three months ago on Nasdaq saw its value spike to almost US$30bn, up from US$300mn at its March IPO, mainly because, like Elon Musk’s electric car company, it was also named after 19th century Serbian-American inventor Nikola Tesla.

Anatole Kaletsky 5 features of market madness

  • While monetary easing usually starts a bubble, a reversal in monetary policy is unlikely to deflate the bubble once the speculative momentum builds.
  • Valuations do not matter while a bubble is inflating, but they become very important after it bursts.
  • Bubbles typically end with the some huge corporate collapses (Charles’s analogy of dynamite fishing), often tainted with fraud.
  • Bubble dynamics need not bear any relation to the strength, or weakness, of the economic cycle.
  • Speculation increases dramatically when prices break through major highs.

These examples show that it is not analysis of valuations, monetary policy or economic data that is driving prices up. Famous economist J.K. Galbraith once remarked that ‘economic forecasting was invented to make astrology look respectable’. He also said that we are mush reassured by the ‘conventional wisdom – i.e. strongly held beliefs that have, at best, a tenuous grounding in reality. John Maynard Keynes stated that ‘the market can stay irrational longer than you can stay solvent’. Mervyn King, former Governor of the Bank of England, argues that economic decisions always occur under conditions of, what he calls, ‘radical uncertainty’ – unaware of what might happen in the future. King says that people use ‘narratives’ to make sense of the world. He also suggest that economists in the 2008 GFC didn’t learn from history – the Great Depression before they were born.Each time they suggest that this time it is different – an expression by experts suggesting that the new situation (GFC) bears little resemblance to previous crises. Carmen Reinhart and Kenneth Rogoff in their book entitled ‘This Time is Different’ show that we haven’t learnt from what happened in the past – short memories make it all too easy for crises to recur.

Wall Street and Main Street – the disconnect.

Excellent video from The Economist regarding the disconnect between Wall Street and Main Street i.e. Stock Market and the Economy. The S&P 500 is up 38% since the middle of March this year when the US economy has been going through one of its worst recessions. The US Federal Reserve had a role here by providing aid packages so the increase in the S&P was seen as a Fed rally and not from normal fundamentals.

Why does Japanese public debt have little impact on bond yield levels?

Japan is top of the table in accumulating government debt and with a record stimulus to cushion the impact of COVID-19 it is approaching debt levels of 250% of GDP. So how does Japan manage to keep its government bond yields so low (see graph below) and investor confidence high that it can avoid default?

Source: FT

To finance this debt, the Japanese government issues bonds known as JGBs. These are snapped up in enormous volumes by the Bank of Japan (BoJ), the country’s central bank that is officially independent but in practice closely co-ordinates economic policy with the government.

Bond Prices vs Yield

Like any investment the buyer of the bond wants to get the greatest return. Bond prices and interest rates (yield) move in opposite directions and an easy way to consider this is zero-coupon bonds. Here the interest is derived by the difference between the purchase price of the bond and the value of the bond on maturity.
Bond price $920 – Maturity value $1000. The bond’s rate of return = (1000-80 ÷ 920) x 100 = 8.7% return. However a lot depends on what else is happening in the bond market. If interest were to increase and newly issued bonds were giving a return of 10% the 8.7% return is no longer attractive. To match the 10% the original bond price would have to decrease to $909. The bond’s rate of return = (1000-909 ÷ 909) x 100 = 10% return

Reasons for low rates on JGB’s

Japanese Government Bond (JGB) is a bond issued by the government of Japan. The government pays interest on the bond until the maturity date. At the maturity date, the full price of the bond is returned to the bondholder. Japanese government bonds play a key role in the financial securities market in Japan.

The BoJ has recently been buying up billions dollars of Japanese government bonds keeping interest rates around 0% in the hope of increasing the inflation rate to its 2% target. Therefore any rise in bond yields triggers a buy action from the BoJ. As of 2019, the central bank owns over 40% of Japanese government bonds. The BOJ’s government bond holdings rose 3.4% from a year ago to 486 trillion yen ($4.5 trillion) as of March 2020, roughly 90% the size of the country’s economy, according to the central bank’s earnings report for the previous fiscal year.

