Global financial markets have their work cut out in 2018

A correction is due and it could come as central banks withdraw stimulus

PUBLISHED : Monday, 01 January, 2018, 12:59pm
UPDATED : Monday, 01 January, 2018, 10:30pm

If 2017 was a year full of hope, 2018 could be the year of reckoning. After all, 2017 is a tough act to follow as economic confidence, global growth and world stock market performance all surprised on the upside last year, helped along by a well-heaped spoonful of monetary super-stimulus. The dilemma for 2018 is how to keep the positive momentum upbeat and forward-moving.

So far there seems little to rock the boat. US President Donald Trump finally came up with the goods, squeezing in his first major piece of legislative success before the year end. The major central banks are still keeping the monetary gravy train moving along at a reasonable pace. None of last year’s threatened bogeymen have surfaced, financial conditions remain supportive and confidence is high.

So where is the catch? The roller-coaster ride of Trump’s promised land of radical shake-up for the US economy captured the imagination of stock market bulls in 2017, but what will step into its shoes in 2018? Maybe a steady stream of global stability, the central banks not withdrawing stimulus too fast and market bulls being content to test new highs should be enough to extend the rally.

Except it never works that way in the real world. Markets thrive on hope and expectations and the font of new initiative is starting to run dry. There is plenty of talk about the bull market running on thin air and testing the boundaries of fair value. Current price-earnings ratios maybe nowhere near the peaks of the 2000 Dotcom boom, but there is still masses to live up to, to justify current price levels.

Comparisons with the Dotcom boom are not out of place. In the run-up to the 2000 bubble, swap and credit spreads looked too compressed, market fear factors such as the VIX volatility index were running exceptionally low and the market was being ramped up by an overdose of market hype and irrational exuberance. Global macroeconomic policies were running fast and loose at the time.

We have entered into a bizarre universe of alternative reality, where markets think it is OK for their governing central bank’s tally of quantitative easing assets to be worth up to one-third of GDP without even balking

Two decades on there are lessons to be learned. Spread products appear far too expensive, the VIX is running close to its all-time low and the market is still whipping up a storm about unlimited opportunities this year. The fact that the rally is being pumped up on a diet of specially engineered central bank steroids gives it the pallor of drug dependency running out of control.

Any rally based on hype is vulnerable, especially in those markets where central bank balance sheets have been bloated by the proceeds of massive bond-buying sprees since 2008. We have entered into a bizarre universe of alternative reality, where markets think it is OK for their governing central bank’s tally of quantitative easing assets to be worth up to one-third of gross domestic product without even balking.

It is a disaster waiting to happen. In this over-leveraged world we live in, we have adapted far too easily to the siren call of the fast-money, speculative, spread-betting, carry-trade brigade that can move in and out of positions quicker than blink, leaving ordinary investors holding the can (and losses) when things go pear-shaped.

The Newtonian rule of market dynamics states that what goes up eventually comes down when rational thinking takes over. A decent size correction is due this year and it must come in the shape of central banks having their epiphany moment. When we wake from the dream of super-stimulus there will be a reality check with a bill that must be paid. Markets will correct on their own accord.

It may have already started and you can see this in the price action of the euro/dollar exchange rate in recent days, jumping to a test of US$1.20 on the back of German inflation rising to a five-year high. German central bankers are terrified we are sitting on a powder keg of demand-pull overheating. If Germany draws a tougher line in the sand for Europe then the market’s cosy notions about perpetual easing are finished. The contagion will spread and risk assets will lurch.

In the past few years we have built a house of cards of endless easing expectations and it will take very little to tip it over. It can start with something very small. Perhaps it already has. Risk-taking can switch to risk aversion in an instant. Caution must be the watchword for 2018.