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Stock market vigilantes put the Fed between a rock and hard place – Gregor Logan

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I was surprised the Fed actually went ahead and raised rates in December — but not surprised by the negative reaction of global stock markets. I sympathise with the Fed’s predicament. There were already obvious signs of distress in the junk bond market, continuing weakness in emerging market economies and currencies and growing evidence of economic slowdown in western economies. However, the asset price bubbles in stock and real estate markets continued to inflate, taking markets to historically elevated valuations and giving the, perhaps, false impression that all was well in underlying economies. This view was helped by strong employment numbers in the US and improving employment trends elsewhere in western economies.

The need to ‘normalise’ rates appears to have been thought appropriate to give the central bankers some policy options should economic activity turn down again. The US economic recovery was already one of the longest post war, albeit one of the most anemic, and should it turn down due to some unforeseen shock there would have been precious little the Fed could do with ZIRP still in place and their balance sheet already inflated from past QE.

The big question is of course what happens now. To answer that question I think we have to put where we are today into context. Since the financial crisis, global government and corporate debt has risen faster than GDP to levels way above where they were in 2008. Despite this, bond yields have fallen due to the combination of ZIRP and QE. This in turn has allowed stock markets to rise far faster than corporate profits, in part because price earnings ratios are a reciprocal of interest rates — but also because there was no reasonable alternative for large institutional investors.

Inflation has been absent, with many economies experiencing disinflationary if not deflationary tendencies, despite the best efforts of central bankers. The collapse of commodity prices has exacerbated this trend. Emerging market economies have been weakening for some time despite currency depreciation, whilst the western economic recoveries are not yet clearly self-sustaining. Most leading, and some coincident, economic indicators are already suggesting a continuation of the weakening trend; for example, global shipping rates as measured by the Baltic Dry Index are down nearly 50 percent over the last year.

All of which confirms the economic and financial world was in a pretty precarious state to cope with a rate rise. Only 0.25 percent, and you might reasonably respond, but it was also a doubling of rates after many, many years of ultra-low rates and build-up of debt to pay for ever higher asset prices.

The Fed’s resolve is clearly being tested. It appears we have stock market vigilantes pushing prices down to encourage the Fed to not raise further and perhaps even reverse the rate rise. This puts moral hazard back on the agenda, and a further postponement of the evil hour when debts have to be repaid and stock prices decline to more reasonably reflect the level of underlying earnings.

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Welcome to my website. I'm Gregor Logan, an independent management professional with over 35 years of experience in all asset classes, including equities, bonds, property, private equity, alternative assets and bonds. I previously held senior-level roles at MGM Assurance, Pavilion Asset Management and New Star Asset Management.

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