Addressing savings glut needs more than monetary policy

Today central banks have a limited toolkit and the powers to deal with the savings glut (see image below), lack of investment, climate change and income inequality. There is a lot of money in the system but the velocity of circulation is slow – MV=PT – and this is one reason why we have little inflation.

Velocity of circulation of money is part of the the Monetarist explanation of inflation operates through the Fisher equation:

M x V = P x T

M = Stock of money
V = Income Velocity of Circulation
P = Average Price level
T = Volume of Transactions or Output

Add to this COVID-19 and the impact it has had on especially developing economies and we have economic stagnation.

Source: Bloomberg Economics

Some economists have suggested the need for more expansionary fiscal policy as well as structural reform to achieve economic growth. The latter being a long-term policy can take the form of price controls, management of public finances, financial sector reforms. labour market reforms etc. Although the US Federal Reserve is adopting a flexible average inflation target to avoid a disinflationary environment it will not be enough to deal with secular stagnation.

Secular stagnation
Since the GFC in 2008 it is evident that low interest rates are the new normal and according to Larry Summers (former Treasury Secretary) we are in an era of secular stagnation. This refers to the fact that on average the ‘natural interest rate’ – the rate consistent with full employment – is very low. There can be periods of full employment but even with 0% interest rates private demand is insufficient to eliminate the output gap. The US was in a liquidity trap for eight of the past 12 years; Europe and Japan are still there, and the market now appears to believe that something like this is another the new normal.

Paul Krugman suggests that there are real doubts about unconventional monetary policy and that the stimulus for an economy should take the form of permanent public investment spending on both physical and human capital – infrastructure and health of the population. This spending would take the form of deficit-financed public investment. There has been the suggestion that deficit-financed public investment might lead to ‘crowding out’ private investment and also how is the debt repaid? Krugman came up with three offsetting factors

  1. When the economy is in a liquidity trap, which now seems likely to be a large fraction of the time, the extra public investment will have a multiplier effect, raising GDP relative to what it would otherwise be. Based on the experience of the past decade, the multiplier would probably be around 1.5, meaning 3% higher GDP in bad times — and considerable additional revenue from that higher level of GDP. Permanent fiscal stimulus wouldn’t pay for itself, but it would pay for part of itself.
  2. If the investment is productive, it will expand the economy’s productive capacity in the long run.This is obviously true for physical infrastructure and R&D, but there is also strong evidence that safety-net programmes for children make them healthier, more productive adults, which also helps offset their direct fiscal cost (Hoynes and Whitmore Schanzenbach 2018).
  3. There’s fairly strong evidence of hysteresis — temporary downturns permanently or semi-permanently depress future output (Fatás and Summers 2015).

Source: “The Case for a permanent stimulus”. Paul Krugman cited in “Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes” Edited by Richard Baldwin and Beatrice Weder di Mauro

Bloomberg Economics – Yellen, Summers Say Central Banks No Match for Savings Glut

Eight body problem in economics

Physicists and mathematicians have puzzled over the three-body problem – the question of how three objects orbit one another according to Newton’s laws. No single equation can predict how three bodies will move in relation to one another and whether their orbits will repeat or devolve into chaos.

John Mauldin of Mauldin Economics wrote about the eight-body problem in economics in which we cannot predict how the economy will react when eight variables change. He lists the following:

What is certain is that as government fiscal intervention starts to lose its effectiveness it will be inevitable that monetary policy will continue to remain very accommodating with bond buybacks and record low interest rates. COVID-19 has turned conventional economic thinking upside down.

What would US$10,000 invested in 2015 have yielded by 2020?

