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A fundamental change is underway in the financial markets and it will not be pleasant

By newadmin / Published on Thursday, 08 Feb 2018 13:53 PM / No Comments / 4 views

It starts with money and rates.

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There is a hot debate among the bulls and the bears as to whether the recent change in equity valuations represents technical market factors that will be quickly reversed or a fundamental change that will take some time to play out.

I am of the view that there is a meaningful fundamental change underway.

It is not economically driven it is financially motivated. Simply stated, in the decade following the financial crisis, money availability was increased through quantitative easing and the cost of these new funds in real terms was negative. The financial crisis is now over and the aberrational financial values created by the manipulated market are ending.

The Federal Reserve has put in place two new policies. The first has lowered the annual growth in the money supply (M2 SA) to 4 percent from what was touching 8 percent, 15 months ago, and over 10 percent, six years ago. The second is progressively increasing the cost of funds. The real cost of money, as measured by comparing the Federal Funds rate to the Consumer Price Index, has been negative 93 percent of the time since 2010.

Restating this point, for a decade there has been a great deal of money around at real prices below zero. This era is over. Anyone who does not understand that this is a significant fundamental change needs to take a thoughtful look at these numbers and think about what they mean.

What make this change more significant is that it is occurring a time when the demand for money is rising. First, the United States government is going to push its $20 trillion debt much higher. Second, the probability of accelerating growth in the economy with moderately higher inflation indicates that the private sector needs more funds. Third, the resumption of economic growth in the Euro zone indicates more money is needed there to maintain forward momentum.

Increased demand for funds at a time when the growth in supply is easing will drive money costs higher and financial values lower. This is about as fundamental as it gets.

But let’s dig deeper. The scoring mechanism in the financial sector is the dollar. If the value of the dollar changes, then the financial assets that it is measuring change. From the trough 10 years ago to the peak at the very end of 2016, the value of the dollar rose by an estimated 41 percent. From the peak in late 2016 to the present it has dropped by 11 percent.

Moreover, while the Treasury Secretary of the United States has indicated that he wants a strong dollar, he has also indicated that the United States would not intervene in currency markets to support the dollar — i.e., he would allow this currency to drop further in value in the short run.

Simply stated, if the scoring system drops in value the items being scored drop in value. A weaker dollar means lower financial assets values. The process is far more complex than being asserted here but the bottom line is that weak dollars buy fewer physical items and financial items must pay higher rates of return to offset the drop in the currency value.

To argue that a shift in money availability; a shift in real interest rates; and a shift in the value of the dollar; have no fundamental impact is simply folly. A folly driven by a lack of understanding concerning how valuation works. The markets are undergoing a far more important change than a technical adjustment.

Be very cautious as to how you invest your money at this time.

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