It seems only the central banks can stop this bull from running
Central banks are poised to row back on QE despite fears of a market meltdown, writes Tom Rees
The global economy is a risky choice for a guinea pig. Monetary policy doctors from the US Federal Reserve, Bank of England and European Central Bank rushed to the grisly scene, stuck the defibrillator on the patient and prayed.
Extensive quantitative easing (QE) from Western central banks – an experimental treatment which through huge bond-buying programmes pushed investors to move money from safer assets into riskier stocks to aid the stuttering recovery – has now become redundant a decade after the financial crisis.
Global stocks are smashing all-time records almost on a daily basis and the recovery, exemplified by the US and eurozone’s robust growth, have persuaded central banks that life support is no longer necessary.
Overvalued stocks, especially in the US, have made some market-watchers a little tetchy, however.
Four of the 10 stock market crashes since 1929 were preceded by the US Federal Reserve raising interest rates, and five were triggered by share valuations pushing their limits. So, should markets be battening down the hatches as frothiness overflows across the pond and Janet Yellen and the Federal Open Market Committee step up monetary policy tightening plans?
In a report studying the source of the next financial crisis, Deutsche Bank highlighted stratospheric asset prices finally feeling the force of gravity and crashing back to Earth as being the possible trigger for trouble on the global markets.
US stocks are the source of greatest investor angst. The Shiller P/E ratio, a moving average measuring the price-to-earnings ratio over the past 10 years for the S&P 500, shows that equity prices have only ever been this inflated twice before and the historical precedence makes for grim reading.
The measure, which is also known as the CAPE ratio, shows that US stocks are undoubtedly at the pricey end of the spectrum with the S&P 500 CAPE ratio standing at just over 30, far above the long-term average of around 15. According to the ratio, that leaves stock prices nearly as inflated as they were just before the Wall Street Crash in 1929 and a couple of notches below the dot-com bubble, the only other time in history when prices have been deemed more overvalued.
On a price-to-book measure, at 3.19 the S&P 500 is only slightly ahead of the post-1990s average of 2.84. However, the FTSE 100 actually looks slightly undervalued and even more so when using the CAPE ratio, according to data from JP Morgan Asset Management. A ranking put together by German asset manager Starcapital, which compiles a number of metrics including the CAPE ratio and price-tobook ratio, ranks the US as the priciest country for stocks while the UK is considered neither cheap nor expensive.
The Dow Jones has hit a record all-time high so often this year it has barely become noteworthy. Christmas for traders every day has become very mundane, very quickly.
At nearly nine years old, the bull run is a little long in the tooth but they don’t die of old age, they need a trigger. However, Deutsche notes in the study that “there are no obvious triggers for historically high global asset valuations to correct”. Underpinned by accommodative monetary policy, the current run is the secondlongest in history after the nearly 10-year run, spanning the nineties, which resulted in the dot-com bubble bursting in 2000. In the US, suspicion has followed the FAANG stocks – Facebook, Apple, Amazon, Netflix and Alphabet (Google). They have had their wobbles, most recently as investors digested the latest iphone release, but any glimpse of a “tech wreck” has proved fleeting and non-contagious.
Loose monetary policy
Many market doomsayers have drawn the link between central banks in the US, eurozone and UK loosening monetary policy to an extent never seen before with equity prices climbing from peak to peak. Was supping the punch of low interest rates and QE merely hair of the dog, kicking a mind-bending hangover for equities down the road?
Panmure Gordon market commentator David Buik believes that interest rates hold the “key to the Kingdom on equity performance”.
“Provided rates do not go up more than symbolically and the tapering of quantitative easing is very gradual, equities should still provide value,” he explained. “Any threat of prolonged rate increase cycles, then I suspect investors will take their profits and pack their bags.”
Asset-purchasing programmes by central banks to push investors into equities were “not only the largest ever direct government intervention in financials, but also by far the most distortionary”, according to Jan Dehn, head of research at investment manager Ashmore.
Last month, the US Federal Reserve announced that it will begin rolling off its huge $4.5tn balance sheet at a rate of $10bn-a-month. Just last Wednesday the minutes from the European Central Bank’s latest policy meeting confirmed that it is likely to unveil its plan to begin tapering its €60bn-a-month quantitative easing programme this month.
If asset prices have ballooned since the beginning of QE, why wouldn’t tapering reverse that effect and knock stock valuations?
“Circumstances were very different when QE was being implemented,” explains Stewart Robertson, senior economist at Aviva Investors. “At that stage we were heading into the abyss, it was almost like the world was ending. Markets were closing, nobody trusted anyone. People didn’t want to borrow, didn’t want to lend. Everything froze and it was a very scary time.
“Today, the global macro economy is in a much healthier state. So the withdrawal of it, I don’t think will undermine those asset valuations.”
Escalating tensions on the Korean Peninsula and populism’s surge in Europe as austerity-wary voters bite back have been cherry-picked as
possible political triggers ready to drag share prices back down. But equity markets – one of the riskier assets which investors flee from in times of strife in favour of safe havens such as the Japanese yen, Swiss franc and gold – have repeatedly brushed aside Kim Jong-un’s sabre-rattling. Risks that would have sent investors scurrying to safer assets 10 years ago have been swallowed whole by markets without a flinch this summer.
Mr Buik notes that while markets were rattled by geopolitical issues such as the Iraq and Afghanistan wars, today “threats are just brushed away”.
He adds: “Analysts are cognoscente of the fact that if hostilities in North Korea become substantive, it’s more or less ‘good night Vienna’ – so little point calling markets down 5-10pc.”
Catalonia’s break for independence has become the latest to cause jitters.
However, after nosediving 2.9pc on Wednesday, Spain’s blue-chip index, the IBEX 35, instantly erased almost all of its losses the following day.
The threat could come closer to home for US stocks. Markets have been galvanised by Donald Trump’s election, with the US president basking in the Dow Jones’s 24pc rise since November. Equities in the US and Europe have, to an extent, priced in Mr Trump’s attempt to seduce Wall Street in the form of tax reform and deregulation and any failure to follow through could spark a correction. The irony of the anti-establishment president sucking up to the glass jungle of the financial district in lower Manhattan appears to have been lost across the Atlantic and, at the moment, markets are “giving him the benefit of doubt that ultimately some things will come through”, according to Michael Hewson, analyst at CMC Markets.
“The US economy is doing OK and looking fairly stable, which you can’t say for the political situation in Europe. There is no new German government, the prime minister of Spain’s position is looking pretty precarious and he can’t even pass a budget let alone keep the Catalans in order and this is even before you start talking about the Italian economy and government.” But he concludes: “Market participants tend to be optimists until they can’t see any other alternative.”
With the sound of the closing bell in New York marking a seventh consecutive record close, it’s difficult to argue. For now, the bull keeps on running.
‘When QE started, people didn’t want to borrow, didn’t want to lend. Everything froze and it was a very scary time’
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