Calm before the storm: how central banks are brewing the next financial crisis
A storm is brewing in world financial markets but stock market investors seem to be the last ones worrying about it. There are clear warning signs of global economic slowdown and a glut of headwinds and tail risks to contend with. This devil-may-care attitude could be the market’s undoing before too long. The world is not in great shape for a rerun of any 2008-style disorder.
Normally stock markets are good leading indicators for the economic cycle, but they seem to have lost their bearings thanks to the flood of super-stimulus following the 2008 global crash. Zero interest rates and quantitative easing from the major central banks might have saved the world from deeper disaster but has left deep distortions in financial market decision-making.
Global policymakers craved a return of ‘animal spirits’ in the global economy but not the over-indulgence that cheap and easy money has brought to financial markets in recent years. ‘Irrational exuberance’ has bulled up stock markets to excessive levels and driven some areas of government debt yields into negative territory, trends that are out of sync with underlying fundamentals.
Zero interest rates and quantitative easing (QE) have become more of a bane than a boon, leaving investors exposed on asset allocation as traditional boundaries governing risk and return continue to break down. Wafer-thin and even negative returns in traditional safe-haven investments like cash, treasury bills and government bonds are tempting investors to stick with riskier assets like stocks, derivatives and structured products to bolster returns.
Exposure to stock market risk has been coming down but equity valuations still seem too high and look vulnerable to steeper correction. European investors are still holding up to 44 per cent of their portfolio weightings in equity investments, far too high considering the underlying risks.
Too much complacency exists to the problems piling up and investors would be better off scaling back risk and hedging their bets. The global economy is slowing down and the real worry is whether it turns into a hard landing further ahead. IMF forecasts for 3.4 per cent global GDP growth this year are hard to reconcile with world trade flows slumping 13 per cent from a year ago.
Event risks are piling up around the world. Emerging markets are in a vulnerable state, thanks to the collapse in global commodity prices, bloating current account and budget deficits in the process. Trillions of dollars of emerging market debt is building to unsustainable levels and remains an accident waiting to happen.
Europe’s crisis might have eased but it has not disappeared. Severe political risks continue to simmer under the surface. The risk of a Greek exit from the euro zone or Britain leaving the European Union threaten to spill over into major market mayhem, especially if the euro was put in danger.
Meanwhile geopolitical risk factors remain a dark shadow over global stability. The resurgence of Cold War tensions with Russia, Middle East instability and the spectre of global terrorism all pose major worries for global confidence and could inflict a heavy toll on markets.
But perhaps the biggest systemic risk of all could be the policy glue that has helped bind global confidence in recent years coming unstuck. Markets are so hooked on the super-stimulus from ultra-low rates and QE, there could be a serious run on risk assets when the tap eventually gets shut off and the flow is reversed.
The 2008 crash was sparked by a catastrophic explosion of toxic risk in financial markets, ripping through private sector and government balance sheets. The next crisis could easily be triggered by an implosion of synthetic central bank money when the global policymaking cycle eventually switches direction. It spells disaster for markets pumped up on expectations of an endless supply of cheap and easy money. An air of ‘rational despair’ would quickly settle in.
There is no such thing as a never-ending punchbowl. The US Federal Reserve has already called time on zero interest rates. But when the Fed finally starts to unwind its US$4-1/2 trillion QE asset stockpile in earnest and global liquidity starts to suffer, then the markets will have good reason to panic.
Right now, an uneasy calm prevails. Stocks are not looking too rattled, credit spreads seem reasonably benign and market fear gauges like the Vix volatility index seem relatively settled. But it could easily mark the calm before the storm. After all, they were saying similar things in 2008.
David Brown is the chief executive of New View Economics