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AFR Article

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Below is the latest article for Australia Financial Review, making two key points. First that moves in markets may lead rather than reflect Economic forecasts and thus we need to be careful of predictions based on market moves – especially commodities. Second, that official forecasts that drive policy are far worse than listening to markets and the apparent lack of understanding of how interest rates impact a household sector with a lot of floating rate mortgage debt or even the basics of how the oil market works are of far more concern.

The link is here. As it is behind a paywall, I have posted it below. Other links are therefore from AFR.

Opinion

Why markets are more reliable than the ‘experts’

While financial markets may be very bad at forecasting, they are way better than the models used by ‘experts’.Mark Tinker

Jul 10, 2022 – 11.11amSaveShare

We are wrong to place too much confidence in markets as predicting economics. But they are way better than the so-called experts.

Bond traders are fond of declaring that bond markets are much smarter than equities, while commodity traders insist that the smartest market is “Dr Copper”, who apparently has a PhD in economics.

Four per cent has been wiped off the value of the US equity market this week as nervousness about inflation is rising.
The curve between the 10-year Treasury yield and the 2-year yield has inverted, signalling a recession. AP

In effect, they outsource their economic view to the markets.

However, it’s sometimes difficult to work out whether the markets respond to the “new narrative”, or the new narrative is created to explain where the markets have just gone.

This last few weeks is a classic case in point.

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After the worst start to the year in literally decades, global bond markets had convinced themselves that they faced twin threats; one from inflation destroying real yields, and the second from the Federal Reserve and other central banks deliberately engineering a sharp rise in interest rates such that they created a recession, and credit markets did even worse than sovereign debt.

Data that supported this view was highlighted, while data that did not was largely ignored.

Recession warning

But then in the middle of last month, US long bonds began to rally from yields close to 3.5 per cent and the narrative began to flip away from stagflation – inflation and poor economic growth – towards straightforward recession.

Forget that this might have simply been a value-based asset allocation decision, or anything to do with rebalancing of quant funds, it was taken as proof of the new economic forecast.

Euro-dollar markets are now saying that the Fed won’t raise rates much more and commodity prices are dropping sharply. Ergo, even though we shouldn’t worry so much about inflation and the Fed, there must be a recession coming. As such, the usual conclusion from bond analysts – sell equities and buy bonds.

Nice to know some things don’t change.

Using short-term price movements as economic forecasts is a particular problem with commodity markets, which need to balance out as a matter of near term supply and demand because they are contracts that are rolled over quarterly and are obviously also subject to the pressures for leveraging and deleveraging.

Recall two years ago when oil prices went into negative territory? This wasn’t anything to do with an economic forecast, but everything to do with the fact that owners of the contracts had no desire, let alone ability, to take physical delivery of oil.

As to what is actually happening in the real world, a combination of radical green energy policies, principally a quixotic belief that “bad” fossil fuels could be replaced overnight by “good” renewables merely at the stroke of a bureaucratic activist pen, had already led to serious mismatches between supply and demand, especially a lack of pipeline and refinery investment.

The impact of this green leap forward had been exaggerated, of course, by a different set of policies on COVID-19, which had damaged supply chains and led to a sudden burst of demand.

But currently we find that, while the headline price of oil has come down, the price of refined products has not.

Thus, inflation was over 7 per cent before what Joe Biden calls “Putin’s price hike” – which was in any event little to do with Putin and mainly to do with the West imposing sanctions upon itself in a curious act of self-harm.

This is particularly true of Europe, which is effectively insisting on buying crude oil at a $US35 premium to what Russia is selling it for on the open market. And that is before taking account of discounts for “friendlies”, and premiums for refined products due to lack of capacity.

Cost of living crisis

Of course, the system is being gamed mightily.

The Gulf states are not actually producing more but are exporting more crude (at the higher prices naturally) by replacing the production they would have retained for home consumption with cheap imports from Russia.

Refiners in China and India are importing discounted crude from Russia and exporting ultra-high margin refined products back to the West that believes it is damaging the Russian economy with its sanctions.

The latest idiocy from the G7 is to believe it can cap Russian oil prices through some form of buyers’ strike or restriction on insurance. This would be the same oil that is already trading at below $US80 and which they are refusing to buy anyway?

Meanwhile, in a further bout of self harm, the central banks in countries like the UK and Australia are rushing to raise interest rates on consumer mortgages to counter a price hike that was caused mainly by other government policies.

An EU ban on Russian oil imports has further pushed up the price of petrol at the pump.

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The cost of living crisis means people are struggling to have enough disposable income thanks to the price of basics going up so much.

The answer then is apparently to effectively reduce their disposable income further by increasing the cost of their mortgages, which are still disproportionately floating rate compared to many other countries including the US.

It would be funny if it wasn’t so tragic (and stupid).

After years of bad forecasting models leading to zero interest rates, zero carbon policies and zero COVID-19, we now have the same mis-applied models threatening to collapse discretionary spending.

The financial markets may be very bad at forecasting, but they are way better than the models used by “experts”.

Mark Tinker is chief investment officer of Toscafund Hong Kong and the founder of Market Thinking

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