What goes up must come down, and go up again, and come back down. That has been the story of the financial markets over the past few weeks, suggesting that, in the spectrum of greed and fear which drives investors, most do not know which way the pendulum will swing next.
One thing is clear, however: there is a huge amount of liquidity sloshing around the world looking for a home, which makes the oscillations of the markets extremely volatile. Where is all this money coming from?
To answer this question, we must go back a few decades and get into the minds of todayï¿½s senior central bankers. Most of these men – you will see them nodding sagaciously to each other at high-powered conferences like the Davos forum – are products of the 1970s. Their formative years were spent learning the theories of Milton Friedman and other monetarists and, in the process, debunking those of John Maynard Keynes. Their overriding fear is inflation – the type of inflation the world experienced in the early 1970s and which persisted till the early 1980s. The Holy Grail for these central bankers is low and stable inflation. Provided that is achieved, everything else should look after itself.
By the mid-1980s, inflation had been beaten – mainly via the excessively blunt instrument of recession, and with it, high unemployment and the disappearance of large swathes of industry. The central bankers achieved this by increasing interest rates to such an extent that our economies ground to a halt. If people are out of work, they donï¿½t spend, and if they donï¿½t spend, prices donï¿½t rise. Most countries have recovered from these man-made recessions and, arguably, most are in better shape now.
Typically, we would have seen yet another inflation cycle playing itself out by the late 1990s – except that the world was hit by the biggest economic shock in a century. The collapse of communism and the rise of globalisation opened up China, India and Russia to the game. This has had the effect of doubling the worldï¿½s workforce and, in the case of China, creating a new sweatshop producing cheap goodies for the rest of us. One of the main ramifications of this has been no inflation. As long as China produced stuff cheaply, the prices of consumer durables fell back, and we in the west got cheap goods. This suited the narrow-gauge central bankers down to the ground. They had their low inflation and now they could let things sort themselves out. If people wanted to borrow, well, let them borrow.
So we have seen an enormous expansion of credit around the world in the past few years. Equally, Alan Greenspan – formerly the capo di tutti capi of central bankers – reacted to the dot.com boom by initially believing the hype and, latterly, printing money to ensure that the dot.com bust didnï¿½t knock the entire US economy out of kilter. So both the upswing and the downturn were characterised by large injections of money into the US system. If this cash was not going to technology businesses, where was it going? It found its way into every other nook and cranny of the system, from the housing market first, and later into commodities and back into old-fashioned stocks.
Global liquidity works a bit like a champagne pyramid. Imagine a tacky wedding with a pyramid of champagne glasses and a gushing bride who begins to pour from the top. Eventually, the champagne finds its way into even the most remote glasses as it overflows down the pyramid. As each layer of glasses fills up, the next layer begins to do likewise. Now think of global financial markets. If the central bankers at the top open the taps, global liquidity flows initially into the top triple A assets, such as prime property, bank stocks and strong companies and into well-run economies.
Then this market overflows, so the excess cash finds its way into other more risky assets. As these fill up with cash and yields fall, the speculative cash goes further afield looking for return. Eventually, as long as the taps remain turned on, even the riskiest projects, regions and ventures get cash.
As a result of the champagne pyramid, liquidity seeps everywhere. So we are left with a situation where everything from speculative mining stocks in Canada, to apartments in Bulgaria and defaulted Iraqi debts get snapped up. In other markets, the sheer weight of liquidity drives prices up to levels never before seen. We are experiencing this all across the commodity markets, the housing markets and in some areas of the stock markets.
All these cycles are the same. Initially, there is the real fall in the level of interest rates and cash starts to flow. Typically, the first investment logic is flawless and is underpinned by sound economics. Take the recent example of most metal prices. The price of copper had been low for long periods.
Then in comes China with strong demand for the metal and investors put two and two together. The Chinese will buy more copper, so letï¿½s buy in tandem, piggybacking on a fundamental change in the global financial/economic backdrop.
So far, so sensible. Then greed takes over. As the price of copper rises, people think that it can only go higher, so more money pushes the price up further. We begin to get into a cycle where the very fact that the price is going up is sufficient to validate buying further.
The ï¿½ï¿½if youï¿½re not in, you canï¿½t winï¿½ï¿½ syndrome takes hold. Greed drives the prices up and then suddenly, at a certain lofty point, investors are gripped with a fear of heights. It is as if they get the wobbles when they look down. Overnight, the greed that got them into the market, making them dizzy with optimistic excitement, turns to total fear and they freak. Panic selling begins and prices collapse.
We have seen this type of bipolar behaviour in almost every market in the past week or so. In many ways, the worldï¿½s central bankers have created a monster. Instead of inflation, we are getting asset price bubbles in every market from exotic property, to copper and steel, classic cars and Irish art – all driven by the fact that there is simply too much liquidity around.
But now we have a dilemma. The central bankers realise that the impact of pricking the bubble now on jobs, incomes and politics could be so debilitating that, every time there is a scare in the markets, they react by cutting interest rates and injecting more cash. This simply re-rates upwards all prices and we are back into the same cycle of greed and fear – but at higher starting prices. The champagne glasses start to fill up one more time.
So the worldï¿½s central bankers are caught in a new type of liquidity trap. As long as traditional inflation does not rise too much, they canï¿½t puncture the asset price bubble, and are condemned to inflate it. But if inflation were to pick up, the bankers could aggressively raise interest rates with a clear conscience, which would be akin to hurling a bowling ball at the champagne pyramid. Party over!
These are the stakes in the global financial markets. The central bankers find themselves in an intellectual cul de sac; investors are trapped by the flawed logic of the last throw of the dice and, all the while, the markets yo-yo up and down. In the absence of a logical and painless exit strategy from this volatility, the only thing people can think of doing now is fastening their safety belts and bracing themselves.