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 Sunday Telegraph - Money & Business - - Front page -

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.”

Po­lit­i­cal risk

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.

Trump dump?

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’

Traders work on the floor of the New York Stock Ex­change; be­low Don­ald Trump’s elec­tion gal­vanised the mar­kets, but the jury is still out on whether he can de­liver his prom­ises Mis­siles pa­rade across Py­ongyang’s Kim Il Sung Square, in­set be­low, but...

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