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Wood-Smith: This market is far from healthy

26 October 2015

Hawksmoor’s head of research tells FE Trustnet that the huge price swings in markets following comments from central bankers is a worrying sign.

By Alex Paget,

News Editor, FE Trustnet

Central banks’ relentless pandering to the markets is a very unhealthy state of affairs, according to Hawksmoor’s Jim Wood-Smith, who says high levels of volatility are likely to persist unless the likes of the US Federal Reserve show signs of leadership.  

Monetary policy has been arguably the biggest driver of returns (both positive and negative) over recent years as ultra-low interest rates and quantitative easing (QE) have acted as spring boards for risk assets, while any talk of or uncertainty surrounding tightening has tended to lead to a correction.

Recently, central banks have once again had a big role to play in market volatility.

While fears of a ‘hard-landing’ in the Chinese economy is commonly viewed as the principle catalyst for the market correction in August, a lack of clarity surrounding the first rate hike in the US has certainly played an integral part in the huge price swings since.

Performance of indices over 3 months

 

Source: FE Analytics

Equity indices have once again snapped back sharply over the last week or so, but Hawksmoor head of research Wood-Smith says it has had very little to do with an improvement in economic fundamentals.

“Equity markets had a belter last week, primarily because Mario Draghi told them exactly what they wanted to hear,” Wood-Smith (pictured) said, referring to hints that the European Central Bank (ECB) would add to its QE programme.

“Now I do not want to be any more of a misery-guts than usual, but I am very far from convinced that the relentless pandering of central banks to the markets is healthy. Janet Yellen’s Federal Reserve has become a floozie, shamelessly flipping from telling markets that lift-off is coming to backing away when the mood changes.”

While Wood-Smith says the Fed, with its decision to hold rates due to weaker than expected global trade, stubbornly low inflation and soggy US jobs data, is the guiltiest party in regard to the recent volatility, he says the ECB under Mario Draghi has made the situation even worse.

Draghi hinted last week that the central bank was prepared to wait in the wings with further QE if markets were to fall considerably again, a policy which greatly aided the MSCI Europe ex UK index’s 15 per cent gains between the start of the year and April, prior to the recent rout in global markets.


 

Wood-Smith says any further stimulus would be completely unnecessary and another sign of significant distortions within the financial system.

“We should not confuse pandering with leadership. Draghi may have sounded in control, on top of events. The reality is that he has become yet another pawn of the market. I cannot see how an extension to European quantitative easing is going to help,” he argued.

“The eurozone is not in bad shape: last week’s ‘flash’ PMI data for instance showed that domestic growth is pretty reasonable. The twin problems are that lower oil and commodity prices are pushing inflation lower again (which is a good thing) and that export markets have weakened. The latter being largely the result of what is (or is not) going on in China and of the huge fall in a number of emerging market currencies.”

Performance of indices in 2015

 

Source: FE Analytics

He added: “European QE has been a success, as it was in America and in the UK (Japan is debatable). But the ECB buying some more European corporate bonds is not going to fix the world.”

Wood-Smith admits central banks’ desires to hand hold the market stem from the events of the global financial crisis, but by constantly pandering to investors he warns the likes of the ECB and the Fed are undoubtedly going to cause more harm than good.

“The most likely explanation for this quasi-fetishism is that central banks have yet to escape the trauma of the great financial crisis,” he said.

“Do you remember the mantra of too big to fail? The belated realisation that the failure of one of the great financial institutions would cause the Walls of Jericho to come crashing down. Well, let’s ask ourselves what has been done to remedy the problem of too big to fail?”

“Banks have been forced to have a bit more capital. And, err, that’s it. Have the banks been split up and downsized? Have they heck.”

He added: “Each and every one is just as systemically important as it was before, during and after the Great Crisis. Global authorities have done precisely zippo to alleviate the threat of too big to fail.”

Anthony Rayner, co-manager of Miton’s multi-asset range, agrees that central banks have had play a huge part in the recent heightened market volatility.

“Making sense of very recent market events has been trickier than normal, not because markets have been more volatile per se but because trends have been much less persistent. Sentiment has been switching frequently between risk-on and risk-off,” Rayner said.

“It has been risk-off when the focus is solely on deteriorating global economic data and risk-on when investors assume that central bank policy will have to be looser than previously expected and so boost financial assets; the well-worn ‘bad news is good news’ thesis.”


 

However, while Rayner says central banks’ antics have created crowded trades and general herding among investors, there may be some areas which benefit from the Fed holding rates at their rock-bottom levels.

He points out that, by keeping policy loose, the dollar (the strength of which had caused headwinds for various asset classes) has begun to weaken.

“More recently, there has been some evidence that expectations for a delay in the US raising rates has been leading to a weaker US dollar. There are very early signs of ‘passive easing’, beyond the weaker US dollar, for example reduced stress in emerging market assets, credit spreads and volatility.”

Performance of indices over 5yrs

 

Source: FE Analytics

While there have been other factors at work (most notably slowing growth in China and falling commodity prices), the strength of the dollar has been a contributing factor to the severe underperformance of emerging market equities compared to developed markets over the past five years.

Therefore, if the dollar were to weaken further, Rayner says it could act as a boost to a further rally in the bombed out asset class. All told, though, the manager says investors need to continue to bear central bank policy in mind when running their portfolio.

“At this stage, it’s unclear whether it’s knee-jerk or the beginning of a trend but it’s something we’re keeping a careful eye on: sustained looser US monetary policy, be it passive or active, is likely to have a profound impact on financial markets.”

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