There has been a general malaise in the markets throughout August as people have worried about the prospects for a return to recession. There is not yet evidence that this is happening. Leading indicators point to a slowdown in growth that will leave the global economy vulnerable to bad events (so the probability of the return to recession is increasing), but that doesn’t seem enough to explain the upset. Rather I suspect that the explanation is fourfold: first, risk markets are generally lower, which sets people off looking for something to worry about; second, economic releases have been disappointing forecasters since the beginning of June, suggesting that traders had got ahead of themselves in expecting a continuation of a strong recovery; third, weak readings for US core CPI and continued high unemployment have caused a fall in inflation expectations among market participants and renewed worries about a lapse into persistent deflation; and fourth, markets are worried that fiscal retrenchment will lead to weaker growth.
The question is whether the market is right to be worried. I have long thought that deflation was a greater threat than inflation in the present environment and have looked forward to the chance to bet on falling bond yields when it arose — which it did, but I missed it. It is always difficult to find a trade when the market’s expectations converge with one’s own but one failed to get in early as the convergence started to happen. It is tempting to bet on a reversal of sentiment, especially in the bond market, which has become very bearish on inflation; but I am concerned that this could be one of those times when sentiment wakes up to reality and they continue downward together.
What is the reality to which the market may be waking up? A double-dip is not yet a reality, with key indicators still showing expansion, albeit at a slower rate. The reality is the unwillingness of the authorities to provide further significant stimulus to the economy. Jean-Claude Trichet appears a convert to Ricardian equivalence, a doctrine for which the evidence is, I read, shaky, and of which I am anyway sceptical. It may be that he is looking both ways on this issue, encouraging governments to cut spending for the sake of the Euro while fully intending to continue the liquidity programmes still in existence, but the prospects for additional stimulus seem remote. Ben Bernanke may have won the regulatory war in Washington DC, but lacks either the will or the political capital to embark upon another serious round of quantitative easing. The fiscal authorities are now fully engaged on cutting their deficits, the second stimulus plan in the US having fallen off the agenda. In other words, the reality concerns the third and fourth points above: monetary policy inaction in the face of disinflation and persistent unemployment combined with fiscal retrenchment.
If this is indeed the reality, then the twin supports of liquidity and positive economic surprise that drove the advance of risk assets between March 2009 and April 2010 are being cut away. This does not mean that we are “turning Japanese” — maybe we are, and maybe we aren’t — but bond yields could remain low for months and equities should follow them down.
All this reasoning was available to me at the beginning of August, and indeed I expressed it in discussions — but my psychological state meant that I failed to act at what would have been an opportune moment. I should be looking for a moment to get short of risk assets. I am already short EUR and GBP against CHF, but I will be looking for further opportunities to bet on declines in risk assets — equities, metals, and so on.