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Satyajit Das: Stock Market Investors Accentuate the Positive!


There is a growing gap between the financial markets and real economic activity, and investors are betting too strongly that a positive resolution is imminent.


The poet T.S. Eliot observed that human beings cannot take too much reality at one time. Suffering from crisis fatigue, investors have decided to largely ignore problems, choosing instead to accentuate positive data and ignore any contrary indicators in the hopes that the good times will return.

US stock markets are making new highs almost daily. Even the Nasdaq (INDEXNASDAQ:IXIC) has risen to levels not seen since the tech bubble. Everybody is looking for the new Google (NASDAQ:GOOG), Facebook (NASDAQ:FB), or Twitter.(NYSE:TWTR).

The reality, which everyone knows, is that the rise in asset prices -- such as stock and property prices -- has been liquidity driven. Zero interest rate policies (ZIRP) and quantitative easing (QE) have encouraged a switch to risky assets to generate some returns.

Even the announcement of a slight reduction in Federal Reserve purchases has had little effect on the relentless rise of equity prices. In fairness, loose monetary policy is likely to continue for some time. Policymakers were careful to sugarcoat the announcement with assurances of the continuation of ZIRP for an extended period and any reduction in future purchases highly conditional on economic conditions. In addition, US fiscal policy is slightly looser as sequestration cuts have been reduced in the near term.

A reader of the Financial Times commented that even an imminent prospect of an alien invasion would result in equity prices rising. Equity analysts would argue that companies could look forward to the prospect of gaining new non-human customers. There is now a bubble in bank analysts who argue that there is no bubble!

Investors assume that normality and the era of easy high returns has returned. But puzzlingly, while financial markets are buoyant, the real economy remains moribund, stuck in a "secular stagnation" of low, volatile growth, high and rising debt levels, slow investment, overcapacity, high unemployment, low income growth, and negative real interest rates.

The underlying problems are well-known: high debt levels, global imbalances, excessive financialization of economies, and a society of entitlement, based around borrowing-driven consumption and unfunded social entitlement programs in developed countries. These issues remain substantially unaddressed.

Since 2007, total debt levels in most economies have increased rather than decreased. Higher public borrowings have offset debt reductions by businesses and households. If unfunded entitlement obligations for pensions, health care, and aged care are included, then the level of indebtedness increases dramatically.

As a result of attempts to boost economic activity following the 2008 downturn, emerging markets (such as China) have also increased debt levels substantially from those prevailing before the crisis.

Even the deleveraging of households is reversing. Consumer debt is now increasing, partially driving the recovery in consumption.

Global imbalances have decreased but only modestly. The decrease reflects lower levels of economic activity with a sharp reduction in imports in many developed countries, rather than a fundamental rebalancing. Large exporters (such as Germany, Japan, and China) remain committed to economic models reliant on exports and large current account surpluses. Increasingly, nations have turned to manipulation of currencies to maintain export competitiveness.

Excessive financialization manifested itself as the rapid growth of the financial sector, an increase in trading volumes of financial instruments, and a focus on financial activities at the expense of the real economy.

The size of the banking sector in developed countries has not decreased materially. Too Big To Fail (TBTF) banks have become larger. Trading volumes remain high -- well above what's needed to support the trading of real goods and services.

Trading in financial claims over real economic activity, earnings, and cash flows still offer larger profits than the real economy, continuing to support a disproportionate level of financial rather than real business activity. Government and central bank policies of low rates and abundant liquidity exacerbate this trend.

The complex links and interaction within the financial system that helped transmit the shock waves during the global financial crisis (GFC) remain. Complex capital, liquidity, and trading controls of dubious efficacy, introduced in response to the crisis, have not addressed the underlying problems. Initiatives, such as the central counterparty (CCP) for derivatives, create new inter-connections and systemic risks.

The links between nations and TBTF banks have increased dramatically, with a sharp increase in risk. Sovereigns needing to find buyers to finance spending have encouraged banks to purchase a growing amount of government bonds financed by cheap funding from national central banks.

Reform of entitlements has proved difficult. Needed renegotiation of retirement benefits and conditions, health-care costs, social services, and funding arrangements to improve public finances have proved difficult. Seeking to maintain their grip on office, politicians everywhere have proved reluctant to seriously tackle major issues.

In December 2012, German Chancellor Angela Merkel pointed out that "Europe has 7% of the world's population... but is financing 50% of global social spending." A year later, as part of the agreement with the SPD to form a grand coalition over which she would preside, Chancellor Merkel agreed to a new minimum wage and more generous retirement benefits, including a reduction in the retirement age from 67 to 63 for some workers.

The official policy throughout the world continues to be "extend and pretend." Rather than deal with the fundamental issues, policymakers have adopted an expedient mix of expansionary policies. ZIRP and QE have been used to boost demand and make high levels of debt more manageable. Central banks increasingly finance governments through the purchase of sovereign debt. Currency devaluation is used to increase competitiveness and also to reduce the value of sovereign debt, held by foreign investors.

Unfortunately, these policies have not created the strong economic growth or inflation needed to address the problems exposed by the crisis. Instead, the policies intended to deal with the issues have spawned toxic problems of their own.

The policies have set off rapid and destabilizing increases in asset prices. Mispricing of risks is now increasingly evident. Commenting on the increased investment by banks of structured securities (which caused major problems in 2007/2008), Adam Ashcraft, head of credit risk management at Federal Reserve Bank of New York observed, "We're not learning the lessons we need to learn. We haven't done anything meaningful to prevent the securitization market from doing what it just did."

Policy settings seem curiously similar to those that contributed to the GFC in the first place. In many markets (such as the US and UK), governments continue to stimulate the housing market despite the fact that this was one of sectors that created problems during the GFC.
Policymakers seem to have forgotten that repeating the same thing over and over and expecting a different result is indicative of insanity.

Official policies are complicated by the "Hotel California" problem: You can check in, but you can never check out. As outgoing US Federal Reserve Chairman Ben Benanke discovered with his "taper" talk, full exit from present expansionary monetary policy, as distinct from a slight scaling back of it, may be difficult or even impossible without a major market disruption, which could truncate the weak real-economy recovery.

There is a growing gap between financial markets and real economic activity, between the 1% who continue to gain in the current environment and the 99% whose economic fortunes have declined, and between the promises of policymakers and economic reality. This gap will have to close at some time. It can close with a significant increase in economic activity. Alternatively, financial markets and prices will have to adjust, perhaps sharply.

Investors are, consciously or unconsciously, betting on the first outcome, while ignoring the risks of the second.

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