https://www.ft.com/content/f6824190-636c-11e3-a87d-00144feabdc0Dead or alive? The puzzle of Schrödinger’s marketsThe current state of US financial markets might be best described with the help of a dead Austrian physicist and a logic-defying feline of unknown vital status.
Schrödinger’s cat is a thought experiment designed by Erwin Schrödinger to highlight the apparent absurdity of one particular interpretation of quantum mechanics when transposed to everyday objects.
The theoretical cat sits in a sealed box containing a flask of poison and a radioactive source. The poison is released at essentially a random time determined by the decay (or not) of a single atom. Once the poison is released the cat dies. Otherwise the cat lives.
The prevailing theory of quantum mechanics at the time implied that, since the probability of an atom of the radioactive substance decaying is equal, until someone opens the box the cat is both alive and dead.
The moment the box is opened and the cat observed, the two “states” – living cat and moribund cat – collapse into one that is either dead or alive (but in both cases presumably quite annoyed).
Such an experiment, intended to demonstrate the eccentricity of a certain school of quantum physics, makes a satisfying analogy for the state of markets after five years of quantitative easing by the Federal Reserve.
Central banks have flooded the financial system with cash, driving investors to park their money in higher-yielding securities and largely obfuscating the true state of underlying markets.
Take, for instance, the corporate default rate and the analytical models that are supposed to help forecast it.
The one-year default rate for US and European junk-rated companies currently stands at about 3 per cent, according to the quarterly review from the Bank for International Settlements released this week, just 1 percentage point above its average during the boom-era years of 2005 to 2008.
With default rates so low, the strategy of investing in higher-yielding, but riskier corporate bonds has paid off. Corporate credit spreads, or the additional yield investors demand to hold riskier securities, are hovering at a historical nadir, indicating that investors have been keen to take advantage of the low default rate and increase their holdings of corporate bonds.
In fact, as the BIS notes, “in addition to reflecting perceptions of credit risk, spreads may also drive default rates.” In an era of cheap and easy money, investors are encouraged to buy bonds from troubled companies and thereby suppress the default rate.
The overwhelming effect of QE on corporate defaults and spreads has, perhaps unsurprisingly, led to all sorts of modelling difficulties. Even top-tier analysts will sometimes (quietly) confess they are at a loss when it comes to estimating future corporate defaults.
Models that incorporate QE extending for the foreseeable future tend to predict that corporate defaults will continue to occur only infrequently. Meanwhile, models that attempt to incorporate some sort of “tapering” of central bank support show sharp increases in default.
Which to choose? What’s really in the box – living, functioning companies or ones that are flatlining?
The same comparison could be applied to the state of the broader US economy.
Deutsche Bank, for instance, writes this week that the current economic expansion in the US economy will be 54 months old by the end of the year. The average expansion since 1854 has totalled just 39 months by the bank’s calculations.
That means the current expansion – hot on the heels of one of the worst recessions on record – is now the seventh longest of the 34 expansionary economic cycles to have occurred in the US over the past one and a half centuries.
As Jim Reid, the well-respected Deutsche strategist, points out, the US appears to have “just about escaped [a correction] due to extraordinary monetary and fiscal stimulus”.
This time really is different. Or, it isn’t.
We will only know for sure when we open the box – once the extraordinary central bank policies have been unwound – and peer in to see whether the cat is dead or alive. At that point the US economy, and the state of its many companies, will reveal themselves to be in reasonable health, or stubbornly inert.
