A Year for the Strange and Unusual

Looking back over the behaviour of the financial markets this year, the one thing that can be said with confidence is that they have not lost their inordinate capacity to surprise. The month of September was a good case in point. Not only did it turn out to be a barnburner of a month for equities, reversing the poor performance more typically associated with the month, but it also saw equities, bonds and gold all rise in value at the same time, the first time that this affront to market normality has happened since the 1930s.

We have also seen the remarkable spectacle of investors buying index-linked gilts to lock in a negative return, and large corporation issuing long-dated corporate debt at rates – yields of less than 1% – that appear to defy all experience. According to Bill Miller of Legg Mason, the year has presented a great best buying opportunity in equities, which have not been this cheap since the 1950s. Yet, according to another fund manager, writing to his shareholders a few weeks ago, there no longer appear to be any asset classes which represent compelling value at today’s prices.

It all makes for one of the most fascinating market environments that I can recall. All those years in the 1990s when bonds and equities churned out double digit returns seemingly year after year now feel like a distant memory – not of course that those periods appeared so straightforward at the time, as anyone who can recall the dramas of 1991 (the Salomon Brothers affair), 1992 (Soros et al and the ERM), 1994 (the bond market collapse), 1997 (Asian crisis) and 1998 (Russian default, LTCM) will readily testify.

The striking thing about recalling these past episodes is that it is possible to make a plausible case that we could see an imitation rerun of nearly all of them in due course.  That the euro is ultimately vulnerable to fragmentation needs no elaboration, given the market’s run at Greek and now Irish debt. Some form of 1994-style rout in the bond market seems unavoidable in the next few years. The risk of a fresh market-induced disruption in emerging markets too, although it is almost certainly some way away, is also growing by the day.

The problem for investors is not that these risks are in any way concealed from view – in fact the more visible they are, the less of a concern – but that some tried and tested tools to analyse the right course through them are lacking. The consequence of the deliberate monetary stimulus now being masterminded by the Federal Reserve, and imitated in other places, is not just that it is distorting asset prices, but that it is also rendering useless the traditional anchors on which valuations and investment choices are based.

When interest rates all the way along the yield curve are being targeted for manipulation on an unprecedented scale, few market prices can be trusted. What today is the risk-free rate? You won’t find it by looking in the traditional places. It is no accident that one of the star performers in the markets over the last few years has been gold, the one asset that cannot be valued by conventional means. Its lustre will remain as long as large parts of the world economy continue to be force-fed negative real interest rates.   

The massive injection of zero-interest rate funds into the US and other economies has been likened, memorably, by the strategist Don Coxe to the battlefield use of heroin for wounded soldiers. Essential in the short term, the challenge for the doctors is to wean the patients off the pain-killer before they become addicts, unfit for either military or civilian life.  If interest rate futures are right, it means that Mr Obama could be the first American President in history to complete a whole term within a zero interest rate environment. “There is no historic precedent for such sustained stimulus”, notes Mr Coxe, “which means no one can predict what longer-term damage it will inflict”. 

That is surely unarguable. It also means, one suspects, that investment performance in an era of rootless valuations will continue to be vulnerable to violent changes in market sentiment. When hardly anyone knows what anything is worth, almost anything can behave like a bargain for a while. All bull markets sow the seeds of a subsequent crash, but while the path of least resistance for equities still looks to be upward from here, it is hard to avoid the conclusion that the end game of today’s strange and unusual market conditions will be painful for many when it comes.  

The only asset class whose merits appear to be built on firm foundations in this environment are commodities, where the medium term arguments for higher prices, driven by demographics and changing dietary patterns in developing countries, are turning out to have survived the financial crisis remarkably intact. Despite the current surge of speculative interest, which has taken several commodities into overbought territory, it will be a surprise if this asset class at least fails to continue to perform for another five years at least.