On February 18 the Chinese Year of the Pig begins. I am counselled by my Chinese friends to undertake nothing risky during the upcoming porcine year. It might easily turn from sweet to sour.
As I write, the global equity rally that began last summer is still motoring along. Last May, the world got a whiff of the sort of damage that tightening liquidity could do and didn’t like it. Monetary conditions have been easing ever since, particularly in the US.
It is a challenge to see how the rally will end. Long-term interest rates remain very low. Published inflation – but not asset price inflation – is declining. The Federal Reserve is believed to be more likely to ease than to tighten.
Global economies are in the cool but seductive platinum blonde phase, with lower US growth being offset by stronger European and (hoped for) Japanese performance. China is having its statistical soft landing as officials rush to report numbers to fit the new mantra of “less growth good, more growth bad” by putting the right numbers in the right boxes.
Geopolitics looks quiet, bar the occasional terrorist attack. Kim Jong Il and Iranian President Mahmoud Ahmadinejad have increased their power but the occasion when they might choose to test it is far enough off for markets to dream on.
Of course, there are bubbles around: investment banker and commodity trader bonuses, nickel and zinc markets, luxury housing in London and Hong Kong (at all-time peaks), art, markets for leveraged loans and buyouts, private equity deals, Chinese IPOs, credit default swaps, infrastructure funds, Asian order books for Lamborghinis and Porsches, Asian prices for Rolex watches (stolen, second-hand or new)... and so on.
Are any of these bubbles likely to bring the financial system and/or the world economy to their knees? After all, the bursting US, UK and Australian housing bubbles failed to undo us.
This amazing financial stability is attributable to the ability of derivative markets to diversify the risk on assets and liabilities. Credit was once the core of the financial system. It is now seemingly but a junior partner to the markets for exotic instruments that control the pricing and availability of credit itself.
This arrangement has redefined the relationship between financial markets and what is called the real economy. Not only has the volatility of inflation (the key to long-term cost of capital) fallen but also that of GDP, household income and labour markets.
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US liquidity* as a % of GDP |
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standard deviation from trend |
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Note: * includes M2 money supply, credit market debt and derivatives.
Source: Datastream, US Treasury, Independent Strategy |
How can such bliss ever end? Sure, calm reigns in the nexus between financial markets and the economy. But this is not necessarily a sign of sustainability. Nothing is more likely to cause instability than a long period of stability.
Low and stable interest rates or inflation are not a sure-fire recipe for financial and economic stability. Such periods might create the conditions for subsequent crises because they encourage excessive borrowing (on the assumption that interest rates will be low for ever) and overly liberal lending (on the assumption that the economy, profits and the lender’s cost of money will be stable or better for ever).
And total credit or liquidity (if the full range of asset money is included) has reacted by growing at rates several standard deviations above trend. According to research by the Bank for International Settlements, this is a strong signal of crashes to come.
Only two things can bring the party to an end: an abrupt decrease in risk appetite or a rising cost of long-term capital. If money were to cost more or become suddenly scarce throughout the liquidity pyramid, multiple bubbles would pop in unison.
Many bubbles burst of their own volition. One day, people come to market and the pigs are too dear. So they stop buying pigs. A generalized rise in the cost of capital would also do the trick. This could be the result of the US economy being stronger than the market expects, Europe powering ahead and Japan catching up. That would close the global resource gap smartly and could start to generate inflation.
If the same economic scenario were to cause a sharp collapse in the dollar because the rest of the world had narrowed its growth gap with the US, this could perversely force up the cost of capital in the savings-starved US. Bingo! Same result for asset markets. The US is the ultimate source of global liquidity. And under this scenario, interest rates would be rising in Japan too, so lessening capital outflows in search of higher yields.
One or both of these things is going to happen and probably in the Year of the Pig.
David Roche is president of Independent Strategy Ltd, a London-based research firm.www.instrategy.com