People queue outside a vaccination centre in Sydney on June 24 as residents were largely banned from leaving the city to stop a growing outbreak of the highly contagious Covid-19 Delta variant spreading to other regions. Photo: AFP
by Nicholas Spiro
by Nicholas Spiro

Markets show a worrying lack of concern over Delta variant and other risks to growth

  • It is increasingly apparent that most investors are no longer concerned about threats to the global economy and markets
  • They seem just as indifferent to virus-induced threats to growth as they are about growth-induced threats to financial stability

As the second half of the year gets under way, sentiment in financial markets remains resolutely bullish. The benchmark S&P 500 equity index gained 14.4 per cent in the first half of this year, its second-best performance since 1998, according to data from Bloomberg.

Global stocks, meanwhile, stand at a record high. Spreads on junk-rated corporate bonds in the United States have fallen to their lowest level since before the 2008 financial crisis.

Even in emerging markets, where the recovery from the Covid-19 pandemic has been hampered by slow vaccination roll-outs and fresh waves of infections, bond and equity funds have attracted US$135 billion in net inflows this year. That is compared with US$55 billion for the whole of 2019, according to data from JPMorgan.

Yet, the statistics do not tell the whole story. In the past few months, it has become increasingly apparent that most investors have stopped worrying about threats to the global economy and markets.

While complacency has been a recurring theme in the past decade, mostly because of the distorting effects of central banks’ quantitative easing programmes on asset prices, the insouciance is striking, given the acute risks in post-pandemic markets.

To be sure, the remarkable progress in deploying vaccines in advanced economies has been a major factor pushing markets higher.

In a sign of the extent to which success in ramping up immunisation programmes has changed the economic landscape, the US is now ranked first in a global Covid Resilience Ranking compiled by Bloomberg, mainly because of the strong headway made in reopening the economy.
Europe, moreover, has exceeded expectations. Having initially bungled its immunisation drive, the euro zone is playing catch-up on vaccines, boosting the outlook for growth as infection rates fall and restrictions are lifted.

What is more, markets continue to be supported by unprecedented amounts of monetary and fiscal stimulus, reducing investors’ sensitivity to risks and vulnerabilities.

In Bank of America’s latest fund manager survey, published on June 15, a net 18 per cent of respondents said they were taking on more risk than usual, close to the highest percentage since the survey began.

Yet, even if one takes all these factors into account, the fact that complacency has set in just weeks after investors were fretting about the consequences of the surge in inflation – and at a time when the pandemic is far from over – is concerning.

The speed at which fears about inflation receded is particularly troubling. While there are good reasons to treat the current spike in prices as a temporary, reopening-induced surge, the risk that it has a longer-lasting impact is significant and should not be dismissed lightly.

Even the US Federal Reserve, which continues to view the increase in inflation as transitory, is concerned, so much so that it expects to begin raising interest rates a year earlier than previously forecast.
Markets are pricing in the best of all worlds: rapid and sustained growth, a temporary surge in inflation and super-loose and error-free monetary policy. Not only does this smack of overconfidence, it shows investors want to have their cake and eat it, too. They are placing too much faith in the ability of central banks to manage conflicting economic pressures without destabilising markets.

Furthermore, judging by the record high levels at which stocks are trading and the collapse in US corporate bond spreads, one would think the pandemic ceased to be a danger some time ago.


The global spread of the highly contagious Delta variant of Covid-19

The global spread of the highly contagious Delta variant of Covid-19
Yet, a cursory glance at the latest data shows that a resurgence in infections and delays in deploying vaccines continue to pose a threat to the recovery. Asia’s economies, which previously led the world in the fight against Covid-19, are lagging far behind on vaccinations.

Some countries, notably Indonesia and Thailand, are suffering their worst outbreaks, keeping restrictions in place and exacerbating global economic divergences.

Even Britain, one of the countries fastest to deploy vaccines, is struggling to contain the spread of the highly infectious Delta variant, forcing countries in Europe to tighten restrictions for British holidaymakers and endangering much-needed tourism revenues.

However, the most important reason to guard against complacency is the dangerous combination of lofty valuations, particularly in the US, and the challenges facing governments and central banks in normalising policy, aptly called “Pandexit” by the Bank for International Settlements in its annual economic report published on Tuesday.

Last month’s hawkish tilt by the Fed was an effort to prepare investors for the eventual withdrawal of stimulus. Developing economies are already tightening policy, with the revival of China’s deleveraging campaign proving the most consequential for markets.

The uncertainty over the conditions and timing of the removal of policy accommodation by the Fed is far and away the biggest test for asset prices, with elevated valuations raising the stakes further.

There is nothing new about complacency in markets. What is remarkable is that investors are just as unconcerned about virus-induced threats to growth as they are about growth-induced threats to financial stability. Despite the pervasive bullishness on Wall Street, caution is entirely warranted.

Nicholas Spiro is a partner at Lauressa Advisory