What the hell are the markets thinking?

After months of denial, yesterday I finally accepted a very basic point: I can’t explain anything anymore.

To do my job, I need to develop a good idea of global economics and politics and how they translate into asset prices in order to develop successful investment strategies. But right now I see a breakdown between “objective” reality and its reflection in the Matrix-like world of financial markets.

This may sound extreme, but bear with me. At first glance, things are not going badly. The world economy is growing at a very good rate and it has proved very resilient to the recent shock in energy and commodity prices. As a result, stock markets the world over are doing great and long-term interest rates are still at or near the lowest levels in decades.

Yet, the political superstructure on which economic prosperity depends is crumbling.

The United States is, for all practical purposes, does not have a functional government. I say this with amazement, dismay and consternation. George Bush has lost even the limited grasp of reality he had and has no idea how to correct his past mistakes, which are rapidly eroding his authority, let alone set a coherent policy agenda. The less we can say about his second in command, the better. And let’s not forget that his party is in disarray, while the opposition does not have the standing, intelligence or leadership to defend the nation’s vital interests.

And we have three more years of this to look forward to.

Looking abroad, things are not much better. Western Europe’s heads of state are discredited (Chirac, Berlusconi and now, to some extent, Blair) or inexperienced (i.e. Merkel). Japan’s Koizumi seems like a strong leader, but he leads a timid nation. Russia is ruled by a thug and China has still not developed a strong, effective voice in international affairs.

In addition, many of the world’s leading multilateral organizations, such as the U.N., the World Bank and the WTO, seem paralyzed or ineffectual.

Basically, this implies that if a crisis that requires effective coordination arises, we probably won’t get it, with predictably negative consequences.

Yet, the bond market isn’t worried one bit: risk spreads are actually below the average of the past 15 years (the BAA/10 yr-Treasury stands at 184 basis points, vs. an average of 208 basis points). Stocks are rising and emerging market assets are once again in full bloom.

Even if the probability of a nasty, unforeseen crisis is very low, the damage would be severe given the above conditions. My impression is that asset prices are not pricing this in.

Why? I have no idea.

Oh, and have I mentioned that GM is about to go bankrupt? Even though this firm is a shadow of its former self, it is still huge by any measure except market value. When a CEO writes to all employees to categorically state that the firm won’t go bankrupt, a Chapter 11 filing is a sure thing (unless the aforementioned CEO is quickly fired and replaced by someone who can act correctly and decisively).