Are markets as uncertain as they should be?

Tuesday, 13th December 2016

In this issue of Money Truths….

  • In search of a certain world….
  • Shocks at every turn….
  • Nobody knows what will happen next….
  • Cast-iron confidence….
  • The Uncertainty Index…..

In search of a certain world….

Markets don’t like uncertainty. It’s a bit of a cliché….

When allocating capital, investors like to feel a sense of confidence about what will happen next, which way things will go, how things will pan out and how that will impact on their holdings.

But the truth is that nobody knows what will happen next or which way things will go – be it up, down, sideways or backwards. Not for sure.

Nobody can be certain. Not about the future. The future is unknowable. It unfolds its own way – and it doesn’t pay mind to what we think should happen.

There are no certainties. Confidence in future outcomes is often false…. misplaced…. delusional. But investors like to feel that confidence anyway. They like the illusion of certainty….

No investor wants to feel like he is gambling his hard-won wealth on the spin of a wheel. He wants to invest in order – not chaos. He wants to feel his judgment has value – that he isn’t relying on blind chance.

A certain world is a predictable world – it works as it should; it can be figured out; it can be understood; it can be played; it can be monetized by the investor who sees things as they really are and understands how they will turn out….

In a certain and predictable world, trains always run on time, weather forecasters always get it right, things pan out as they should, expected outcomes come to pass and the rewards end up in the hands of the most deserving.

It can’t be easy being an investor this morning. Uncertainty runs rampant….

Shocks at every turn….

Just look at recent world events. Things nobody thought would or could happen have happened…. the unexpected has come to pass….

In June, the British people voted to withdraw from the European Union – a result that went against everything the polls, the betting and the expert pundits told us.

And it was a result that went against establishment desire. The prime minister resigned – having staked his position on the outcome of the referendum. His chancellor followed him out of the window – though he had to be shoved having failed to jump.

In America, Donald Trump was voted into the presidency….

His victory came as a shock. It stunned the establishment, the press and the people – all around the globe.

It was considered unthinkable that America would vote a preening, blustering, bigoted, sexist and potentially dangerous and deluded braggart with no political experience whatsoever into power. But vote him in they did…

Then, just last week, the Italians voted against constitutional reform. The result brought down another prime minister and paves the way to the dissolution of the EU.

Nobody knows what will happen next….

Nobody knows what will happen next….

In Britain Article 50 still hasn’t been invoked. Courts are being used to challenge the will of the people. Voices of influence are calling for a second vote….

Some believe the public are too dumb to vote this issue. They believe MPs or unelected judges know best and should be left alone to call the play. The government doesn’t seem to have a strategy….

In America, Donald Trump doesn’t start work until January 17th. Nobody knows what he will do – including Trump himself. It probably won’t be what he said he would do.

During the election, he talked about ‘draining the swamp’ – clearing out the cronies, parasites, insiders, lobbyists and vested interests who get rich on the back of comfortable relationships with the power hub in Washington….

But with Wall Street predators and ex-Goldman Sachs players prominent among early appointees to team Trump, it looks like business as usual at the White House. The swamp will remain what is has long been – a cesspool of corruption….

Trump also said he would lower taxes…. spend trillions on infrastructure…. make America great again. But nobody knows if Congress will support plans to add trillions more to a national debt already amounting to trillions….

And nobody is even thinking about the scale of conflicts of interest that exist between Trump the President and Trump the business mogul and commercial brand….

In Europe, the big political experiment is in danger of falling to pieces. Britain delivered the first blow. The Italians are next in line. More might follow. The whole edifice could eventually fall….

France has elections next year – and the far-right Front National party, under the leadership of Marine Le Pen, is gaining traction.

In Germany, the far-right also gathers support. The ground is set for additional ‘shocks’….

And last week the European Central Bank dropped a bombshell. It announced the removal of a comfort blanket that has kept everybody warm since Europe first crashed into a debt crisis.

The bank’s bond-buying activity is to be tapered. The spigot that has delivered billions of new monies into the system is to be turned off. It will be turned off slowly – withdrawal will be managed carefully – but the money-printing machine is finally being de-commissioned.

Monetary policy has changed. European economies must soon rely on their own legs to keep them upright. If they can’t stand, they must fall. We don’t know exactly what it will mean. But the transition will not be painless or trouble-free. You can rely on that….

Cast-iron confidence….

With so much up in the air at home, in Europe and in America…. With so many unknowns, so much in flux and so much open to interpretation….

With so many unprecedented events having happened…. and so many more with the potential to occur….

With so much uncertainty hanging over the respective futures of Britain, Europe and America….

You might forgive the investor if he were a little cautious right now. And you might expect to see that caution, that sense of uncertainty, that lack of confidence, expressed in the markets.

But the fact is that the uncertainty is nowhere to be found. You can’t see it – no matter where you look.

If or when it does appear, it appears like a phantom – in view for a short while before disappearing again. Blink and you miss it.

The uncertainty showed up straight after the Brexit vote. The markets fell. But within days they were back up. And they’ve been up ever since. This morning the FTSE 100 is not too far from its 10-year high.

It’s was the same when Trump was elected. The markets dropped when the news broke but within 24-hours they’d bounced back. And the market has thrived since. Last week the S&P 500, the Dow Jones Industrial Average and the NASDAQ all set new highs.

And it was the same with Italy last week. The markets shrugged off the unscheduled loss of an Italian prime minister and potential catastrophe for the EU project in less time than it takes to get over a mild hangover.

It isn’t that the uncertainty isn’t there. It’s there for all to see – in many separate locations. It simply isn’t being reflected in the markets. Investors are ignoring it or over-looking it. Investors feel confident despite the prevailing climate of uncertainty….

Maybe they are too confident. Maybe they are more confident than events and the outlook suggest they should be….

The Uncertainty Index….

The Economic Policy Uncertainty Index measures uncertainty.

And when the Index says levels of uncertainty are high, credit spreads on US, UK and Euro corporate bonds go up against their benchmark levels.

That’s how it tends to work. That’s what happened back in 2008. And again in 2011. As levels of uncertainty rose, credit spreads on bonds increased.

There’s a close relationship between levels of uncertainty and credit spreads. They tend to move in the same direction. They go up and down together. Or, at least they did do….

Right now, following on the heels of the Italian referendum, the Economic Policy Uncertainty Index is at an all-time high-point.

In other words, over the time the Index has been in existence, levels of uncertainty have never been higher….

Yet credit spreads on bonds are currently at median levels. They haven’t risen along with the uncertainty level….

The lack of movement in the credit spreads – despite uncertainty levels – is another sign that the market is more confident and bullish than it ought to be…. and not as uncertain as it should be in the current climate….

I can only guess what current levels of investor confidence are based on or nailed to. And I don’t know how long this confidence will last. All I can tell you is that the confidence is probably misplaced and that it will ultimately prove wrong-headed. Things are far from as certain, secure and stable as market sentiment would have you believe.

I don’t know what happens next or exactly when it will happen. Nobody does. But I do know that when outcomes fail to meet with expectation, people get disappointed.

Plenty of investors are headed for disappointment. It will come somewhere down the line. At some point, markets must re-adjust to reflect the real world. Somewhere down the line there lies a correction.

That’s how it looks from here….

I’ll be back with more next Tuesday.

All the best,

Dave Gibson

Dave Gibson

Money Truths