Warning signs are telling us this is the right moment to exit risk markets

‘The exposure of highly indebted emerging markets to rising short- and long-term borrowing costs pose a multitude of risks to global financial stability’

PUBLISHED : Monday, 03 July, 2017, 12:12pm
UPDATED : Monday, 03 July, 2017, 10:37pm

It is finally starting to dawn on global investors that the perfect world of cheap money, a never-ending stock market rally and limited risk is slowly coming to an end. Global equity markets are finally hitting “the wall” and exhaustion is starting to set in after eight years of plenty. The big question is whether it is a temporary setback in the second-longest bull market on record or the start of a major correctional slide.

The odds are tilting to the latter. America’s much-vaunted “Trump Bump” rally seems to be turning into a “Trump Slump” as the investment mood continues to dim over the US President Donald Trump’s faltering agenda. Markets still have cheap money by the boatload, but it is inevitable that global monetary conditions are set to tighten. Central banks are laying bare preferences for future tougher policy in no uncertain terms.

The wake-up call has arrived and investors need to take some protective measures

Interest rates around the world are heading higher. The availability of cheap money will start to dry up, not dramatically at first, but, in the long run, it is all a reminder that things will turn back to normal. Investors cannot have their cake and eat it. And there will be consequences for investment intentions.

The US Federal Reserve is raising rates and later this year the mountain of money artificially created by the Fed’s quantitative easing programme will begin to erode. And more recent hawkish hints by the European Central Bank and the Bank of England are rattling market fears that global super-stimulus has finally reached the end of the line.

There is a new paradigm in town and markets need to adjust to it fast. Central bankers are looking beyond the post-crash horizon to a changing reality. Markets have prospered through eight years of sluggish growth, subdued inflation and rock-bottom interest rates, but it is not the job for central banks to keep propping up undue speculation and irrational exuberance now that the economic picture has consolidated.

With the International Monetary Fund expecting world gross domestic product growth to hit 3.5 per cent this year, prolonging the market’s “easy ride” is anathema to central banks. The reality for markets is a higher cost of funds and more expensive leverage. Investors will need to think much harder about asset allocation decisions. The sure-fire, one-way equity bull market bet is about to end.

The key question for markets is whether recovery is sustainable in the long run once the pit-prop of quantitative easing is removed and interest rates press higher. It is true that most major global risks have receded for the time being, but they have not disappeared for good. They may seem dormant for now but have huge potential to resurface with a vengeance in future.

The 2008 global financial crisis might have passed, but many of the after-effects remain lurking in the shadows. Balance-sheet restructuring, debt deflation and austerity cutbacks are still working their way through the system. High-risk financial innovation and esoteric synthetic investments are still posing massive headaches for official regulators and supervisors.

Fears about a China slowdown might have eased, but markets still need to come to terms with long-term risks to the domestic economy from an excessive build-up of credit and risky lending. The exposure of highly indebted emerging markets to rising short- and long-term borrowing costs pose a multitude of risks to global financial stability.

In Europe, the Greek debt crisis and potential shock waves from Britain’s Brexit vote last year might have subsided for now, but they are far from over. And consumers, businesses and investors used to years of low interest rates remain untested on how they deal with tougher credit conditions in future. The potential pitfalls to sustainable recovery should not be treated lightly.

With stock market valuation levels running at their highest levels for 15 years, it is no surprise investors are starting to feel fazed by the central banks’ intentions, especially while the macroeconomic backdrop looks less than rock-solid.

It may well be the case that investors need a period of consolidation for economic fundamentals and market valuations to come back into synch again. There might be no sudden day of reckoning but gradual market attrition looks likely as the monetary policy clamp continues to tighten in the months ahead.

The wake-up call has arrived and investors need to take some protective measures. Policymakers may take their time, but investors need to stay vigilant to sudden routs in market confidence.

David Brown is chief executive of New View Economics