Hold onto your hats. Stock markets look much as they did in 2000 and 2007
Many stock markets are close to their all-time highs, the oil price is plummeting, delivering a significant boost to Western and Asian economies, the European Central Bank is getting ready for full-scale sovereign QE – or so everyone seems to believe - the American recovery is gaining momentum, Britain is experiencing the highest rate of growth in the G7, God is in his heaven and all’s right with the world. All good, then?
No, not good at all. I don’t want to put a dampener on the festive cheer, but here are five reasons to think things are not quite the unadulterated picture of harmony and advancement many stock market pundits would have you believe.
The first reason to worry is the curiously juxtaposed state of asset prices, with generally buoyant equities but falling sovereign bond yields and commodity prices. They cannot both be right. High equity prices are – or at least, should be – indicative of investor confidence and optimism. Low bond yields and falling commodity prices point to the very reverse; they are basically a sign of emerging deflationary pressures and a slowing economy. If demand was really about to roar away, both would be rising along with equities, not falling. The markets have become a kind of push-me-pull-you construct. They look both ways at the same time.
Yet this is no mere anomaly. There is a good reason for these divergent asset prices – pumped up by central bank money printing, abundant cash is desperate for fast vanishing yield, and is chasing it accordingly. Spanish sovereign debt might have looked a good buy a couple of years back, when the yield still factored in the possibility of default.
But today, the yield on 10-year Spanish bonds is less than 2pc. In Germany, it’s just 0.7pc, not much more than Japan, which has had 20 years of stagnation and deflation to warp the traditional laws of investment. If it is yield you are after, sovereign debt markets are again exceptionally poor value, barely offering a real rate of return at all. Commodities were the next port of call, but that game too seems to be up.
01 Dec 2014
The much trumpeted commodities super-cycle has taken a giant lurch down, leaving hundreds of billions of dollars in debt, extravagantly plunged into new reserves during the boom, stranded by the receding tide.
With bonds and commodities having run their course, equities and property have become the asset classes of last resort. Any damage done to stock markets by the collapse in oil and mining shares has been more than made up for by the boom in pharmaceutical and technology stocks. Abundant buybacks and gushing dividends from companies that cannot think of a productive use for the money have fed the frenzy.
After 10 years of going nowhere, pharma is all of a sudden the sector of choice, in eager anticipation of thousands of miracle cures that may never come. In their oblivious disregard for the uncertain world around them, stock markets look today very much as they did in 2000 and 2007. We had a slight premonition of what’s to come in the October mini-crash.
The second reason for caution is our old friend Europe, the problem economy that refuses to go away. The collapse in the oil price should be a boon, and indeed would be were it not for the fact that it gives the European Central Bank yet another excuse for doing nothing. Logically, it should be the other way around. On the way up, rising oil prices were treated as an inflationary influence that required the therapy of higher interest rates.
But now that energy prices are falling again, they are seen in a different light - as a reflationary force that removes the pressure for easier monetary policy. This in turn provides the German bloc with further justification for resisting sovereign QE. No longer necessary, the German contingent will be saying, apparently oblivious to the asymmetry of their approach. Every time he speaks, Mario Draghi, the ECB president, comes that little bit closer to announcing a programme of sovereign bond buying, but it’s only words. His hands are much more securely tied politically than generally imagined. Markets are promised jam tomorrow because that’s all that can be delivered; a tomorrow that never comes. For how much longer can Mr Draghi maintain the charade?
British and American economists still tend to blame the eurozone crisis on bad policy, and in particular on fiscal austerity and lack of monetary activism. But it is actually more intractable than that. If obligations were mutualised in the way that would normally occur in a single currency regime, things would be fine, but this is out of the question as long as the eurozone remains a collection of separate sovereign nations. Since there is no practical likelihood of federalisation, or even appetite for it, the eurozone is condemned to a kind of locked-in syndrome of helplessness. Eventually, there will have to be a massive, European-wide debt restructuring if the euro is to survive. Such an endgame is years, if not decades, away.
Political uncertainties provide a third cause for anxiety. The rise of populist parties such as the Front National in France, Podemos in Spain, Ukip in England and the Scottish National Party north of the border has upset the established political order of things. In such circumstances, stable, pro-business economic policies become hard to impossible to sustain. Things fall apart, the centre cannot hold and mere anarchy is loosed upon the world.
The fourth reason to worry is that an increasingly turbulent international situation, made worse in some of the world’s major flashpoints by declining oil prices, greatly enhances the chances of unanticipated shocks. Such risks are, of course, always with us, but are greater today than markets like to believe.
Finally, overarching all these concerns, is the biggest of the lot – that few of the underlying problems highlighted by the financial crisis have yet been convincingly addressed. If anything, they’ve got even worse.
Since 2007, the ratio of non-financial sector debt to GDP among G20 countries has risen by more than a fifth. This has helped prop up demand, but it has led to new financial booms which mask fundamental weaknesses and loss of productive potential in many advanced economies. There is an evident disconnect between buoyant financial markets on the one hand and underlying economic realities on the other. Policymakers have repeatedly gone for the easy option, rather than the tough decisions necessary to create a durable recovery. Despite relatively strong growth, Britain is no exception. To still be running massive budget and current account deficits at what may well be the top of the cycle is a truly dangerous place to be.
Hang onto your hats. Conditions will be getting decidedly ugly again in the new year.
