Big changes in policy frequently herald market turning points. Britain severing its 43-year membership with the EU is about as big a policy reversal as could be imagined. Policymakers in Britain and continental Europe will henceforth be making it up as they go along. Multiple uncertainties abound. Does this mean that an equity bear market is now inevitable?
Of course investors are bound to want compensation in the shape of higher risk premia for the uncertainty stemming from Britain’s potential exit from the EU. That said, the normal preconditions for a full-blown bear market are not yet there.
Monetary policy across the developed world remains accommodative. Having modestly raised its policy rate last December, the US Federal Reserve is in exceptionally cautious mode, as we saw last week.
Despite the devaluation of sterling it is hard to believe that there is sufficient inflationary pressure in the UK economy to justify an immediate rate rise. Meantime central banks’ unconventional measures continue to underpin the valuations of both bonds and equities.
The central banks are the biggest group of price insensitive buyers in the market. That insensitivity is potentially stabilising even if it causes distortions in particular markets.
To take one obvious case in point, the fixed rate offered on US dollar interest rate swaps against floating rate payments traditionally gives a positive spread over US Treasury yields, reflecting the counterparty risk of the banks involved in the transaction. Yet spreads have sporadically turned negative since central banks have been at play.
That kind of distortion mirrors but is much less damaging than the larger economic distortions that result from ultra-low or negative interest rates. One result is a misallocation of resources whereby low borrowing costs direct capital to suboptimal investments and keep zombie companies alive. Negative rates weaken the banking system since they cannot be passed on to retail customers. The outcome is a squeeze on margins.
At the same time the example set by British voters will reverberate around the eurozone, highlighting the political difficulty of creating a more effective infrastructure for a flawed monetary union.
The urge to protest against the arrogance of the European political elite will be strengthened. Note, too, that on Friday European stocks fell more than British stocks. In a week when markets spectacularly misread what was happening in the UK referendum, that was one market judgment that struck me as being on the mark.
All of which underlines the extent to which central banks are keeping uncomfortable reality at bay. As the Bank for International Settlements remarks in its latest annual report, the world faces a “risky trinity” of conditions: productivity growth that is unusually low; global debt levels that are historically high because debt has been acting as a political and social substitute for income growth; and room for policy manoeuvre that is remarkably narrow. There lies much of the explanation for today’s exceptionally low interest rates.
Normalisation of monetary policy would be a more obvious catalyst for a bear market than Britain’s exit from the EU. But that remains a long way off. The more immediate risk concerns the decline in the potency of the central banks’ tool kit.
Unconventional measures worked well to offset the immediate impact of the financial crisis. They are proving less effective at dealing with the longer-term structural problems faced by Japan and the eurozone.
And now currency markets have subverted the impact of the negative rates introduced by the Bank of Japan and the European Central Bank. As long as the Fed remains cautious it is difficult for other central banks to engineer competitive devaluations.
It could be that the tipping point for markets will come when the great mass of investors concludes that the wizards of central banking are emperors with no clothes and that anaemic global growth provides inadequate support for current equity valuations.
Fears about the fragility of the eurozone banking system will then resurface. So too will worries about market liquidity. A system which has seen a shift in trading from the traditional dealer community to principal trading firms playing with algorithms has survived squalls but has yet to be tested in a financial hurricane.
In the short term “risk off” will be investors’ mantra. Further ahead, forecasting the timing of a tipping point is a gift given to few.