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Stability leads to instability

And other market thoughts.

Many major economies, developed and emerging, have been experiencing a period of unusually long economic expansion, albeit at a slower pace than previous cycles. It is estimated that the current economic expansion in the United States is the second longest in history, and will be the longest if it continues beyond May 2019. A similar development is playing out in many other parts of the world.

When long expansions start to mature, capacity constraints are encountered, high inflation becomes a feature and macro imbalances materialise. These could include over-investment, misallocation of resources, a narrowing of margins and unsustainable leverage or bubbles in credit or debt. A lengthy period of macroeconomic stability can encourage excessive risk-taking in markets and the economy. As American economist Hyman Minsky said: “Stability leads to instability. The more stable things become and the longer things are stable, the more unstable they will be when the crisis hits”.

Thankfully, at this stage and after one of the longest expansions in history, these potential risks to the current cycle are however relatively subdued. While the major economies have experienced rather slow but steady growth since 2009, global financial conditions have been quite buoyant with most major equity markets reaching new all-time highs.

Although the present economic cycle has not reached overheated levels, the mature or late stage of the financial market cycle, as opposed to the fundamental macroeconomic cycle, could however be more of a risk. A number of sentiment and market indicators and elevated asset prices are reflective of this. We are seeing evidence of softness in key international real estate centres such as Toronto, London and Singapore while many other cities are at stretched levels given unsustainable growth rates. We have experienced weakness in global bond prices, in particular, US bonds. With history as a guide, the flattening of the US yield curve has raised concerns and conjecture about the next possible recession. If the US Federal Reserve continues to raise interest rates such that the yield curve inverts, many market pundits would view this as a classical signal of trouble ahead.

Given the sanguine market views among many market participants at the beginning of the year, the increased financial market volatility experienced to date appears not to have dented the bullish bias. For many the slogan remains one of “buy-the-dips” after a sell-off as sentiment remains largely upbeat. Some big house brokers have however taken a more cautious outlook with one propounding the catchphrase of “sell-the-rip”.

Markets have to contend with the threat of potential international trade wars as a protectionist mood surfaces, coupled with heightened geopolitical tensions and developments. Within this environment, it would appear that markets may have to adjust to an environment of quantitative tightening as the withdrawal of global monetary stimulus and rising real interest rates impact confidence and raise market risk premiums. The US Fed has been reducing the size of its balance sheet and is in an interest rate hiking cycle. The European Central Bank and Bank of Japan are set to join the tightening cycle in coming quarters following nine years of unprecedented global monetary stimulus or easing, and bullish markets.

While long expansions become more susceptible to these vulnerabilities, the duration of the macroeconomic cycle is not necessarily a catalyst for market weakness. It would take serious financial turbulence and trouble to threaten the current macroeconomic cycle.

Nonetheless, with asset prices remaining high relative to history and central banks tightening policy, the possibility of a serious deterioration in sentiment could trigger weakness in financial markets. After a lengthy period of exceptional calm, markets might even overshoot on the negative side, eventually impacting the global economy.

Bear in mind that economic conditions could, as in the past, remain relatively positive for some time even if and when financial markets have started to turn bearish as stock markets, which are a reflection of sentiment, tend to lead the economy. Investors may think the stock market will be fine because the economy looks good. This tends to be a catch during market turning points because by the time the economy deteriorates, the stock market could have lost quite some value, the 2008 bear market and ultimate recession being a typical example. Market pundits should thus be alert to the potential disconnect between the two at stock market turning points.

Fabian de Beer is director of investments at Mergence Investment Managers.

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