British Prime Minister David Cameron recently did a blunt and glum assessment of the global economy. In an article published last week in Britain’s Guardian newspaper, he wrote, “Six years on from the financial crash that brought the world to its knees, red warning lights are once again flashing on the dashboard of the global economy. As I met world leaders at the G20 in Brisbane, the problems were plain to see.”
The gloomy predictions come at a time when equity markets are at an all-time high. S&P500 is currently at 2064, more than three times its level compared to 683 in March 2009. Similarly, Dow Jones Industrial Average is now at around 17,685 as against 6,626 in March 2009. The UK’s FTSE 100 is a mere 250 points away from its highest-ever level reached in 1999. Equity markets have witnessed a sustained bull run in the last five years. It is easy to mistake this for an economic recovery if one believes that everything is fine and dandy in the world as long as stock markets are going up. This surmise could lull most world leaders into their comfort zones and they can easily take their eyes off the ball, spending with abandon like the good old days before 2007. So, it takes some courage and cheek to go against the tide and make a contrarian forecast, like the British Prime Minister has done. I, for one, have long been a staunch critic of the so-called economic recovery in the United States and Europe. My suspicion is that inflated stock prices are due to the Fed’s intense quantitative easing (QE) programme and near-zero interest rates. If stock markets decrease from hereon, it has to be because of an interest rate hike ‘not engineered by the Fed’.
Cameron’s warning is useful not just for the world leaders but also for the man on the street for a couple of reasons. First, it brings some reality back to the markets that risks exist. Ebola, Russia, ISIS, Middle-East tension, a stagnant eurozone and a recession in Japan should be sending shivers down the market’s spine. However, investors find it remarkably easy when markets are booming to look the other way around, as risks start to build up. So, just because the S&P 500, Dow Jones or FTSE 100 is creeping closer to record highs does not mean that all is well in the world. Second, the next couple of years could see even more risks accumulate, so we shouldn’t take 2014’s performance for granted. In fact, things can get to boiling point and then explode, causing market carnage.
As we near the end of 2014, clouds are gathering on the horizon. The Fed is planning to hike interest rates for the first time since 2007. If oil prices continue to fall, then we could see oil producers start to halt production, which could cause a price shock when we least expect it. Even if oil producers don’t try to engineer an oil price rise, there are risks to the economy since hidden inflation is rife in the western world. A significant reduction in purchasing power of dollars and euros in the US and Europe because of higher money supply could trigger economic meltdown, as the British Prime Minister seems to suggest.
And David Cameron is not the only one sounding the alarm when it comes to bubbles. Recently, a group of Deutsche Bank economic strategists wrote in their research report that the sovereign bond market is facing a bubble and is already experiencing quite a bit of frothiness because the risk-return trade-offs are skewed in favour of the governments. The concern is that the bond markets have nowhere else to go to because it’s already in the hands of governments and central banks. I have felt for some time that the ultimate bubble, when we look back a few years from now, is going to be sovereign debt, both US and other, because it is way below any kind of reversion to the mean of interest rates. If you look at where the US 10-year has averaged in the last three decades before the crisis, it has been north of 6%. If it reverts back to that level at some point, there will be terrible losses in the long-term Treasury market, and those will probably be accentuated in other areas of fixed income.
Even Fed Chair Janet Yellen has concurred that stocks are in a bubble, but noted that the Fed wouldn’t raise rates in order to burst them. She was quick to pass on the buck to the financial regulatory bodies for bringing about stability to markets rather than monetary policy, although it’s the Fed’s artificial rates and money printing that’s producing bubbles.
My concern is that there is nowhere left for this bubble to go given that it is now in the hands of the lenders of last resort—governments and central banks with regulators ensuring other large captive buyers. Although I imagine that this bubble needs to be maintained to ensure the solvency of the current financial system, the best-case scenario is that it slowly pops over time via negative real returns for bondholders. The worst-case scenario can be worse than what David Cameron predicts.
By K Vaidya Nathan
The author, formerly with JPMorganChase’s Global Capital Markets, is a finance faculty at the University of Connecticut
