Global financial markets have enjoyed unusually calm conditions over recent years but strategists at two major investment banks, Bank of America Merrill and JP Morgan Chase, believe that a sharp correction could be due as early as this autumn.
Comparing current markets to Icarus in flying too close to the sun, both warn of a “Humpty Dumpty” fall ahead, caused partly by the role of the world’s central banks in inflating asset prices through their policies of quantitative easing (QE) and record low interest rates.
BofA Merrill’s chief investment strategist, Michael Hartnett, who has warned for some time that the monetary stimulus resulting from QE is excessive, cites various signs of excess in the markets such as:
• High-yield bond issuance regularly touching record levels.
• This month’s issue by Argentina of a 100-year sovereign bond, which triggered heavy investor demand despite the country’s past defaults.
• Facebook’s market capitalisation now exceeds that of the entire MSCI India index.
• This year’s record highs for tech funds, where investment inflows have been rising at the fastest annualised rate in 15 years.
Hartnett notes that a recent survey showed so-called “millennial investors” – those aged between 18 and 34 – currently allocate just 30% of their portfolios to equities compared with 46% by older age groups. Around a quarter of their investment is in cash while 17% foes to “alternatives”.
He says that any rise in millenials’ participation in the equity market should be regarded as evidence that the market is at or near its peak and a fall is imminent. “Greed/Icarus take time to kill, but peak liquidity and peak profits [mean a] big top in autumn,” the bank’s weekly note on investment flows warns.
This could mean that the Federal Reserve, which has been gradually moving US interest rates higher since December 2015, could even reverse the process and start easing next year.
Another warning sign is that US stock market capitalisation as a percentage of nominal gross domestic product (GDP) – the best measure of valuation according to legendary investors Warren Buffett – is nearing an all-time high, although as yet there is “limited irrational exuberance” in the flows and positioning among older, institutional investors.
Hartnett’s remarks were echoed by Marko Kolanovic, global head of macro, quantitative and derivatives research at JP Morgan Chase. He writes that risk assets such as equities have been rallying for an extended period while market volatility has remained near record lows.
“While fundamentally volatility should not be high, it is clear to us that the current macro environment does not warrant all-time low volatility either,” he comments.
The Fed’s three rate rises in the past 18 months and the ending of its five-year QE programme back in October 2014 are likely to be followed in due course by the European Central Bank (ECB) and Bank of Japan (BoJ). This will remove many of the factors that have supported high valuations across financial assets, according to Kolanovic.
“Medium term, this is likely to lead to market turmoil and a rise in volatility and tail risks,” he concludes.
A similarly pessimistic note is struck in the Bank of International Settlements’ (BIS) just-published report, which warns that rising stock markets have become detached from underlying values and that unjustified exuberance has replaced last year’s pessimistic response to political upsets such as the Brexit vote in the UK and the election of Donald Trump as US president.
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