Investors’ blindness to risk has pushed the asset-price bubble to alarming levels
While the rally is likely to persist for some time yet, investors have been warned – and by members of the Davos elite no less
As the world’s political, corporate and financial elite descended on the Swiss ski resort of Davos on Tuesday for the opening of the annual meeting of the World Economic Forum, the mood was unmistakably bullish.
The International Monetary Fund had set the tone a day earlier when it issued a new set of forecasts showing that the global economy is enjoying the “broadest synchronised growth upsurge since 2010”.
Yet it did not take long for the sceptics to voice their concerns.
A major theme at this year’s Davos is complacency in financial markets. The extremely benign global economic backdrop, coupled with the persistence of ultra-low bond yields despite the beginning of the withdrawal of monetary stimulus, have driven valuations in debt and equity markets to record highs. This has desensitised international investors to a plethora of financial and geopolitical risks.
Michael Corbat, the head of Citigroup, put it succinctly when he said on a panel at Davos that “there is a numbness out there that’s concerning. When the next [major sell-off] comes – and it will come – it’s likely to be more violent than it would otherwise be if we let some pressure off along the way.”
Make no mistake, the Davos elite see the writing on the wall.
The stronger the momentum behind the rally and the loftier the returns on assets, the greater the risk that a major correction will occur. Goldman Sachs threw these dangers into sharp relief on Monday when it published a note showing that risk appetite around the world has risen to its strongest level since 1991.
The “numbness” that Corbat and other executives attending Davos are worried about is evident in the degree to which assets have become mispriced. While there are many examples of this, the ones which stand out, and are most worrying, are the following:
European debt: On Wednesday, the publication of a purchasing managers’ index survey by IHS Markit showed that the euro-zone economy is now growing at its fastest clip in 12 years, with European firms recruiting staff at the briskest pace since 2000 and price pressures running at their highest for seven years. Yet monetary policy is still being run as if Europe’s economy was suffering a depression.
The yield on German two-year bonds remains deep in negative territory even though Germany’s economy is expanding at its fastest pace in six years. More worryingly, nearly a third of euro-zone bonds are negative-yielding, according to an index compiled by JPMorgan, including the 2-year debt of Italy, the bloc’s most vulnerable economy. This is deeply alarming. The shift towards tighter monetary policy in the euro zone could well lead to a bloodbath in European debt.
Junk bonds: An even more egregious case of mispricing is in the high-yield, or “junk”, bond market. When sales of sub-investment grade US corporate debt enjoy their strongest start to the year since 2014, helping push down spreads (or the risk premium) to their lowest levels since 2007 in the face of a tightening in US monetary policy, it is clear that “irrational exuberance” has taken hold.
In a sign of the scale of the mispricing in the junk bond market, the average yield on European high-yield bonds fell below the 2 per cent barrier in November for the first time, even dropping below the yield on benchmark 10-year Treasury bonds.
This shows that investors have stopped discriminating between risky corporate bonds and the supposedly risk-free debt of the US government.
Volatility trade: The most blatant case of mispricing in markets is the volatility trade. Hundreds of billions of dollars are backing bets that volatility in equity markets will continue to remain subdued. The “short volatility” trade now amounts to a staggering US$2 trillion, according to a report by Artemis Capital Management.
While betting against volatility has proved extremely profitable over the past couple of years, the “short-vol” trade is feeding on itself, exacerbating vulnerabilities in markets so that when volatility finally does erupt – which it inevitably will at some point – the sell-off will be that much more disorderly. Artemis compares the “short-vol” trade to a snake “that is blind to the fact that it is devouring its own body”.
At Davos, Ray Dalio, the head of Bridgewater, the world’s largest hedge fund, said the process of self-cannibalisation has already started, with bonds entering a bear market and potentially facing the biggest crisis in 40 years.
While the rally is likely to persist for some time yet, investors have been warned – and by members of the Davos elite no less.
Nicholas Spiro is a partner at Lauressa Advisory