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Thursday, 19 October 2017

A predetermined random walk

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SwissInvest strategist Anthony Peters worries that central banks have left markets breathing on a ventilator

Anthony Peters, SwissInvest Strategist

IT’S GREAT TO be involved in discussions about market transparency. It’s great to be involved in conversations about the perfect market where price formation is a pure function of supply and demand. It’s also great to dream about Chipping Norton RFC winning the Heineken Cup. But how true are the markets we are trading in today?

Central banks, once the eminences grises, who sat behind us controlling the front end of the money markets by managing liquidity and who apart from that could only raise eyebrows or verbally intervene in markets – I’m not talking currencies here – have now taken over.

By way of quantitative easing, they now directly control market prices out to three years and even beyond.

The liquidity they have injected into the economy allows some to believe that markets, especially equity markets, are in good shape. But in truth they are no more than breathing easily while on a ventilator.

Please don’t get me wrong. I am not criticising the central banks. I continue to remain, it appears, one of the few who still respects their work and who acknowledges that they have generally done pretty well.

It is so easy to snipe at them from the second row but given the hand that they were dealt by their political masters, they’ve done a sterling job.

However, in doing so, and in keeping with the card-playing analogy, they have restacked the deck in the process.

SO WHAT IS the correct price of an asset? The easy answer is that the correct price is what a buyer is prepared to pay for it, but I would like to go one step further and define it as the utility value of the asset to the purchaser, adjusted by the risk that either the cost or the benefit have been incorrectly assessed.

Equity and bond prices are hugely driven, as we have seen, by the effects of central bank activity in the markets. Whether we call it QE or OMT or whatever, the fact is that whatever we see in markets is all happening with the compliments and at the behest of the monetary authorities.

That should mean that the actual dollar price paid for an asset is a risk factor which is not being priced in. The cost of not correctly nailing pricing risk along with the utility value is why we are sitting in the biggest economic downturn in three quarters of a century.

For instance, how can the residential mortgage market, with its expression in RMBS, be regarded as fair and true when mortgage rates themselves have been stapled to the ground by the near-zero rate policy and delinquencies are artificially being prevented from becoming defaults? It is hard to escape the impression that we are limit long smoke and mirrors.

I tripped over a piece last week which retold a Chinese tale of an adviser to the Emperor who asked the latter whether, if he heard a certain incredible story once, he would believe it? Of course not, came the response. But it transpired that if retold by enough sources and often enough, the unlikely event would begin to gain credence.

Central banks have removed the stuffing out of the teddy bear and have turned it into a hand puppet

Does this means that if enough houses place the same closing price on a security, it has to be correct? And how do they arrive at the price other than by listening to what the others have heard too? Is this transparency or simply a game of Chinese whispers?

Traders make profits and portfolio managers outperform by positioning themselves where the market is going before the market has got there. For that they need to sense that they have an edge. The significant intervention in the markets by the central banks has taken much of that way – the random walk of markets has become, to some extent, predetermined.

REMOVE THE JOY of the educated guess from the process and you end up with either the flaming obvious or with blind speculation. Risk management – I mean the instinctive kind, not the quant at the end of the desk – does not like this. Hence, the desire to trade fades and with it the turnover volumes which create the real transparency of markets.

The central banks have helped markets rally to such dizzy heights but at the same time these markets lack the basics which justify the prices and thus the warning lights should be flashing.

Recent equity market volatility – I don’t believe that volatility only occurs when markets sell off – is largely a function of asset prices lacking the underlying necessities for confirmation. The enormous amount of cheap liquidity and the wholly artificial interest rate scenario may have caused asset prices to rise but I sense that they are not comfortable with themselves at these levels and are now struggling for justification.  

If looking for a reason why hedge funds, especially those of the macro persuasion are struggling for performance, look no further. For all the right reasons, central banks have removed the stuffing out of the teddy bear and have turned it into a hand puppet. They have changed the rules of the game and it is we who are slow to adapt to a changing world, not them.

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