It is 10 years since the last financial crisis, and it has taken that long for normality to return.
For the first time since the crisis, major economies are expanding together. Unemployment rates in the US and UK economies have halved.
However, productivity and investment growth has been on a declining trend in major economies.
This productivity puzzle may simply reflect the fact that, in a digital age, we’re mis-measuring actual, real productivity, but it is disturbing that debt levels in the major economies are now higher than pre-crisis levels. The debt overhang may itself weigh on longer-term potential growth, and could also be problematic should interest rate rises continue.
A potentially bigger problem is financial market bubbles, alongside what some commentators have called “irrational complacency”.
Major central banks never take responsibility for creating asset price bubbles, but it is often cheap money that is to blame. A decade of unconventional monetary policy has amounted to a $20 trillion monetary stimulus, which now threatens the return of financial instability.
There is a risk of market crashes in equities, bonds, and credit markets. Wage inflation might have been absent, but financial asset price inflation most certainly has not been.
In the process, this has created substantial income and wealth inequalities.
Central bankers are realising that their policies might backfire, creating financial instability, though they are publicly careful to play down the risk of market crashes and systemic financial failure.
The Fed has just implemented a third rate hike for this year at the December meeting. However, given the stimulus implied by record highs in US equities and dollar decline, US financial conditions are looser than last year.
There is little ammunition to combat either another recession, or another financial crisis – unless you think ever-lasting quantitative easing or helicopter money is the way to go.
There are more danger signs.
US equity markets are at record highs and the S&P 500 is up around 20 per cent this year. The tech-heavy Nasdaq is up over 25 per cent – reminiscent of the 2000 dot-com crash. Government bond yields are near rock-bottom. The Bank of England has found that the global risk-free rate has touched a low not seen since the 1300s.
At the same time, the ECB has created a credit bubble, with European junk bond yields actually below US Treasuries. It is unsurprising that the ECB is reluctant to withdraw monetary stimulus due to concerns it may trigger another Eurozone banking crisis.
Strategists suggest we are nearing the longest bull market in equities and bonds for 100 years. Risk-adjusted returns have been the strongest on record since the 1980s. Equities, bonds and credit are not usually simultaneously strong, apart from during the Roaring Twenties. It’s no secret what happened then.
And it’s not just traditional markets that have stretched valuations. Other asset classes and instruments are in a bubble.
Bitcoin and fine art are displaying “Eiffel Tower” chart formations, where the fall is just as steep as the rise once you crest the top.
Sotheby’s share price has been a historic indicator of financial crises on the way. A peak in the share price coincides with speculation and record art prices. Guess what it’s pointing at now.
We’re also seeing a return of so-called toxic debt instruments.
Pay-in-kind toggle notes, which allow companies to make interest payments with either cash or more debt, are coming back. When companies have a cash-flow problem, these instruments allow them to “toggle” interest payments. This can catch investors and companies in a deadly embrace when a default wipes them both out.
Ultra-easy central bank policies have created ultra-low volatility. Equity market corrections are now rarely more than five per cent. Investors trust central banks to back the markets so look to buy the dip and not go short. This explains why equity markets seem impervious to geopolitical risk.
These same policies can contribute to herd behaviour, sadly with the result that everyone goes over the cliff in the event of a crash. A big trade at the moment would be to short the CBOE VIX volatility index, based on a belief that low volatility is here to stay.
These conditions have encouraged passive investing, algorithmic trading and growth in ETFs. Passive investment has been described as “equity market quantitative easing”, as money goes in but never comes out.
These signs seem to point to a crash, but it’s worth remembering that, historically, crashes are often caused by innocuous events – ones that fly below the radar. It’s not always immediately obvious what the real culprit is.
Neil MacKinnon is global macro strategist at VTB Capital.
Banking September 15, 2020