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Calm before the storm? Major central banks must act fast to prevent another global crash

Policymakers in the ‘Group of Seven’ nations continue to throw caution to the wind – but not before investors have had their fill of booming stock, credit and bond markets

PUBLISHED : Monday, 16 October, 2017, 9:30am
UPDATED : Tuesday, 17 October, 2017, 9:46am

If the world’s major central banks could be held responsible for being asleep at the wheel in the lead up to the 2008 global financial crash, then there is a definite case for careless driving in the build up to the next market meltdown.

World stock markets are hitting record highs, with investor sentiment spinning out of control. It is all down to extreme policy super-stimulus, interest rates running too low and market liquidity awash with too much officially-engineered synthetic money.

There will be tears before bedtime, but not before investors have had their fill of booming stock, credit and bond markets.

It has become a Pleasure Dome of never-ending festivity, with markets hell-bent on pushing the limits of super-charged sentiment, risk-taking and leverage. In the old days it used to be called “irrational exuberance”. Nowadays it seems to be “fair game” especially since it seems to have the central banks’ seal of approval.

Policymakers in the “Group of Seven” nations continue to throw caution to the wind, mainly focused on “weak” inflation and ruing fears about insipid economic recovery, rather than the implicit risk of overheated financial markets.

It is clear in the US Federal Reserve’s recent policy minutes, with some board members still expressing concerns about weak inflation trends, leaving markets rife with speculation about softer rate tightening intentions ahead.

It has become a Pleasure Dome of never-ending festivity, with markets hell-bent on pushing the limits of super-charged sentiment, risk-taking and leverage. In the old days it used to be called ‘irrational exuberance’

It is the same in Europe, where markets are more inclined to believe the European Central Bank will steer towards easier policy for quite a while rather than fall in with Germany’s demands for battening down the hatches against future inflation risks.

Meanwhile, in Britain, the Bank of England seems more pre-occupied with future fallout from a hard Brexit landing to worry too much about overcooking the pot for UK financial markets.

In Japan, the beat goes on for the Bank of Japan’s endless pump-priming with super-loose monetary policy aimed at keeping economic growth and inflation expectations afloat. The stock market is booming, with the Nikkei close to beating a 21-year high, yet the economy still needs to break free from decades of dismal economic performance.

These are hardly hallmarks of an enduring global rally. Investors are indulging in ‘ostrich economics’, burying their heads in the sand to a host of big problems.

It is classic bull market mentality, over-playing the positive side and downplaying the risks. Investors also have the problem of being cash-rich, with limited “copper-bottomed” investment opportunities.

With so much depending on the continuation of easy policy, global recovery hopes and stock market confidence are balanced on a hair trigger, especially once the clamour for tougher policy starts in earnest. Voices for common sense and normalisation remain in the minority for now, but will intensify over time.

Economic risks still abound, not least in the US from President Trump’s much-vaunted reflation reforms, where failure to deliver could knock global stock market hopes for six.

In the euro zone, expectations are running high for sustainable recovery once the ECB begins its policy taper, but this is a big ask considering the post-crash austerity mindset still affecting Europe.

Investors are indulging in ‘ostrich economics’, burying their heads in the sand to a host of big problems. It is classic bull market mentality, over-playing the positive side and downplaying the risks

The mountainous weight of global bad debt exposure still poses major risks of loan defaults hurting economic confidence and financial market stability.

In Europe, the banking sector has amassed a US$1 trillion bad debt portfolio, with Italian banks alone accounting for up to 30 per cent of the total.

It means ongoing balance sheet restructuring poses a major drag on growth, as banks need to set aside more capital to cover default risks, leaving fewer funds to meet borrowing needs effectively.

There is no shortage of risk events which could sour the feel-good factor for financial markets. Britain and Europe are spiralling towards a hard landing over Brexit which could seriously dent global market confidence. Catalan independence demands will be no cake-walk for political stability in Europe. Meanwhile, the threat of military conflict between America and North Korea is still an unquantifiable risk for global markets. The list is endless.

Central banks are well aware of the dangers but are under intense pressure to strike a careful balance between nurturing growth and keeping a lid on excessive risk-taking. The longer they take to normalise policy, the greater the chances they set the markets up for a bigger fall.

Central banks are between a rock and a hard place, but preventing an epic global bubble from bursting must be their utmost concern.

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