The View | The calm before the storm in stock markets, or the storm before the calm?
Central banks’ monetary stimulus has helped stocks surge to record levels, but the question now is what happens when the withdrawal of that liquidity begins in earnest
Hardly a day goes by without a warning of the dangers of elevated valuations in financial markets.
Signs of froth have been evident in many parts of the markets for some time but are coming under increasing scrutiny because of the withdrawal of monetary stimulus by the world’s leading central banks, led by the United States’ Federal Reserve.
In its latest quarterly review published in September, the Bank for International Settlements warned that asset prices remain heavily dependent on the ultra-low yields on government bonds stemming from years of extraordinarily loose monetary policy. Prices continue to rise, moreover, because of the “unprecedentedly gradual pace of policy normalisation” and, more worryingly, because of international investors’ “belief that central banks will not remain on the sidelines should unwanted market tensions arise.”
If the BIS is correct in its assessment of market conditions – central banks’ fear of tightening policy too aggressively and the seemingly never-ending succession of fresh record highs in global equity markets suggest it is – then concerns about asset price bubbles will only intensify in the coming months.
Just in the last few weeks, corners of the market where valuations have become the most stretched have come under strain because of growing nervousness about markets priced for perfection.
Last week, US high-yield, or “junk”, bond funds suffered their second consecutive week of outflows and the largest withdrawal of money in two years, according to data from Bank of America Merrill Lynch. Year-to-date flows into the frothy US non-investment grade corporate debt market, where spreads, or the risk premium, recently reached their tightest levels since the 2008 financial crisis, are now in negative territory.
Another major area of concern is US stocks which last week hit another fresh all-time high, buoyed by rapid gains in technology and energy stocks. According to the most popular valuation measures, US equities are significantly overvalued. Based on the so-called cyclically adjusted price-to-earnings ratio, or CAPE, which compares stocks to their average earnings over the previous 10 years, US shares have not been this expensive since the months leading up to the Wall Street crash of 1929 and the bursting of the dotcom bubble in 2000.
