There’s one key reason why markets have had such a rough 2018

Trump, Brexit, Frenchmen on the rampage – no wonder markets are depressed. Politics has certainly grabbed the headlines, that’s true. But it’s not the real reason for the market slump.

181217-markets

We're coming up for the end of 2018.

If markets are going to put in a Santa Claus rally (which I'll admit, I'd half-expected), they're leaving it kind of late.

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So just what exactly has freaked investors out so badly this year?

2018 has been a tough year for markets. With all the focus on politics right now, if you ask someone why, then they'll exclaim: "Trump!"

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Or: "Brexit!"

Or: "les gilets jaunes!"

They'd be wrong.

Politics has grabbed the headlines but it's not behind market falls

You might think that I have a tendency to downplay the importance of political events. It might even be true. (Although if it is, at least it's a counterweight to the hysterical importance with which most papers treat the tedious minutiae of the Westminster bubble.)

But you'd have to accept that this year's political fun and games are nothing new. 2017 saw at least as much political upheaval (including that scary North Korea business remember that?). Yet markets spent the entire year coasting happily it was exceptionally calm.

So why has this year been so much tougher? If you're a regular reader, you'll already know the answer. This is a topic I keep returning to, but right now it's probably the most important one in financial markets. (In fact, it's pretty much always the most important topic in financial markets, thinking about it.)

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It's all about interest rates. The big scary thing this year was not Trump, or Brexit, or French rioters (or Italian budgets or even trade wars). The big scary thing was Federal Reserve boss Jerome Powell.

The US central bank chief has been raising interest rates steadily but relentlessly all year. Many on Wall Street are praying that he will pause this week, but there's really no way of knowing what he might do.

And it's not just Powell. His colleagues at central banks around the globe are tightening too. Indeed, according to Crossborder Capital, which monitors global liquidity conditions using various measures, global liquidity is now slowing at its fastest rate since the 2008 crisis.

This is primarily because of central banks. Crossborder keeps an eye on 80 central banks around the world. Of that total, four-fifths are now running "tight" monetary policies apparently.

The European Central Bank, for example, has just confirmed that it plans to stop quantitative easing (QE) at the end of this month. This is despite the fact that Europe is clearly not out of the woods yet. You just need to look at its rapidly-imploding banking sector to see that.

Yet current boss Mario Draghi is leaving next year. There's only so much he can do. I suspect that, come 2019, someone else will have to prove, once again, that he or she (it almost certainly will be "he") has what it takes to do "whatever it takes" to save the euro.

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Anyway tightening global monetary conditions cannot be good for markets overall. Asset prices are ultimately dictated by one thing only the amount of money flowing into or out of them.

You hope that this money flow is informed by rational decision-making that investors are picky, and that they choose decent productive investments, rather than Ponzi-scheme rubbish.

But overall, if there is less money to go round, then all of those investments are competing for a share of a smaller pie. This is why something like 80%-90% of asset classes have lost money this year. Just as a rising tide lifts all boats, so a receding tide dumps them back down again.

Liquidity is drying up will the Fed unleash it again?

Now, is this necessarily a bad thing? I think we could have a long and interesting debate about that. The key to this is something I said in that last paragraph if there is less money to go round, then all of those investments are competing for a share of a smaller pie.

In other words, in times of high liquidity, any old rubbish can get funding as long as it promises something shiny enough in return. In times of low liquidity, people are much more stingy with their money.

You can't just say you've got a good idea you need to prove it. You can't just promise them jam tomorrow they want jam today.

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So tighter monetary policy does not have to be bad news for investors, or even in the longer run for the economy. Investment will go towards genuinely productive businesses rather than on funding hopes, dreams and scams. Put very simply, we're likely to see a switch from "growth" to "value" (more on that in the next issue of MoneyWeek by the way, subscribe here if you haven't already).

However, the problem with tighter monetary policy is that it derails all the bad investments that were made during the era of loose monetary policy. And when that happens, you often get painful side effects that then catapult you back towards looser monetary policy again.

There's no denying that it's getting messy out there. As John Authers points out on Bloomberg, around the world, banks' share prices are sliding. That's a bad sign. Banks tend to be leading indicators when they're doing well, stocks will go up. When they're falling back to near-2008 levels well, that's not a benign omen.

Also, it looks as though December will be the first month since the Lehman Brothers crash in which no junk bonds were sold.

The question is: will all of this be enough to persuade the Fed to hold off this week? And if so, would that be enough to spark a Christmas burst of relief? If not, expect the hard times to continue into 2019.

Keep working on your watch list. The UK and emerging markets are my main areas of interest right now in terms of opportunities. And subscribe to MoneyWeek if you haven't already next year looks like it could be genuinely interesting for investors.

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