Melt-up before the eventual meltdown
What is the outlook for S&P 500 in 2018? Some, like Jeremy Grantham of GMO, predict a melt-up scenario where the index ends up at somewhere between 3,400 and 3,700 points. Some investment banks strike a pose of moderation and sobriety and predict high single-digit or low double-digit returns. But most agree that the S&P stocks are expensive by most measures, with or without the inclusion of technology stocks. Of course, valuation alone was never enough to end a bull market. This market did not display the classic signs of a bubble until the last few months and, conversely, did not decline when economic growth was disappointing and the world looked like it was coming apart (China, eurozone) on a few occasions between 2012 and 2016. The absence of economic dynamism globally was reflected in the prolonged slump in commodities prices but stock prices in the US were extraordinarily resilient.
But this is not the first time that the two have diverged. Between 1995 and 1998, the S&P 500 index went up gradually. Commodities did not play ball. They had other things to worry about, such as the Asian crisis, for example. However, between 2003 and 2008, commodities and stocks rallied together. There are plenty of similarities (from 2016 onwards) to 2006-08.
Then, as now, two forces were at work. One, there was a synchronized global recovery. The stock market bubble—technology, media and telecom—collapse did not leave too many economic scars as there was not much leverage involved. Hence, recovery was swifter. China had been admitted to the World Trade Organization in December 2001. Asian currencies were still cheap relative to the dollar after the collapse of 1997-98.
As the recovery gathered steam in 2003 and 2004, the US was too slow to tighten, as now. The moves were telegraphed in advance. The combination of a strong global recovery and plentiful liquidity was a big tail wind for stocks, real estate and commodities. The George Bush administration, keen to take the body bags coming from Iraq and Afghanistan off the front pages, encouraged loans to sub-prime borrowers. Further, regulatory changes made since 2000, favouring financialization and securitization, turbocharged asset markets. President Donald Trump too is pursuing a deregulation agenda. Then in 2001, as now, there was a tax cut and widening fiscal deficits. But the bond market did not protest because foreign exchange reserve accumulation by central banks in Asia blunted the bond market. Now, advanced countries’ central banks have muted the bond market.
Two, interest rates were cut everywhere in 2001-03 as the US slashed rates to 1%. Now, central banks are considerably looser than they were in that period. Financial conditions are too loose. Even now, $9 trillion of bonds carries negative yields. Europe has stabilized, and so has China. Finally, now as then, there is overvaluation and a “bubble in everything”—art, new asset class (crypto currencies), investment grade and high-yield bonds, emerging market (EM) stocks and EM bonds, etc. So, we have a globally synchronized recovery and a highly favourable liquidity setting.
What is the outlook now? The melt-up scenario will happen unless other risks (trade and military conflicts) materialize suddenly. Another risk is that Jerome Powell has a much stronger spine than his three predecessors. He did make some statements of caution when the Federal Reserve launched quantitative easing-3 but he always voted with the majority. Further, the fear of acting and triggering a collapse will likely see him stick to the playbook of his immediate predecessor. He would rather let the asset bubble collapse through monetary policy omission than commission.
Unfortunately, the only message G-3 central banks have taken from the crisis of 2008 is not to let asset prices go down. It makes sense at one level. When the economic and financial systems are built on leverage, it is a disaster to let the assets side of the balance sheet go down. But the big flaw in this logic is that such an attitude makes the risk of an eventual big correction in asset prices, even bigger. But they have not learnt this lesson at all.
If anything, they have concluded that they should be bolder about venturing into negative rates, buying more assets and targeting nominal gross domestic product and price indices rather than be bogged down by the zero lower bound in interest rates. In other words, they believe in monetary medicine, and that the failure of the medicine to deliver economic growth and inflation up to 2016 was because the dosage was not high. The current monetary policy framework is a toxic mix—freshwater monetarism and salt-water interventionism topped up by dollops of hubris.
Politicians lack the courage to take any decision that would hurt voters’ sentiments and shower them with populist giveaways. Central bankers lack the courage to take decisions that would undermine market sentiment and shower the market with forward guidance, transparency and downside protection. Is there any difference? At least, there won’t be any pretensions or expectations of independence if politicians set monetary policy.
The unfolding market scenario this year has the potential to make the eventual crash far more dangerous—in terms of the social, political and economic consequences—than the 2008 meltdown in the housing market. But, for now, the path of least resistance for US stocks is up.
V. Anantha Nageswaran is an independent consultant based in Singapore. He blogs regularly at Thegoldstandardsite.wordpress.com. Read Anantha’s Mint columns at www.livemint.com/baretalk
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