Stock markets on both sides of the Atlantic were in euphoric mood last week.
On Wall Street, the Dow Jones industrial average leapt to record levels,
while in London the FTSE 100 index notched up repeated six-year highs,
making an eventual, and long-awaited, return to its all-time record a real
possibility.
On the face of it, these exuberant spirits across global financial markets are
quite rational. There are plenty of good reasons for investors to feel
cheerful, and to propel equities onwards and upwards.
Much of any justification for the present outbreak of optimism can be traced
to a recent spate of “upside surprises” over existing macro-economic
conditions and future prospects in the world’s key economies. Globally,
things have been going better than many pundits and investors anticipated,
even as recently as the turn of the year.
This rosy picture was strongly reinforced by last week’s very buoyant growth
figures for both the eurozone and Japan — two economies that have, over the
past decade or more, seldom failed to disappoint.
Not this time, though. A resurgent Japan charged to the top of the growth
league among the Group of Seven developed economies, with GDP climbing a
heady 1.2 per cent, in the best performance in almost three years. The
eurozone notched up fourth-quarter growth of 0.9 per cent, lifting its
annual pace of expansion to a six-year high of 3.3 per cent.
For once, America looked like the laggard. Still, across the Atlantic Ben
Bernanke, the Federal Reserve chairman, added encouragement for Wall Street
with reassurances that the US seems set to shrug off the slump in its
housing market and to enjoy a continued, steady expansion, with inflationary
pressures gradually subsiding.
Plenty of cause, then, for financial markets to fizz. Yet as investors party,
they appear relatively heedless of the pressing reality that central bankers
are intent on playing their traditional role amid the festivities, and plan
to take away the punch bowl.
Sure, the resilience of US and global growth, and the revival of Japan and
Europe are great news. But the neglected consequence is that world interest
rates now look set to rise further and faster than many had expected.
The track on the dancefloor at this particular party ought to be The
Automatic’s Monster — “What’s that coming over the hill, is it
a monster?” The monster in this case being an impending tightening of world
monetary conditions, and a further contraction of already declining global
liquidity. Investors, though, are too busy jumping up and down to the music
to register any ominous theme.
Yet in the eurozone, a March interest rate increase from the European Central
Bank is now, in effect, a done deal, with another move upwards likely to
follow by summer.
Here, the Bank of England last week kept a further base rate rise firmly on
the agenda, with some economists believing that this could come next month.
And in Japan, the central bank may well double official rates this week,
even if that would still leave them at an ultra-low 0.5 per cent. In the US,
rates are going nowhere fast, but Mr Bernanke’s analysis last week further
undercut lingering market hopes for an early cut by the Fed.
Optimists in the markets will retort that none of this is cause for concern:
imminently tighter policy is merely a side-effect of economic success. But
this is to ignore a more fundamental shift in global financial conditions
that is likely to ensue.
As the first chart above, from Merrill Lynch, shows, recent years have seen an
extraordinary period of global liquidity growth, with the world's markets
awash with capital. This glut of money unwound substantially through recent
months as the Fed completed the long campaign of rate increases that it
began in 2004, before liquidity growth stabilised at levels just above 10
per cent.
Now, however, the latest phase of monetary tightening in the eurozone, Britain
and Japan seems set to further squeeze liquidity. This could well prove to
be a watershed for markets, triggering a period in which volatility rises
sharply from its mainly very subdued levels of the past few years.
The second chart above shows the so-called Vix index. This is a benchmark
measure of market volatility that is calculated from the pricing of options
linked to the US S&P 500 index. Comparisons show that volatility tends
to spike upwards when global liquidity growth slides into single figures —
just what looks likely to occur shortly.
There is a good case for believing, then, that some time this year there will
be a bout of increased market turbulence, if not turmoil.
The International Monetary Fund observed, as long ago as last April, that
asset price volatility tends to increase, with falling prices for risky
investments, as economies enter the mature, later periods of the business
cycle, and begin to run short of capacity, leading to greater inflation
risks and rising interest rates. We are now moving into just such a time.
The grounds for being wary of the scope for heightened market volatility look
even greater if you factor in the unusual risks accumulated by institutions
during the recent period of abundant liquidity stimulated by earlier,
historically low official interest rates.
As ample supplies of capital fuelled a boom in demand for investments of all
kinds, the resulting rapid rise in asset prices depressed the returns being
earned, triggering the well-known “search for yield”, with moves into
riskier asset classes and increased use of leverage, not least by hedge
funds and private equity players.
The threat plainly is that, should volatility now rise sharply, a scramble to
unwind some of the riskier positions and more outlandish speculative bets
piled up during a time of unusually benign conditions will amplify the
fallout. Turbulence could mutate into turmoil. The true danger may be less
than this, but what is apparent is that present market exuberance is likely
to prove, if not irrational, then at least excessive.