Just finished reading the book ‘The New World Economy – A Beginner’s Guide’ (2020) by Randy Charles Epping – a recent addition to the King’s College library. It is particularly good for those students who are new to the subject and it explains current issues in a very understandable language. It looks at:

Bitcoin – Economic Crisis to Global Crisis – Ranking Countries – Brexit – Globalisation – Inflation vs Deflation – Hot Money – AI – BRICS – Inequality – Tax Evasion – Climate Change – China – Trade Wars and many more economic issues.

One table I found interesting was the return of US$10,000 over the last five years – see table below. Bitcoin has been incredible but stay clear of Argentinian stocks.

Source: The New World Economy – A Beginner’s Guide (2020) by Randy Charles Epping

US dollar under pressure as the reserve currency.

In doing most introductory courses in economics you will have come across the four functions of money which are:

  • Medium of exchange
  • Unit of Account
  • Store of Value
  • Means of deferred payment

Since the Bretton Woods Agreement in 1944 the US dollar was nominated as the world’s reserve currency and ranks highly compared to other currencies in the above functions. As a medium of exchange the US dollar is very prevalent:

  • 60% of the world’s currency reserves are in US dollars
  • 50% of cross-border interbank claims
  • After the GFC, purchases of the US dollar increased significantly – store of value.
  • Around 90% of forex trading involves the US dollar
  • Approximately 40% of the world’s debt is issued in dollars
  • n 2018 banks of Germany, France, and the UK held more liabilities in US dollars than in their own domestic currencies.

So why therefore is there pressure on the US dollar as the reserve currency?

The COVID-19 pandemic has closed borders and will inevitably lead to more regionalised trade, migration and money flows which suggests a greater use of local currencies. However China has made its intention clear that the Yuan should become a more universal currency. Some interesting facts:

  • Deposits in yuan = 1trn yuan = US$144bn
  • Yuan transactions have grown in Taiwan, Singapore, Hong Kong and London.
  • Investment by Chinese firms into Belt and Road project = US$3.75bn which was in yuan
  • China settles 15% of its foreign trade in yuan
  • France settles 20% of its trade with China in yuan
  • 2018 – Shanghai sock market launched yuan-denominated oil futures.
  • The IMF suggest that the ‘yuan bloc’ accounts for 30% of Global GDP – the US$ = 40%

However if the past is anything to go by the US economy has gone through some very turbulent times but the US dollar has remained firm. This suggests that how we perceive the US economy doesn’t seem to relate to the value of its currency.

Source: The Economist – China wants to make the yuan a central-bank favourite
7th May 2020

US or China for Post Covid-19 financial dominance

Very informative video from The Economist with Matthieu Favas – Finance Correspondent – talking about the balance of power between the USA and China. The US didn’t show global leadership during the pandemic and China might fill the global vacuum that the US has left on the world stage. China has the second biggest bond market in the world and Covid-19 provided a rigorous test to suggest that people trust Chinese bonds. However there is a distrust of Chinese intentions and remember that Chinese officials covered up the spread of COVID-19.

This Time it is Different

I have mentioned in previous posts the work of Ken Rogoff and Carmen Reinhart – co-authors of “This Time is Different” – 2009. Below is a summary from Amazon

Throughout history, rich and poor countries alike have been lending, borrowing, crashing–and recovering–their way through an extraordinary range of financial crises. Each time, the experts have chimed, “this time is different”–claiming that the old rules of valuation no longer apply and that the new situation bears little similarity to past disasters. With this breakthrough study, leading economists Carmen Reinhart and Kenneth Rogoff definitively prove them wrong.

However the rise of the coronavirus and the impact it is having on the global economy is not the same as previous recessions/ depressions in history. Ken Rogoff found it hard to think of a historical parallel and came up with the Spanish flu epidemic which killed millions of people worldwide. Rogoff talks to Paul Solmon of PBS about the impact of the coronavirus.

What is ‘Value’ in an economy?

