Over-reliance on central banks the real cause of current market pain

CONVENTIONAL wisdom has focused on China's slowdown as the main cause of the current weakness in global equities, a slowdown brought on by the country's transition from an investment/infrastructure-dependent economy to one that is consumer/services-dependent.

This transition and its consequent impact on growth is widely believed to have led investors to shift their money away from emerging markets (EMs) in favour of developed markets (DMs), thus continuing a DM-over-EM theme which originated in 2014 when the US Federal Reserve first started "tapering" its monetary stimulus.

As explanations go, the China slowdown, DM-over-EM theory has been accepted because it sounds plausible. And it may well be that international money has temporarily abandoned EMs because of concerns over China's growth, and will return at some point in the future when the transition starts to show positive results.

The problem with accepting such neat reasoning is to ignore the possibility that China is really simply a convenient culprit, its economic transition held aloft too easily as the main cause for stock market woes. To accept it would also be to ignore the real reason global equities are suffering, namely a dangerous conditioning markets have undergone over the past eight years which is an over-reliance on central banks to constantly bail out economies and markets when trouble strikes.

This conditioning was pioneered by the Fed in 2008 when it stepped in to bail out the US's crooked banks after the subprime crisis threatened to bring down the banking system's shabby, rotten facade that had been built during the preceding post-deregulation decade, and it is a practice that continues today on three main fronts - with the European Central Bank's promises to "do what it takes" by way of bond purchases to achieve its inflation targets, with the People's Bank of China's numerous interest rate and bank reserve ratio cuts last year and with the Bank of Japan's massive yen injections over the past two years to lift its economy out of a deflationary spiral.

Thanks to explicit and implicit promises from these monetary chieftains, asset allocation has been largely based on where the stimulus is greatest, and not according to their most efficient or productive uses.

Perverse maxim

This introduced complacency into markets and equally damaging, far-ranging distortions into price-setting mechanisms as economic decision-making became based on the perverse "bad economic news is good for stocks" maxim.

Nowhere is this more evident than in China, where the government and central bank have repeatedly intervened over the past eight months to prop the stock market up, prompting hordes of retail investors to throw in their lot with equities in the misguided belief that they will be bailed out when things go belly-up.

As many are now painfully discovering, the effectiveness of central bank propping-up erodes with each fresh crisis if the fundamental issues have not been solved. Rate cuts and liquidity injections serve only to produce knee-jerk upticks in economic and financial activity if not accompanied by lasting structural reform, productivity and efficiency improvements and genuine change.

The upheavals experienced in global equities may appear to be because of China's economic transition but are more likely because markets everywhere are struggling with a different transition, from a world where massive central bank action seemed to have an appreciable if only temporary effect to one where it is becoming less and less effective. How long this transition will take is anybody's guess but it looks as if after about eight years of bad economic news being good for stocks, bad news now really is bad news.

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