The rally across financial markets reflects a tailwind from central banks and evidence of a rebound in global economic activity. The important question now is whether bullish equity and credit market expectations have outrun economic reality.
Investors have time on their side, but the absence of a bounceback in growth strong enough to lift corporate earnings threatens to undermine asset price performance over the course of this year.
For some analysts, the path of global monetary policy remains the biggest driver of investment performance. Concerns about lofty valuations, pressure on corporate margins, political shocks and other sector-specific challenges all ultimately give way to a popular market refrain of “not fighting central banks”.
Bob Prince, the co-chief investment officer at Bridgewater Associates, attracted attention at the World Economic Forum in Davos this week when he told Bloomberg News that the era of economic boom and bust, as we know it, has ended. In Mr Prince’s view, rate-setters at the US Federal Reserve are stuck in a box where they cannot move either to tighten or ease policy.
Some quickly noted that a certain UK chancellor issued such a call just before the global financial crisis erupted. Back then, many investors were lured by what was dubbed the “great moderation”: a period that reflected low economic and financial market volatility. The Fed had aggressively lowered rates after the internet bubble popped, creating a period of calm.
The boom-and-bust cycle that transpired for much of the post-second world war period has certainly become less pronounced thanks to the risk-management policies of central banks. The past few decades have also seen a relentless decline in government bond yields and inflation, against the backdrop of dramatic technological and demographic change in the developed world, which is now registering in some emerging economies.
Since the 1987 stock market crash, which prompted the Fed and other central banks into firefighting action, asset prices including housing have greatly benefited from central banks responding quickly to counteract any bout of financial market turmoil that threatens the broader economy. This approach has only intensified over the past decade with central banks buying and holding vast amounts of bonds and other assets in an effort to push inflation and growth higher. The US economy has not endured a recession since the 2008 financial crisis, but growth has been modest.
While equity and credit markets have generated substantial gains since the crisis, many people in the wider economy have not benefited, as illustrated by a rising tide of populism. Judging by current flows into equities and credit, investors appear resigned to more of the same, although ever more expensive financial assets are certainly vulnerable to a macro shock that not even central banks can limit. Many investors, including Mr Prince, have faith that they will feel the tremors before the next major earthquake and have time to avoid the worst of the sell-off.
As central banks target asset prices, concerns are mounting about the longer-term consequences of a financial system built on negative and low interest rates, and one spurring a rush for risky assets. Fred Cleary at Pegasus Capital said that central bankers avoided a more painful economic bust following the financial crash through their extraordinary monetary policies. But “prolonged zero-interest rate policy creates zombified companies and defers the day of reckoning”, he added.
Central banks are expected to maintain their current accommodative stance for some time. Thomas Costerg at Pictet Wealth Management believes the US central bank “will remain hypersensitive to financial markets”, adding: “It is in perpetual accommodation mode and to some degree it’s trapped by the level of private debt in the system.”
Indeed, in the current environment of narrow corporate credit risk premiums, the Institute of International Finance estimates $19tn of debt securities are due for refinancing this year across the US, UK, eurozone, Japan and key emerging markets.
How does this usually end? Credit stress and a rising level of corporate defaults spark a recession and a severe sell-off in equities, as seen in the early 2000s and during the financial crisis.
That was the point rammed home this week by another Davos delegate. Scott Minerd, global chief investment officer at Guggenheim, warned that while central banks may have delayed the next recession until 2021 or 2022, “ultimately we will reach a tipping point when investors will awaken to the rising tide of defaults and downgrades”.
Investors could be in for more pain this time round. Thanks to central bank policies, government bonds provide little protection against either a more inflationary future or a major shock that triggers a sharp decline in the value of risk assets.