Both equity and bond markets are riding high, suggesting an over-valuation in financial markets that is unsustainable over the longer-term. The equity market in the US and Europe stands at a record high, whilst the bond markets appear to be shrugging off concerns around inflation and over-leverage. The bullishness we see in both markets creates a divergence that is ultimately incompatible. In the long-run, one has to be wrong.
The questions we should be asking
Whilst equity market performance can be rationalised by:
- Strong US economic growth (2.4% expected this year), and
- the effect of a new President promising tax cuts, deregulation and infrastructure investment,
there are still unanswered questions. For example, shouldn’t the economic growth mean higher bond yields and increased inflation (which is high but below anticipated levels)? Trump’s wish list (see blog post from 9 May) promises greater investment, economic activity and growth, which could account for the record highs in equities compared to a year ago (before Trump was elected). But, if these engines for growth actually materialise, then it’s happening at a time when the US is at full employment. That then pre-supposes a shift in the participation rate, leading to more people joining the active labour force. That’s a big supposition and, if that happens, then the bond markets have to be overvalued on the basis that the available resources are unable to meet the growth in demand, leading to overheating. At the moment, that doesn’t appear to be priced in.
An artificial market?
You could argue that bond markets face another problem. Whilst investing in equities would appear to make sense because the yields on bonds are so low, that’s on the basis that bond market prices are free. But are they? The US central bank, for instance is sitting on some $4tn of government debt, which has forced bond yields down. So you could argue that there’s a false market in bond yields, which makes any relative return comparison with any other asset class misleading. The same is true in the UK and in the Euro area with regards to relative returns on bonds and equities.
Significant domestic and global risks
Looking across various volatility and risk indices they are all back at pre-2007 highs. In other words, these markets are eerily sanguine and bullish about all of the risks that are out there. These include:
- Trump could fail – there’s no sign that the promised tax cuts, deregulation and infrastructure spend will actually happen. There’s also enhanced political risk around this President lasting a full-term without having political crisis after political crisis.
- The fallout from the UK leaving the EU.
- UK jobless rate at its lowest since 1975 – with the economy running at full tilt, where can growth come from if not increased interest rates?
- Core inflation in the UK is above 2% (headline CPI is at 2.7%) and whilst some may argue this is temporary as a result of the falling exchange rate, which is a possibility, it begs the question of why equities are booming if this rise is merely a temporary phenomenon.
- General election is looming, which would appear to be a done deal, but we have been surprised before.
- Wider global risks, such as continued uncertainty in the Middle East, simmering conflict in Southern Sudan, overvalued credit markets in China, issues of Russian adventurism and weak recovery in Europe.
Surely we are facing a market correction?
So there are clearly big challenges facing financial markets. What seems odd is that markets are back to pre-2007 levels, when UK growth was at 3%pa and both emerging markets and the developed economies were growing at above trend rates, when we have clearly identified a number of risks.
In other words, markets could be ripe for a fall; they are positioned for correction. Therefore, perhaps now is the time for us to be wary about the signals we take from current pricing in financial markets.