Markets priced for perfection imperiled by rising risks

Global asset markets are priced as if the world economy is in perfectly upward trajectory, but a rising raft of risks suggests the best bet for investors could be on a secular recovery for the safe haven US dollar.

The threat of protracted economic slowdown, gnawing geopolitical tensions and an imminent end to nonstop easy money are there for all to see. Markets can only shrug it off for so long.

Market fear gauges like the VIX market volatility index have begun to trend higher from historically low levels. 

Investors should be looking for higher returns to compensate for implied higher risk. Instead complacency seems to have set in.

The world's major stock benchmarks are locked in a five year-long rally and US Treasury bonds are charging along in a 33 year super bull market. 

That has encouraged investors to turn to more esoteric assets to boost returns - commodities, exotic derivatives, structured products and hedge funds.

It is no surprise that the likes of the International Monetary Fund are warning about excessive risk-taking in financial markets.

The world's major central banks are getting nervous too.

They have craved a return to healthy and exuberant markets since 2008 when they were forced down the path of unconvential monetary policy and quantitative easing (QE). That would signal a return to more normal economic conditions.

What they now face is a monster of their own creation - a market in which animal spirits run wild, fed by excessively cheap money that has papered over the cracks of the legacy problems that remain in the international banking system six years after the global financial system almost fell apart.

Make no mistake though, a change is in the air.

Investors will feel it most from the United States. Five years into its asset buying programme – QE – the Federal Reserve is about to turn off the monetary printing presses. 

The Fed is calling time on zero interest rates and paving the way for higher interest rates that will halt the hitherto endless flow of easy money to US consumers, businesses and markets.

Without a doubt it will be a shock to the system and is bound to have adverse effects on economic confidence. The 4.6 per cent GDP growth rate notched up by the US economy in the second quarter of this year could well mark the peak in the present recovery cycle.

As the Fed wrestles to contain its massively inflated balance sheet - quadrupled in size in the last five years - it is not only domestic growth potential that will be affected. 

Much of the Fed’s funding trove has found its way overseas into emerging markets and high yield assets. The end of US QE could mark a significant sea-change in global investor sentiment.

Near-zero interest rates elsewhere also have nowhere left to go other than up in the long run. Bank of England Governor Mark Carney has already started warning that rates could go up more quickly than previously anticipated. 

The spectre of higher rates is not good news for investor confidence, which will also take a hit when markets inevitably start to look at the global economy with a sharper eye. 

The euro zone is sliding back down into a spiral of recession and deflation. The European Central Bank is dragging its feet so much that whatever policy response it comes up with will probably deliver far too little, too late. Political risks are also becoming deeply embedded. The survival of European Monetary Union and euro cannot be guaranteed in the long run.

Asian fundamentals fare no better. Japan’s economic stimulus strategy – ‘Abenomics’ – appears to be losing its edge. Growth potential has lost momentum and inflation seems to be slipping back again, threatening the government’s long run economic agenda.

None of this is being lost on China’s economy. The downturn in global growth prospects is already casting a much chillier wind on China’s outlook. Growth has plateaued out to a level well below the meteoric expansion rates enjoyed in the early 2000s. 

As investors look for more assured performance in an uncertain world, the US dollar will inevitably be rediscovering its roots as a reserve currency. 

The prospect of higher US rates, stronger relative growth and better safe haven protection make a compelling case for dollar bulls. The dollar’s secular recovery looks set to extend.

Reprinted courtesy of South China Morning Post 29 September 2014