Four financial questions for foamy markets

Happy Easter, and happy Passover. As Christians celebrate Good Friday, and Jews hold their first seder to commemorate the flight from Egypt, it is a good time to reflect.

At the start of a Passover seder, Jews must ask four questions on why things are different to other nights. The Long View has found over the years that this is also a good discipline for framing the markets when they make no sense. Here, then, are four financial questions for Passover in 2015:

Why will investors accept a negative yield from many government bonds, when in centuries of history they have never been prepared to do so before?

There are two arguments. One is that it is all down to central banks. If they buy bonds and keep yields low, or keep negative official rates as the Swiss National Bank now does, investors will eventually, in their desperation, accept a negative yield.

The other argument has to do with the economy. If the economy is slumping, and the price level is falling (through deflation), then the value of money is expected to go up over time. Thus it might make sense to take a negative yield. Those who believe we are caught in a "liquidity trap" like this point out that US treasury yields, contrary to all expectation, have fallen since the start of last year, even as the Federal Reserve tapered off and then ended its QE bond purchases, and prepared for rising rates.

The two are not mutually exclusive, but the circumstantial evidence is that the central banks are more important. The chart shows yields on Dutch government bonds. Over the centuries, there have been many instances of deflation - not at all uncommon under a gold standard. But the current low yields are truly unprecedented. That points the finger at unprecedented central bank behaviour. As for falling US treasury yields, they came as European yields plummeted. Money is fungible. The lower the yield elsewhere, the more people are inclined to buy treasuries - and push down their yield.

Why are US stocks so expensive, with no 10 per cent fall for almost four years, even as earnings forecasts collapse, and investors brace for higher rates?

The simple answer is that bond yields are low. The fact that they have fallen even as the market gets more nervous about a rate rise from the Fed is all the more reassuring. When rates are low, a higher multiple on stocks is justified. Their own yields seem more attractive. But how far can that logic be taken?

The S&P 500 now trades at almost 28 times its average earnings for the last ten years (known as the cyclically adjusted p/e or Cape). This is its highest in 13 years, below only its peaks before the infamous crashes of 1929 and 2000.

Stripping out noise, US stocks have basically moved sideways for six months now, as QE bond purchases end and the Fed agonises over the next step. There is a high risk of a sell-off when rates finally rise.

Why have emerging markets started cutting their foreign exchange reserves, when for over a decade they have been increasing them?

The first year-on-year fall in emerging market reserves since the International Monetary Fund started keeping data 20 years ago is historic. The reserves were built up as western money poured in searching for growth, and as central banks built defences against a repeat of the 1990s devaluation crises. Now, investor sentiment has turned against developing markets, while central banks are trying to stop their currencies weakening too far versus the dollar.

It was once fashionable in the US to view these reserves as a financial weapon. The Chinese authorities, like cat-stroking James Bond villains, could decide to sell their dollar reserves, and crash the US currency. That never made sense. Reserves are falling now out of weakness, not strength, without denting the dollar or US bonds. In the long run, either the trend continues, putting pressure on the US, or sentiment turns and EMs look cheap. Short-term, this is bad for emerging markets.

Why is the Chinese stock market up 90 per cent in the past 12 months, when everything else about China suggests worries about a slowdown?

It is best to treat China's rally as a financial phenomenon, not an economic one. Many reliable indicators suggest a sluggish economy - iron ore prices have fallen, and the April supply manager survey suggests that the manufacturing business is contracting.

That has prompted authorities to ease financial conditions, and cut rates on deposit accounts for savers. That leads them to look for a greater return elsewhere and pour into the stock market. The pattern from the Shanghai stock bubble of 2007 has repeated. The authorities can manipulate share prices, but only with a blunt instrument - a nudge can lead to a dramatic reaction.

For non-Chinese, the implication is sadly that the Chinese market is not cheap, and that it is still too foamy and illiquid to be worth the risk.

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