analysis

Beware of the false sense of market stability

What it hides are situations built around artificial support systems

By Satyajit Das, Bloomberg
12:54 January 4, 2018

Since 2009, as policymakers have sought to return the global economy to normal, “stability” has usually been their byword. Unfortunately, their actions have only created a false calm — a “stable instability”, to coin a paradoxical phrase.

Although a repeat of the financial crisis has so far been avoided, this relative tranquillity has had the effect of derailing normal market mechanisms, thereby masking a worrisome accumulation of risks. Stable instability creates the illusion of normality, obscuring dangers hidden behind the apparently stationary and familiar. It’s analogous to a person who shows no obvious symptoms of an as-yet-undetected terminal disease. In this state, the same arguments can be used to rationalise contradictory events and different arguments used to reconcile identical facts.

Today, optimists argue that economic prospects are sound, with globally synchronised growth, low inflation, strong labour markets and buoyant asset prices. They ignore low labour-force participation rates, flexible definitions of employment, the poor quality of new jobs created, low wage growth, limited productivity growth, weak capital investment, and continued imbalances in global trade and savings.

They’re sanguine about continued fiscal deficits, accommodative monetary policy and perpetually increasing debt, while seeing the normalisation of interest rates and the withdrawal of central bank liquidity as manageable. They’re unconcerned about widening inequality, resistance to immigration, rising geopolitical tensions and the risk of trade wars.

Pessimists reach diametrically different conclusions from the same facts. But they forget that a major fall in asset prices or a substantial slowdown in economic activity is unlikely to be tolerated.

Instability

Policymakers will reduce interest rates, resume asset purchases and increase government spending to preserve the status quo. Irrespective of whether the optimists or pessimists are correct, the fact that they can interpret the same metrics so differently suggests a longer-term worry -that stable instability could destroy the underlying market mechanism.

By boosting asset prices, policymakers aimed to buttress elevated debt levels and, via the wealth effect, increase confidence, consumption and investment. But rising values of financial instruments representing claims on productive assets don’t create real purchasing power unless converted into cash or real enterprises producing earnings.

Any gain for a seller of such assets is contingent on somebody else buying and holding the security, frequently with borrowed money. The economy itself does not benefit from the transfer.

Higher asset values are neither permanent nor sustainable. Unfortunately, once asset prices become the focus and instrument of policy, they also can’t be allowed to freely adjust to their true level, because that might threaten the too-big-to-fail banking system, insurers, and pension funds.

Stable instability also distorts capital allocation. Low interest rates allow zombie companies to survive, delaying bankruptcy and preventing capital from being redeployed. Fundamental principles of value — future cash flows, price volatility and inter-asset correlations — are subverted, encouraging the mispricing of risk and distorting investment economics.

In functioning markets, investors sell overvalued assets and buy undervalued ones. This strategy fails when interference with the market mechanism means that all assets become artificially overvalued. Investments become premised on momentum.

Direct central bank purchases are especially distortionary. With increasing restrictions on its ability to purchase government bonds, the Bank of Japan has been forced to buy equities.

Risk and valuation

The Swiss National Bank has become a major shareholder in many US companies as it invests the proceeds of its currency interventions. These purchases are based purely on artificial formulas (usually index weights) to avoid favouring individual securities, meaning that they largely ignore the fundamentals of risk and valuation.

Stable instability also concentrates power in the hands of unelected central bankers and policymakers, with indifferent records in economic and financial management. Authority is wielded without transparency, with limited oversight and without regard to wider social mandates, thus reducing trust in economic institutions.

The current stable instability has its origins in the errors of 2008 and 2009, when leaders avoided painful but necessary actions, such as writing off unrecoverable debt and allowing corporate and bank failures. The underlying problems of over-indebtedness, a financialized economy and expectations of unrealistic increases in living standards were allowed to persist, creating a weak and vulnerable recovery.

But financial gravity can’t be resisted indefinitely. Although the exact timing and sequence of events are unknown, it will end, as always, in a Torschlusspanik moment — a German word for last minute or literally door-shut-panic — as investors try desperately to exit when they fear that stable instability is tipping over into simple instability.

To paraphrase Trotsky, the impossible will then become inevitable.