This summer marks a decade since the first stirrings of the global financial crisis. A lot of water has flowed since two hedge funds backed by Bear Stearns collapsed in July 2007 because of their exposure to US subprime mortgages.
For investors the defining outcome of the financial crisis has been the presence in financial markets of central banks and their bulging balance sheets. The constant nourishment of easy money — the ultimate put option — not only keeps driving up asset prices but, critically, limits bouts of market tremors.
While the markets fixate on a host of issues including the outlook for growth and inflation, the prospects of the Trump trade, China’s credit bubble and eurozone politics, the steady expansion of central bank balance sheets via quantitative easing is still keeping the now-familiar show of equities at record levels and negligible risk premiums firmly on the road.
“I call QE the IV drip that has stretched market valuations,” says Jack Ablin, chief investment officer at BMO Capital Markets.
This year alone, central banks have topped up the financial system’s “liquidity punchbowl” by $1.1tn, says Bank of America Merrill Lynch. When you combine the main four central banks from the US, Japan, UK and eurozone, their collective holdings of financial assets are just shy of $14tn. What is more, the overall size of these official balance sheets will rise into 2018 even as investors focus on the beginning of the end game, with the Federal Reserve scaling back and the European Central Bank expected to follow.
What is critical, though, is that the pace at which the Fed unwinds its balance sheet and any tapering from the ECB will be very measured. David Ader, chief macro strategist for Informa Financial Intelligence, says: “The Fed will tiptoe around its balance sheet reduction plan. They will test the market slowly, as they are wary of causing a surge higher in yields.”
Helping to nudge the S&P 500 further into record territory this week was the message from the Fed that it would proceed slowly and steadily when it began shrinking its $4.2tn balance sheet by slowing the reinvestment of maturing debt it held. The minutes of the Fed’s May meeting, released on Wednesday, revealed that these reinvestments would be subject to dollar-value caps that would rise over time.
The upshot, as Lou Crandall at Wrightson Icap notes, is that the Fed will scale back its balance sheet slowly. He expects an initial run-off pace of “no more than $10bn to $15bn per month”.
So more good news then for risk assets? Worryingly, it looks increasingly likely that the coming months will be defined by already-rich asset prices entering a final phase of exuberance, as seen during the late 1990s.
“The longer it takes central banks to tighten, the greater risk of 1999 speculative mania,” is the warning from analysts at Bank of America Merrill Lynch.
They also highlight that US growth stocks are now above their 2000 “tech bubble” peak when compared with global value stocks. In the absence of fiscal stimulus from Donald Trump allied to signs of weaker global core inflation, the old playbook of owning big tech stocks and seeking yield through bonds is back in fashion.
“Our bullish Icarus melt-up view is working, but more because of a reversion to the max liquidity, minimal growth, minimal volatility backdrop of yesteryear, rather than the successful implementation of inflationary economic policies,” those at BofA argue.
As the investing herd gathers pace, the current backdrop offers plenty of worries and casts us back to the illusion of tranquility that pervaded markets a decade ago. Overcoming a brief tumble in the summer of 2007, US and global equities climbed to record peaks in October of that year, suggesting all was well.
Returning to today, one of the most striking examples of central bank inspired market dysfunction is the current low equity risk premium.
Dhaval Joshi at BCA Research says investors appear to mistakenly believe low volatility justifies higher share prices, but that they are missing a bigger point: slumbering volatility is not a signal that the riskiness of owning equities is lower.
Instead, as money flows into eurozone equities, Mr Joshi notes that the uptrend in the Stoxx Europe 600 index — a benchmark for eurozone equities — has reached a key technical limit based on a statistical measure across six months.
This suggests “excessive trend following and group think have reached a natural point of instability likely to break down with or without an external catalyst”, he warns, raising the risk we may be near a Minsky moment, whereby the illusion of systemic stability breeds systemic instability and an eventual tipping point.
The point is certainly worthy of consideration by those investors looking over the horizon, as they see massive central bank support suppressing volatility and fuelling very crowded trades almost a decade on from the crisis.
John Authers is away