Are investors flirting with euphoria or complacency?

Unprecedented is an overused word in financial markets – but this time it’s justified.

Since the global financial crash, central banks have engaged in a global economic support operation like no other, with the world’s three key organisations gorging on US$15 trillion of bond buying to save financial markets from themselves and prevent a recession that might have been … well, unprecedented.

As of last month’s US Federal Reserve meeting, we are now witnessing an unwinding of those purchases. Fed chairwoman Janet Yellen says the central bank will liquidate $10 billion of the bonds on its $4.5tn balance sheet every month.

Ms Yellen believes the US economy is strong enough to take it, and markets are robust enough to withstand the modest implicit tightening of monetary conditions, even as inflation is still short of the Fed’s target.

The Fed has been preparing the markets for this move for months, in the hope that a gradual shift from quantitative easing (QE) to quantitative tightening (QT) will barely cause a ripple in the monetary pond. But not everyone is convinced that the consequences of this move are obvious or predictable.

Back in July, JPMorgan chief executive Jamie Dimon warned of potential disruption saying: “We act like we know exactly how it’s going to happen and we don’t”. In other words, QT is a “known unknown” – there’s a lot of good guess work but no one has done it before.

There are other reasons for investors to be wary. Since the crash and the beginning of the QE programmes, the world has changed. Global debt has mushroomed to over $200tn and the Bank for International Settlements (BIS) recently suggested at least $13tn of derivatives exposure may be missing from official figures. How will holders of this debt stock behave?

Within this story there are also some other areas of particular concern like China, where S&P Global Ratings has just joined Moody’s in cutting the country’s sovereign credit rating. Beijing has been trying hard lately to deepen its capital markets and entice overseas bond buyers, but foreigners still only represent about 2 per cent of the market for central and local government debt. Any default risk therefore largely remains concentrated in Chinese hands, and concentrating credit risk is rarely a good idea.

There are a plethora of current market fears: most assets appear fully priced and therefore vulnerable to a correction or worse; US president Donald Trump’s long promised tax and infrastructure bills are yet to appear; and he has a provocative approach to international relations that could go badly wrong. On top of all this the financial system itself has changed.

If any of this leads to a much talked about, but so far unseen, major “riskoff” market pullback, hopefully the financial system is now robust enough to cope without QT being sacrificed. Only we can’t be quite sure how the system will respond given the average age of a Wall Street trader is now said to be 30 and most will not have seen a proper market meltdown before.

All of this makes current portfolio construction challenging. Professional equity and bond fund managers are struggling to generate anything better than index matching performance – and many are failing to achieve even that. One approach is to adopt a barbell strategy towards risk. Since no one can predict the timing of a pullback and markets grind higher, Altaf Kassam, the head of research and strategy at State Street Global Advisors, suggests an “overweight” rating in growth equities like emerging markets, while at the same time overweighting long dated US treasurys for downside protection.

He worries that, “current market pricing for risk is flirting with “euphoria” or complacency, which is a warning signal of the need to be risk balanced in the search for return.

Others in the market encourage finding opportunities in income stocks. Like Jane Shoemake, the investment director for global equity income at Janus Henderson Investors, who believes equities are, “supported from an economic backdrop even with a removal of central bank support”.

Ms Shoemake points out that global second-quarter dividends hit a new record at $447.5bn, a 5.4 per cent yearon-year jump. Quarterly records were achieved in both developed and developing economies. She likes financials, technology and industrials for their strong dividend growth.

It is a market truism that nearly all major market pullbacks are caused deliberately or accidentally by central bank’s tightening monetary conditions. The Fed’s current gentle approach to normalisation doesn’t appear to be a major cause for concern right now, but for the most risk averse there is always comfort to be found in holding higher weightings of cash or gold, even though most market professionals are unlikely to recommend significant positions at this point.

Geoff Cutmore is co-anchor of Squawk Box, CNBC’s flagship show in Europe. The National and CNBC International are global content sharing partners