Hewson's View
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SINCE the global financial crisis in 2008, central banks have generally responded by flooding the world with liquidity - cheap money and very low interest rates, especially in the US, Europe and Japan.
The hope has been to lift their economies out of recession, to return to sustainable economic growth.
This is somewhat ironic, as an essential cause of the GFC arose in the Greenspan era at the US Fed, through the mid naughties, when he flooded the world with liquidity, that drove a quest for yield that, in turn, encouraged the development of a host of debt products, like subprime loans, CDOs, credit default swaps etc. - where risks were underpriced - and all of which collapsed in the crisis, along with stock and credit markets.
Moreover, so far at least, all this liquidity hasn't worked as they had hoped.
Six years on, most developed economies are still relatively weak, with Europe still barely out of recession, and it has "cost" much more than the authorities ever imagined in terms of the liquidity provided.
Low interest rates have stimulated very little, sustained, consumer and business confidence or activity, and even less willingness in the corporate sector to invest.
Yet, there has been much speculative activity, with money flooding into emerging markets and stock markets, all chasing yield.
This all begs the question how all of this will come to an end, and how will the authorities unwind?
How much of the improvement in stock markets is sustainable, or will they correct?
If so, when, and by how much?
Important questions, especially now the US Fed is "tapering" its money creation.
Of course, if I could actually answer these questions accurately, I wouldn't be here, would I - rather living in the South of France with my feet in a bucket of champagne.
However, I can point out the major factors at work, and suggest probabilities.
Clearly, key stock markets have benefitted from this flood of cheap money chasing yield.
With very low interest rates there have been few investment alternatives.
This has seen a sizeable "risk premium" open up in stocks over bonds, not as wide yet as say pre-GFC, but significant.
My concern is that this premium will only be "validated" if corporate earnings continue to improve, but it is hard to see how they can unless there is a significant acceleration in capital spending which, as I said, hasn't been happening.
So, a reassessment of stock markets seems inevitable. What might trigger it?
Some feel that it has been happening already, over the last week or so, as markets have been jolted by geo-political tensions such as Russia/Ukraine, Israel/Hamas, US air strikes over Iraq, and so on, combined with mixed economic news.
Others feel, including me, yes, but this is not "the big one".
For that, we may have to wait until the US Fed ends tapering, and starts tightening, raising interest rates, thereby significantly changing sentiment in both stock and bond markets.
Another risk is climate risk, which is being seriously underpriced in financial markets, much more so than was the case in relation to subprime and debt obligations pre-GFC.
The big global investors, pension and super funds, sovereign wealth funds, and university endowment funds are heavily over-invested in carbon-exposed industries.
A global agreement on emissions reductions, or on carbon pricing, or new technologies etc, could see many of these investments "stranded", seeing their share prices collapsing.
The biggest danger is "compression" in financial markets, where some of these factors come together to drive an "over-reaction", accelerating a downturn in stock prices.
So far, markets have been surprisingly complacent and dismissive of these risks.
It will not always be so!