A tale of two cities

“It was the best of times, it was the worst of times; it was the epoch of belief, it was the epoch of incredulity!” 

A similar dichotomy was widely echoed in financial markets this year. As the risk pendulum swung from aversion to a full blown market rally into the quieter summer months, the run up in risk assets was met with much scepticism. 

The ‘sweet spot’ experienced in US markets for much of 2009 and 2010 again warmed investors in full measure across many asset classes. The S&P 500, DAX and FTSE 100 Indices all experienced double digit gains with long dated credit, high yield and emerging market sectors joining the ensemble. This performance appears in stark contrast with the reported slowdown facing the global economy and the far from stellar third quarter earnings and negative outlook issued by corporations. One then begs to question, what fostered this jubilee and massive run up in prices during a traditionally quiet period? 

For fundamental equity investors, the movement in prices at first glance appears superficial. The global economy faces significant headwinds as recent economic data in China confirms a slowdown in the world’s fastest growing economy. Europe continues to battling their sovereign debt crisis with Greece consistently failing to meet the agreed austerity measures. Yet, deadline after deadline result in massive handouts to a country still practising unsustainable and imprudent fiscal policies. The recent tension between the International Monetary Fund and the European Union in increasing the limits and extending Greece’s debt reduction target to 120 per cent of GDP to 2022, has added a new dimension to the conflict. While there are certainly significant improvements in some very important sectors of the US economy, the weak readings in corporate spending, hanging financial regulations and impending ‘fiscal cliff’ facing the country toward year end have added significant uncertainty in the direction of the economy. 

Notwithstanding these glaring negative economic fundamentals, the rally pressed on throughout the summer ignoring bad economic news yet applauding any move by global central bankers to reduce tail risk from the market. The general consensus of global policy actions synthetically driving asset prices higher was a similar dynamic to the recovery of asset prices in 2009 market rally. The recent commitment by the Federal Reserve to maintain a zero interest rate policy into 2015 and only after the economy has shown signs of improvement, seemed to have successfully supported markets to date. But is this the panacea to US economic ills? And how sustainable is this strategy? 

The Taylor Rule, developed by John Taylor in 1993, is one of the many tools used by the Federal Open Market Committee in targeting the benchmark rate. The model estimates the rate for overnight loans between banks by balancing deviations from the central bank’s inflation target while minimising the output gap. The Taylor rule suggests the Fed should end their economic stimulus and adopt a benchmark rate of 65 basis points, 40bps above the upper range. This is based on an inflation rate of 1.7 per cent, unemployment of 7.9 per cent and a non-accelerating inflation rate of unemployment of 5 per cent. Should unemployment fall to 7 per cent and the inflation increases to 2 per cent, the Taylor rule suggests an even greater increase in the benchmark rate to keep inflation at bay while preserving growth.  

Admittedly, some economists are debating the validity of the model in our dynamic environment of significant deleveraging in private and public sector debt (assumed at sustainable levels in the model). The FOMC and European Central Bank, it appears, have chosen to accept a higher potential inflation rate over the risk of derailing growth and balance sheet repairs.  

Depending on the camp you are in, you would either have missed the summer rally or realised double digit returns within your portfolio during the period. Irrespective of your beliefs on the effectiveness of quantitative easing to aid the economic recovery, the rally was indicative of broad based support across risk assets. The million dollar question remains, how long will this support last and at what cost? 

In the end, the chairman and his global colleagues continue to bellow with unwavering resolve “It is a far, far better thing that we do, than we have ever done; it is a far, far better rest that we go to, than we have ever known”. 


Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.