Thesis’ Lally: You have been warned!


Last year May proved to be a torrid month for investors as fears of a eurozone collapse and global recession sent markets into a tailspin – at least for a few weeks. Our advice then was “…buy in June it’s not too soon” and markets duly obliged with a remarkable run up until, yes, May this year.

The term ’groundhog day’ comes to mind, but this time the sell-off was precipitated not by fears of recession, government defaults or banking collapses, but of growth – hence the retrenchment in bonds and gold over recent months. As usual the participation of short sellers has probably served to ensure that falls have been overdone.

Nevertheless many private investors may question why most equity markets also fell. The answer lies in the fragility of the global recovery and its sensitivity to the policies of central bankers.

Large cars, like large countries, can consume resources at an alarming rate. One of my infamous old V12s would drain a battery within days if left unused. Hence one of my best investments ever was a battery charger. In effect most key central banks have been ‘plugged in’ to the retail and commercial banking system in particular for the last five years and what has spooked the equity markets is whether the respective economies now have enough accumulated reserves to stand alone and power ahead if the plug is pulled.

It seems that in everywhere except the US the answer is an emphatic no. Statements from the ECB president Mario Draghi and the new Bank of England governor Mark Carney have been decidedly downbeat on economic growth forecasts and indicate a continuance of low interest rates and financial support (via quantitative easing amongst other policies).

Maybe not everyone will get the turbo charged Japanese style stimulus, but otherwise we can expect most central banks to act, as a minimum, as ’trickle chargers’. In Europe there will be pressure to switch economies in the less diligent countries from flamboyant resource draining V12s to more economical 6 cylinder or ideally hybrids.

There has been much debate over the reasons behind Federal Reserve Bank chairman Ben Bernanke’s comments (which triggered the general market falls). Certainly he was testing the water (although without the devious methods usually adopted by politicians), but was it a coincidence that his remarks were made as the US market hit an all time high, or Treasury yields were close to record lows? If he wanted to take out some of the froth he certainly achieved it on the bond front, but only outside the US in equities. In truth I believe it was more a warning shot across the bows, to the recipients of QE, to prepare to stand on their own feet or face being thrown to the wolves.

The actual wording is more enlightening, and is sometimes overlooked, i.e. if the US economy continued to improve in line with their forecasts then it would be possible to reduce the amount of QE on a month on month basis from $85bn to $65bn. However, this was contingent upon positive economic data, specifically 3 per cent growth in the second half of this year with a trajectory of 3.4 per cent next.

In the UK, market indicators had priced in a rise in UK base rates from 0.5 per cent to 0.75 per cent in two years’ time rather than three whilst the cost of fixed term borrowing shot up, as measured by sterling five-year swap rates, which rose to 1.787 per cent between early May and late June. These are hardly enough to warrant some of the more hysterical headlines, and market reactions, but are perhaps a reminder that, in this respect at least – and barring a shorter term partial recovery from oversold levels – then it is ‘the beginning of the end’ of the rally in bond markets.

So, the start of a bear market in bonds then? Not yet, but it does depend who you listen to. For example reducing the base rate from its current historical low of 0.5 per cent into negative territory “remains an option” for the Bank of England’s MPC, according to deputy governor Charles Bean (in response to a question from Treasury Select Committee chairman, Andrew Tyrie).

Bean pointed out that the MPC had always had the power to set negative interest rates – a move which would see commercial banks pay the BoE for holding reserves, rather than the other way round. Unfortunately that would probably encourage banks to substitute out of reserves into alternative assets which could, in turn, lead to a reduction in savings rates.

Bean said the MPC believes that further asset purchases and targeted policies to restore the functioning of the monetary transmission mechanism, such as the Funding for Lending Scheme, represent more reliable tools for stimulating aggregate demand than a further reduction in the base rate.

“But,” he said, “a reduction, including to below zero, remains an option which the MPC will keep under review lest circumstances change in the future.” You have been warned!

Michael Lally is the investment manager at Thesis Asset Management