When the bubble bursts…

by George Hatjoullis

Traders prefer bear markets because they can, in theory, make their budget in a week and take the rest of the year off. In practice, managers do not like them to be idle (“that desk costs £x a day etc”) so they often end up giving some, all or more back! Investors hate bear markets. In a bull market everything you buy goes up and no one really cares about beating the index if you make money. They do not really care if you beat the index in a bear market either. Losing money is never good news. Despite what people say, bear markets are always bad news, though corrections can be useful. Distinguishing between the two, ex ante, is almost impossible. Is this a correction or a bear market getting going?

August is a poor predictor month. What happens in August stays in August. All the big boys are on holiday and trying to keep in touch with the juniors by phone, video and text. A ‘holiday’ for money managers is just terminal relocation to a place with many distractions. It is not conducive to good decision taking which is why August is often the scene of car crashes. What we have seen so far is exaggerated reactions (thin markets in August do not help) to events elsewhere. They could reverse and some of it will into month end an early September. The question is what happens later in September?

The China Syndrome has largely been priced. Commodity markets and commodity currencies have taken a beating already. The Chinese economy did not start slowing down last week. Moreover, fund managers globally seem to have a lot of cash. The extended rally has made investors nervous and they have kept a big cash reserve in place for a ‘correction’. This supports the idea that what we have seen so far is a typical August car crash. This cash may well be put to work between now and the end of the year. However, not necessarily in September.

There are two problems. First, September is seasonally not a good month for the US markets. Second, the Federal Reserve may raise rates. There seems to be a growing consensus that in the midst of all this turmoil it will hold off. This does not follow. Yellen has made a big song and dance about something called the equilibrium real interest rate and the need to normalise to this rate as soon as possible. The concept is, in my view, a nonsense but this is beside the point. Who cares what I think. Not even I care! What matters is what Yellen thinks. She introduced this notion and did so for a reason. I suspect the reason was to provide an excuse to raise interest rates in the face of very little inflationary pressure. Do not rule out a rate increase in September just because equity markets have sold off. This would be unwise. It is also where the risks lie.

If the Fed raises rates in the face of market conviction that it will not, and should not, then the autumn could see more stormy weather. The correction could become a bear market, albeit not of the magnitude we have seen in the last 12 years. Indeed, even if the Fed does hold off for the moment, the sell off may still extend because of fear. The equity markets (in the west at least) may not stabilise until the Fed raises rates. The event of the first increase may cause more damage but then the bear market should prove short-lived. The Fed, it seems, needs to be raising rates (for what may be political reasons) but it does not have to raise very fast. A steady and predictable rate of interest rate increases is not inconsistent with rising equity markets. Normal service may be resumed later this year.