Markets might look calm, but they are behaving abnormally

The pessimistic view is years of loose monetary policy have made investors complacent

Gillian Tett 

Demand for risky debt is so high that the spread between safe and hazardous corporate debt is a wafer-thin 50 basis points © Bloomberg

Do markets look a little weird right now? That is a question many investors might be asking. In recent weeks geopolitical tensions have intensified, and the monetary policy cycle is turning in both the US and Europe.

Equity markets quivered on Monday, which was the day after China said it would retaliate against new US tariffs by imposing tariffs of its own, but the jitters were modest. Indeed, the MSCI world equity index is up 10 per cent up for the past 12 months — never mind that pesky trade war.

This is odd. But what is more striking — and alarming — is that equity valuations are far from the only bizarre feature of today’s markets. If you peer into the weeds of global finance, you will see peculiarities sprouting all over the place.

Consider credit. These days, pundits often wail about the rising risks attached to corporate debt. A survey from Bank of America Merrill Lynch shows that 42 per cent of asset managers now think that developed world companies have borrowed too much money— beating a previous 2008 peak of 32 per cent.

No surprise there, perhaps: corporate borrowing has indeed soared, amid numerous leveraged buyouts and mergers, and almost half of all US corporate bonds issued this year carry a risky rating of triple B-plus, triple B or triple B-minus. What is startling is that investors are not running scared. Instead, demand for risky debt is so high that the spread between safe and hazardous corporate debt (bonds rated triple A and triple B respectively) is a wafer-thin 50 basis points. In 2012 it was 200bp.

The second puzzle is the so-called dollar “term premium”— the US Federal Reserve’s calculation of the extra compensation investors require to convince them to tie up their money in longer term bonds rather than rolling over a series of short-term ones. Normally this would be positive in this stage of the business cycle. The Fed is raising rates, inflation is edging up and the US government will sell lots more debt in the coming years, due to tax cuts and rising budget deficits. But the US term premium has been zero in recent months. More peculiar still, JPMorgan calculated that the global yield curve has recently inverted for the first time since 2007.

A third oddity is the lack of correlation between currencies and interest rates differentials. Derivative prices currently suggest that investors expect to see a widening gap between US, European and Japanese interest rates. Citigroup calculates that the spread between projected overnight rates for dollars and euros is 250 basis points, up from 25 basis points in 2016 and 100 basis points last year.

In past economic cycles this gap has led to a stronger dollar. That has recently appeared — a bit. On a trade weighted basis, the dollar is 5 per cent stronger than in February, but it is also 4 per cent lower than it was at the start of the year. The correlations seem to have broken down, as Catherine Mann, Citi’s chief economist, points out.

The list goes on — and on. Ms Mann thinks it is odd that house prices keep surging in countries such as Denmark, the Netherlands and Canada, even as the monetary policy cycle turns; and that investors keep rushing into US equity markets, even though valuations should favour non-US assets. Then there is the fact that gold prices have fallen 5 per cent in the past two months — even though geopolitical turmoil normally boosts the price of gold. And the Vix index (which reflects expected US equity market volatility) has recently fallen below 15, after rising above 30 earlier this year. That looks completely counter-intuitive given the geopolitical risk — and the fact that some investors holding Vix derivatives suffered big losses a mere four months ago, when this index gyrated.

So what explains these odd features? One optimistic explanation might be that investors are so wildly confident about global growth that they presume companies will tackle their debt and produce earnings that justify the share prices. Under this theory consumers would continue paying down their mortgages, as inflation remained low (perhaps because digital disruption will suppress labour costs). But there is another pessimistic explanation: years of ultra-loose monetary policy have made investors so complacent that they are mis-pricing risk.

I fervently hope the first explanation is true. But I fear the second is a more likely bet. Either way, the key point is this: don’t assume that markets look “normal” today even if they are (mostly) calm, especially not in a geopolitical world that looks anything but peaceful, let alone normal.

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