The year under review witnessed important events, some geopolitical and others of a financial nature. For a better understanding of financial markets, it is worth looking at these various events to assess their influence on individual investor behaviour and, more importantly, on broader markets.
At the start of 2023, observers lamented the ongoing war in Ukraine, soon to enter its second year. At the time, it was generally acknowledged that Vladimir Putin had broken all international rules of conduct as well as previously signed legal agreements as he prosecuted his barbaric attack on his western neighbour, using nefarious reasoning to justify his atrocities. Few, though there were some with a limited grip on history and geography, were fooled by these arguments as Putin turned to weaponizing commodities under his then-control to ramp up tensions. As the prices of oil and other crucial raw materials exploded, the immediate effect was rampant global inflation which, as expected, was to have adverse effects on bond, currency and stock markets. This unfortunate set of circumstances coincided with the pullback in quantitative easing by the world’s leading central banks. In turn, this opened the path of least resistance for bond yields dramatically to rise to levels not seen in many years and for equity prices to enter bear territory, to be felt by most investors.
This was a clear and painful example of how geopolitics, involving superpowers as well as crude oil and other commodities, could influence financial markets. However, when yields had substantially risen in the first wave, legitimate questions arose as to the yield level that would attract marginal buyers back into the market now that central banks had taken a passive back seat. In the US Treasury market, for example, the main group of marginal buyers was represented by foreign investors such as China, Japan and others. Of lesser importance were US-based institutions such as pension funds and life insurers. Be that as it may, the search for yield did not attract buyers from the sidelines, as some observers, this writer included, had predicted. (This goes to show how an elastic band can be stretched much further than what could logically be expected before it snaps). That was an important post-QE lesson that should be remembered and learned.
As winter turned to spring, a fresh banking crisis was brewing in the United States and came to fruition with the demise of Silicon Valley Bank (SVB), a California-based institution offering finance to technology start-ups. At its core lay the classic risk of a banking model based on the long-term re-deployment of capital borrowed at short-term maturities. In this case, the short-term maturities consisted of retail bank deposits while longer-term assets were US Treasuries, deemed free of risk. Subsequently, the explosion in long-term bond yields caused the bank to write down the value of its bond holdings and suffer huge losses estimated by the Federal Deposit Insurance Corporation to amount to US$ 20 billion, no small amount. And this was not counting the damage caused to other local banks in the region. In today’s world of social media, it took no time for depositors to become aware of SVB’s troubles and resulted in massive outflows, at the click of a mobile phone, thereby severely aggravating the crisis that had formed.
As other banks in the region suffered a similar fate, tremors hit markets across the world and culminated in the demise of Credit Suisse, that most venerable of Swiss banking institutions. But in this case the debacle was not based on any lack of capital on Credit Suisse’s balance sheet. It was the result of mismanagement, historical scandals, and rumours that, here again, caused social media to become the platform on which rushed deposit-withdrawal decisions were based.
Credit Suisse’s subsequent absorption by UBS created a mega-bank whose balance sheet consequently grew to a size that overtook the gross national product of Switzerland. As to the success of this operation, the jury will remain out for many years to come. In the forefront of investors’ minds were the risks that the banking crisis could spread across world markets, infecting one bank after another. The Global Financial Crisis of 2008 was on all investors’ lips, and with good reason.
So far, that has not come to pass. On the contrary. As inflation reached multi-year highs across the world and observers predicted further price explosions, cost-of-living aggravation, and prolonged bear markets, that very inflation had already begun to subside. Whilst individual investors and perennially bearish media commentators were slow to grasp this crucial shift, markets as a whole were one step ahead, as is their wont.
As summer turned to autumn, and the Ukraine war dragged on without noticeable results on either side, a terrorist attack by Hamas in Israel once more caught the political world on the wrong foot. Still, swift were observers to predict how the price of oil would inevitably rise to challenge the $150 per barrel level reached during critical times in the past. Coinciding with the aim of OPEC Plus to reduce the output of crude oil, this forecast was a no-brainer. But like many no-brainers it was wrong, once again.
Of greater importance were events in fixed income markets in the US during October and November. The massive increase in indebtedness and budget deficits, courtesy of President Biden, had caused many investors to predict an explosion in new government bond issues to be met with a buyers’ strike, as bond investors felt safe in sitting on the sidelines and waiting for yields to rise even higher. As yields rose, share and bond prices were severely marked down. This was most evident in the share prices of long-duration assets such as Quality Growth businesses, irrespective of the health of their underlying business operations. But as yields on ten-year US Treasury bonds surpassed the crucial five per cent level, and the buzz phrase in markets was that rates would stay “higher for longer”, other voices opined that the bond markets were doing the central banks’ job for them, thereby questioning the need for further rate hikes.
As November unfolded, the narrative changed radically. Disinflation had now become appreciated by investors, aided by China falling into deflation. This should not be underestimated in the world’s second-largest economy. Its cross-border effects are evident.
Lo and behold, bond yields reversed course and fell dramatically across the board to reflect this new reality. (The explosion in yields of the previous month, followed by their momentous reversal in November, merits closer investigation, but that is for another day). At the same time, the Federal Reserve made it all but clear that the path for rate cuts was being laid.
The Santa rally in share and bond prices had taken hold even as horror stories from Israel, Gaza and Ukraine worsened by the day and no end is in sight at the time of writing.
Investors inclined to learn from financial markets may have understood that the ultimate influence on stock markets are bond prices; and the ultimate influence on bond prices is the prevailing and expected price of money.
Absent real geopolitically sourced dangers to the flow of world trade and financial liquidity, interest rates will always have the last laugh.
December 26th, 2023
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