Here’s a somewhat scary statistic for those meant to know about these things. After a six year bull market, the typical stock in America’s S&P 500 shares index is valued on a multiple of more than 18 times estimated forward earnings. This is not just expensive by historic standards but super expensive. In fact, according to analysis by Goldman Sachs it ranks in the top 98th percentile of historic valuations since 1976 – or in other words one of the highest in nearly 40 years.
It scarcely needs saying that these peaks tend to signal the top of the cycle, with some kind of bear market or crash just around the corner. But hold on a moment, you might say, we’ve barley recovered from the last downturn. It surely cannot already be time for another? Regrettably it can. Most business cycles last little more than seven years and if anything they tend to be getting even shorter. The US economy contracted in the first quarter and has shown few signs of significant recovery since. As for the eurozone, spring has brought a rare burst of growth, but few believe it will last, let alone be strong enough to undo the damage caused by the crisis.
Meanwhile, the prospect of Greek default continues to hover over everything like a permanent sword of Damocles, threatening at any moment to plunge much of the advanced world back into financial and economic turmoil. If economic prospects look so precarious, why are stocks, bonds and other asset prices so high? Part of the answer lies in central bank money printing, or so called “quantitative easing”. This has now all but ceased in Britain and America, but where the Anglo-Saxon world has left off, Europe, Japan and China have taken over. The world is awash with cheap liquidity.
This in turn is creating new sources of financial instability to replace the old incubators of it in the banking system. History rarely repeats itself exactly, and if looking for crisis there is absolutely no point in looking for them in the last one. Banks are no longer a threat to the financial system or the economy. To the contrary, they have become so shrunken by credit loss and neutered by regulation that they have gone be the other way, and if called on to help counter renewed turbulence elsewhere in financial markets would no longer be up to the job. As Kevin Corrigan, head of fixed income a Lombard Odier, puts it: “New regulation designed to make the financial sector less risky has paradoxically damaged the shock absorbing capabilities of the banking sector, and thereby made other parts of the system more risky.”
Banks are no longer willing to act as warehouses for ordinary buyers and sellers of financial assets. Denied this ‘market making” capacity volatility in some markets has already picked up significantly, with often violent swings in prices and yields form one day to the next. With eurozone bond yields climbing sharply this week, Mario Draghi, president of the European Central Bank, warns us to expect further turbulence to come. So where do the new threats come from? Hedge funds and other leveraged operators such as private equity – according to popular imagination, the original evil of finance- can reasonably be excluded. Even if they were thought dangerous, they are too small to be systematically important. Rather the main threat comes from conventional asset managers. Their portfolios have been swollen to bursting since the onset of the crisis by central bank money printing. Recent analysis by the International Monetary Fund found that globally these funds today hold intermediate assets worth some US$76 trillion ($106 trillion), equivalent to 100 per cent of world GDP. Via burgeoning bond markets, they have come to replace the banks as primary sources of finance for governments, corporations and even households. The upshot is that great chunks of credit intermediation have shifted from the banking to the non-bank sector. Assets under management of some of the bigger players in advanced economies are as large as those of the largest banks, and show similar levels of concentration. Now add to these markets the wholly price incentive buying power of the central bank printing press, and all the conditions are again in place for a major train crash. Normally an investor judges value on the basis of perceived prospects for the asset involved – credit – worthiness, market position, the outlook for growth, inflation, interest rates and so on.
The central bank printing press has rendered these market judgments substantially meaningless, and by flooding the system with cheap money, encouraged indiscriminate, herd-like pursuit by asset managers of credit risk almost any price. Worse, the downtrodden banks no longer have the capacity to act as effective market makers if and when perceptions change. In a panic, prices would plummet, with nothing to act as financial fire breaks. Nobody can tell you when the next crisis will come, but the notion that governments have somehow got on top of the forces of financial instability is for the birds. Credit expansion obeys the water bed principle – push it down in one area, and it merely rises up somewhere else. Central bank money printing undoubtedly helped stem the last crisis, but if it has also sown the seeds for the next one, you have to wonder about its long term consequences.
Article from NZ Herald, Thursday 11 June 2015 – Telegraph Group Ltd