High time for global investors to start connecting the dots
Last Friday, the benchmark S&P 500 equity index rose above the 2,500 mark for the first time ever as international investors downplayed North Korea’s latest missile test and mounting concerns about stretched valuations in stock and bond markets.
The rally in the S&P 500, which has surged nearly 270 per cent since its low in March 2009, is now the second-strongest bull run in the history of US equity markets.
There are plenty of other indications that sentiment continues to remain buoyant. The Vix index, Wall Street’s so-called fear gauge which measures the anticipated volatility in the S&P 500, currently stands just a whisker above its lowest level in two decades. The 10-year US Treasury yield, meanwhile, is 25 basis points lower than where it stood at the start of this year while the dollar index – a gauge of the greenback’s performance against a basket of its peers – has plunged 11 per cent, leading to a sharp easing in financial conditions as I explained in an earlier column.
Yet for every sign that markets remain resilient, there is an indication that sentiment is becoming more fragile. If investors bothered to connect all the dots of fragility, the mood music in markets would be noticeably less cheerful.
One of the biggest dots of vulnerability is investor perceptions of global monetary policy.
The current calm in markets belies growing anxiety that investors may be misreading central banks’ policy signals or, more worryingly, that central banks themselves may be underestimating the dangers of withdrawing stimulus.
Just last week, investors were caught off guard by comments from policymakers at the Bank of England suggesting that interest rates may rise sooner than expected, possibly as early as November. These hawkish remarks sent the pound surging to its highest level against the dollar since the Brexit vote in June 2016.
If the timing of a 25 basis point interest rate increase in Britain is able to cause such a stir, then it is fair to say that the removal of stimulus by both the Federal Reserve and the European Central Bank, the world’s two most influential central banks, is likely to prove far more damaging to sentiment.
Years of ultra-loose monetary policy have distorted asset prices. One of the clearest indications of this lies in the eurozone where yields on benchmark Spanish and Italian 10-year government bonds have plunged from 6-7 per cent in July 2012, when the ECB pledged to do “whatever it takes” to keep the bloc intact, to close to 2 per cent. So it is almost inconceivable that the end of quantitative easing will not prove disruptive.
As Citigroup correctly notes in a recent report, “even small balance sheet adjustments may create outsized responses in markets – especially when several central banks are adjusting policy simultaneously”.
Yet it is the second dot of fragility which is more concerning, and which makes the first one that much more consequential: expensive valuations in global bond and equity markets.
Not only are stock markets at record highs, more prudent investors are becoming nervous about the risk of a sharp correction. The latest survey of fund managers published by Bank of America Merrill Lynch last week revealed the biggest increase in the share of investors who are buying protection against the threat of severe sell-off in over a year.
Valuations in bond markets are also worryingly stretched. Yields on US corporate debt are close to all-time lows while spreads on emerging market corporate bonds are just a few basis points above their historical lows.
It is dangerous enough that leading central banks are calling time on years of ultra-accommodative monetary policies. It is doubly risky that this is happening when asset prices are at record highs. As Citigroup rightly notes, withdrawing stimulus “would be less disruptive if market valuations were fair rather than expensive”.
Other areas of vulnerability in markets include the escalation in geopolitical tensions, Donald Trump’s crisis-ridden US presidency and the worrying degree of complacency over China’s economy.
Some investors are beginning to connect the dots, as the sudden increase in hedging activity reported in the fund manager survey shows. Most investors, however, still believe that a sharp correction is unlikely, probably because they have grown accustomed to low volatility and swift recoveries in asset prices after every sell-off.
While market bulls have consistently been proved right over the past several years, the combination of a removal of stimulus and stretched valuations is far too dangerous for investors to ignore.
Nicholas Spiro is a partner at Lauressa Advisory