Don’t be surprised if you feel an icy blast ripping through global financial markets right now. A long overdue, ill wind of risk aversion is settling in after nearly nine years of plenty. If you are an investor that hooked up to the post-2009 rally, then you need hardly complain. You will have had a good run for your money. All good things eventually come to an end and the central bank inspired Great Reflation trade has finally reached the end of the road.
The circle of life that governs financial cycles is reasserting its immutable logic. As sure as night follows day, bull markets eventually fade away as the jaws of the bear market ultimately snap shut. Markets rallied on the back of huge central bank super-stimulus and now that boost is being withdrawn, it is game over for the exultant tide. There is little left on the radarscope to justify much more jubilation. It is time for correction, reflection and consolidation.
It is not to say the world economic recovery is in poor shape or that we are about to fall victim to another dire contagion crisis akin to the 2008 crash. But markets are overextended on a flood of cheap and easy leverage, speculation is rife and the bulls are pulling in their horns. If the first trading month is supposed to set the tone for the rest of the year, January’s rout bodes badly for 2018.
World equity markets are taking their cue from the turnaround in global bond markets. Money market rates are too low, the recovery cycle looks overdone, inflation remains a nascent threat and the biggest bond market buyers, the central banks, are about to abort one of the biggest bond-fests in history. It is no surprise bond yields are pressing higher and borrowing costs pushing up.
Stock markets are looking addled and in need of good news. If the drop in money market rates and long term bond yields was the spark igniting the great reflation trade, now that funding costs are heading higher the appetite for risk should be entering into deeper introspection about prospects for global self-sustaining recovery ahead. The jury is still out on that one.
How high rates and yields are set to surge is the US$15 trillion dollar question investors should be asking themselves right now. The US Federal Reserve is already rattling nerves by intimating a faster incline in rates than previously assumed. If the Fed funds rate is heading to normal levels in the 3 to 4 per cent zone then US Treasury yields still have a significant way to go on the upside.
The Fed is also hitting markets with hard home truths that bond yields should be going higher in any case as a delayed reaction to stronger growth. It is not just the Fed’s exit as the dominant buyer-of- last-resort of treasury bonds under quantitative easing which is doing the damage. The weight of stronger growth, rising inflation expectations, tighter money and higher risk perceptions are all taking their toll on bond market confidence.
The assumption of underlying US economic growth at 2.5 per cent, stable inflation around 2 per cent and the return of “bear steepening” in the US treasury curve could easily set a target of 10-year bond yields over 5 per cent in the next year, close to peak levels prevailing before the 2008 crash and roughly double where they started this year. Not a serious sell-off, but enough to do significant damage all the same.
As far as asset allocation goes, there are few places left for investors to run and hide. Stocks and bonds enjoyed parallel rallies under quantitative easing, so as super-stimulus unravels, global equity and fixed income markets should suffer in tandem too. It will be like re-arranging deckchairs on a sinking ship, going down with all hands.
The good news is world financial markets are so flush with excess loose cash that it has to go somewhere, providing a safety cushion in the process. It is a matter of how far global equities plunge as sentiment begins to crumple. Judging by the implosion of confidence in recent weeks, a further downward correction of 10 to 20 per cent seems a reasonable bet.
Global markets have reached tipping point and it’s time to hunker down and take stock.
David Brown is chief executive of New View Economics