Beyond the stock market correction

The current stock market correction is likely to be over quite soon, the fund manager Neil Woodford suggested yesterday, and I suspect that he is right for now. His view, sensible as always, is that the main reason for the market’s fall is that investors have taken fright at the evidence of slower than hoped for global economic growth, particularly in Japan and Europe, plus a number of other contingent factors. The market correction, the sharpest for over two years, is long overdue, given increasing investor complacency in the face of Federal Reserve and other central bank manipulation of market prices.

The scale of the correction, however, as so often in market squalls, is exaggerated by the most leveraged market participants being forced to liquidate holdings. Many hedge funds, for example, have taken a beating with the apparent withdrawal by AbbVie of its planned takeover bid for the drugs company Shire. There has also been enforced unwinding of positions in the high yield debt market and various carry trades. This in turn has spilled over into the prices of other asset classes. (Simon Lack, author of The Hedge Fund Mirage, points out that in agggregate hedge funds are heading for a 12th successive year in which they have failed to beat a simple portfolio split 60% in equities and 40% in government bonds).

There is of course no shortage of genuine worries and risks to concern investors at the moment – geopolitical uncertainties, slowing growth, Ebola and the spectre of genuine debt deflation in the Eurozone and maybe other developed countries too, to name but four. The CFA institute’s annual European conference, taking place over two days in London, has highlighted some of the bigger risks. Paul Mills of the IMF gave a particularly sober overview of the worries that are preoccupying global policymakers. Here is one of the charts from his presentation, which highlights the decline in market liquidity in a number of financial markets since the financial crisis.


And here is another, which points to the potentially dangerous concentration of ownership by asset management companies in the corporate and high yield bond markets (a somewhat ironic problem, given that this is the direct result of central bank policy to drive savers into higher yielding areas of the market).



Somewhat to my surprise, equally interesting was Lord Turner’s presentation in which the former FSA chairman pointed to the central role which cycles in real estate lending play in the development of financial crises, a theme that has also been highlighted by the Bank for International Settlements. He referenced a recent paper by three academics which shows how the vast majority of the world’s overall  rise in debt since 1950 has been accounted for by increased real estate lending – not just in the UK, where house prices and property ownership are a national obsession, but across 16 other advanced economies as well. Their conclusion:

With very few exceptions, the banks’ primary business consisted of non- mortgage lending to companies in 1928 and 1970. By 2007 banks in most countries had turned primarily into real estate lenders. The intermediation of household savings for productive investment in the business sector – the standard textbook role of the financial sector – constitutes only a minor share of the business of banking today.

Lord Turner’s own argument is that to avoid future crises policymakers will need to act far more decisively than in the past to control not just only the volume of credit in an economy, but also how and where it is allocated – meaning, in particular, that real estate lending has to be controlled far more vigorously than before. This process has of course already started: look at the Bank of England’s Funding For Lending scheme, or the ECB’s latest targeted funding scheme, both of which are intended specifically to boost lending to small and medium sized companies, but not lending for any other purpose. Mortgage lending, meanwhile, is also increasingly being regulated by Bank or Government initiatives.

These new moves, however understandable as a response to the global financial crisis, represent a reversal of the financial liberalisation agenda of the 1980s and 1990s. You may not like the financial repression policies we have seen introduced in the last six years under which central banks use interest rate decisions to direct the flow of savings away from bank and other short term instruments into higher risk asset classes. But it is very unlikely that the policy will just end there: more capital controls and credit rationing are most likely coming too. This erosion of personal freedom is the price we will all have to pay for the excesses of the pre-crisis period, and the failure of policymakers and regulators to anticipate them.