The View

If Theresa May’s huge blunder can’t disrupt this bull market, what can?

‘Global investors continue to climb a wall or worry, brushing off every risk and vulnerability that emerges and choosing to take a glass-half-full approach to any market development which bodes ill for sentiment’

PUBLISHED : Monday, 12 June, 2017, 7:02am
UPDATED : Monday, 12 June, 2017, 10:51pm

Another week, another illustration of the enduring resilience of financial markets.

In the early hours of Friday last week, a decision by British Prime Minister Theresa May to call a snap election backfired spectacularly as the opposition Labour party, which had been trailing in the polls by as much as 20 percentage points just several weeks ago, made strong gains, resulting in a hung parliament and plunging the country into further political turmoil just as it prepares to start negotiations on its withdrawal from the European Union.

This was the result markets had feared, with some investors having predicted that the pound would fall as much as 7 per cent against the US dollar in the event of an inconclusive election outcome.

Yet by the end of trading on Friday, the mood music in markets was an all too familiar one: calm bordering on insouciance.

The subdued volatility levels in markets stem from years of ultra-loose monetary policies

Not only did the pound drop less than 2 per cent against the greenback, US equity markets hit new record intraday highs as the Vix index, Wall Street’s “fear gauge” that measures the anticipated volatility in US stocks, ended the week just above its historic low set in February 2007.

Over the past year, Teflon-like conditions have prevailed: nothing that has been thrown at markets, not even the shock of Britain’s decision to vote to leave the EU and the election of Donald Trump as US president, has managed to stick.

Global investors continue to climb a wall or worry, brushing off every risk and vulnerability that emerges and choosing to take a glass-half-full approach to any market development which, on the face of it, bodes ill for sentiment.

In the case of renewed political instability in Britain, many traders and investors are now pinning their hopes on a change in the next government’s Brexit strategy. Since May was seeking a strong mandate for a “hard” Brexit, markets are interpreting the disastrous election result for the British premier, whose position is now increasingly tenuous, as the catalyst for a softer Brexit, which would keep the country in the European single market.

Indeed, international investors are seeing silver linings in every cloud hanging over markets.

The most conspicuous example of investors’ willingness to focus on upside scenarios for markets as opposed to downside ones is the dramatic rally in equities following Trump’s election as president. Stock investors remain bullish despite the damaging allegations against Trump and the debilitating impact the scandals are having on his administration’s ability to advance its pro-growth agenda.

Rather than fret about the possible impeachment of Trump, many equity investors seem to be taking comfort from the reduced scope for “a massive fiscal stimulus, which could force the [Federal Reserve] to accelerate its policy tightening”, as Standard Chartered noted in a report last month.

This begs the question: what, if anything, could precipitate a sharp and sustained sell-off in markets?

For the time being, investors are being reassured by improving fundamentals in both advanced economies and emerging markets, as well as strong growth in corporate earnings, particularly in the US. In a sign of the extent to which fears surrounding the euro zone have abated, last week’s dramatic rescue of Spain’s sixth-largest bank, which under Europe’s new rules for failing banks required losses to be imposed on the lender’s shareholders and junior bondholders, failed to spark wider contagion, in stark contrast to the 2011-12 euro-zone crisis.

More tellingly, China’s clampdown on financial leverage, which has put the country’s equity and debt markets under renewed strain and contributed to the recent sell-off in commodities, has so far conspicuously failed to undermine sentiment towards emerging markets, mainly because of investors’ belief that Beijing will prioritise stability and growth in the run-up to November’s National People’s Congress.

Yet the elephant in the room is central banks.

The subdued volatility levels in markets stem from years of ultra-loose monetary policies. It stands to reason, then, that the withdrawal of policy accommodation will, eventually, start to take its toll on investor sentiment, particularly when the European Central Bank and its Japanese counterpart join the Fed in taking measures to tighten policy.

Indeed, the longer monetary conditions remain overly stimulative – the percentage of fund managers claiming monetary conditions have become too loose is now at a record high, according to a monthly survey by Bank of America Merrill Lynch – the bigger the scope for a sharp and disorderly sell-off.

Markets are not as Teflon-like as it appears. At some point, something will stick and, almost certainly, make quite a mess.

Nicholas Spiro is a partner at Lauressa Advisory