I was recently given a review (from Palladium Governance Futurism) of Mariana Mazzucato’s book ‘The Value of Everything : Making and Taking in the Global Economy’ in which she challenges the view of what ‘value’ is in an economy. She refers to ex Goldman Sachs CEO Lloyd Blankfein’s quote

The people of Goldman Sachs are among the most productive in the world.’

Goldman Sachs was one of the many investment banks that had to be bailed out after the GFC but how do we value their productivity?

Privatise reward and socialise risk
It seems that the investment banks were happy to privatise the reward but socialise the risk – when it all “turns to custard” they need to be bailed because they are too big to fail. The question that people are now asking is what is the vulnerable asset class? Mortgage-backed securities was the cause in 2008. For a lot of these companies a large payout is a sign of success in that they are too big to fail and leave the government no alternative. However where is the value generation from this?

Value – historical perspective

  • French physiocrats – value was produced from the land
  • Adam Smith – saw landlords as rentier class
  • Marx – labour is the source of value

Today economics is more focused on a subjective, utility-focused approach and therefore sidestepping the historic debate about value which is undermining the discipline of economics. This new approach, according to Mazzucato, has weakened neoliberal economies to innovate. Key to understanding the the value debate is what is considered production in our GDP. The informal economy is a part of all economies but is not included in the national accounts. As is someone building their own house. So what is considered to be real wealth/value? Rather than focusing on how wealth was created and what counted as wealth, economists began to ask how utility was satisfied on the margin. This allowed for the mathematical approaches to be used in modern economics.

Thomas Aquinas stressed the need for a ‘just price’. It was immoral for a supplier to raise his price when consumers are in great need of a specific good (inelastic demand). The price should cover the cost of production and the maintenance of the worker and his family. Today value is in the eye of the consumer and price, in turn, reflects utility gained by a consumer from an additional unit go goods or services.

Finance and productive value

Finance’s case is founded on the notion that it is a necessary part of production by allocating capital to businesses. However Banks direct their revenues into interest payments and the share price. This fuels speculative bubbles which are refinanced through the securitisation food chain and therefore inflating assets without investment.

Australian bank Macquarie acquired utility company Thames Water – increased its debt to US$10.05 bn over 6 years, therefore leveraging the privatised assets they had acquired into increasing debt. By doing this they saved their own revenues for interest payments and shareholder distributions – hard to make the case for privatising public assets. Mazzucato also points out that since the GFC the finance sector has focused on debt deflation and unemployment and wage reduction so corporate profits could be maintained at the expense of employee earnings. So the financial sector continues to make contributions to GDP in the money it generates but firms in the tech sector and natural resources can’t contribute to the money supply the way commercial banks can, and can’t easily hedge parts of the economy.

The book also gives examples of factors that contribute to GDP but they don’t actually produce anything.

  • Ford – 2000’s – they made more money from selling loans for cars than by selling cars themselves
  • General Electric – finance arm of the business made around 50% of the whole group’s earnings.

On a more positive side Welsh Water was a company with the lowest ratio of debt to equity and the highest credit rating. It is mutually owned and operated as a not-for-profit operation.

Two great myths – Innovation and Public Sector

She points out that the world’s biggest companies have built themselves on the legacy of state backed, publicly funded innovation. EG:

  • Nearly all major parts on smartphones were developed in university-based research facilities using public money.
  • Defence Advanced Research Projects Agency – developed the Internet and SIRI
  • US Navy – GPS system used by phones and computers.
  • National Science Foundation grant – created the algorithm behind Google.
  • Pharmaceutical drugs – 2/3 of the most innovative drugs trace their research to funding by the US National Institutes of Health.

Final thought

Keynes was seen as the last supporter of government investment. He recommended state intervention during downturns in order to stimulate growth and spending. This intervention is intended to shock the economy into greater output

According to Mazzucato the public sector is the true creator of economic value – value which could not just be created by private counterparts. Vital to this is the rebuilding of the public sector’s funding for innovation. Her clear goal is that economists and governments alike to cease viewing value as a purely subjective and individualistic measure.