Home / Markets / Mark To Market /  Markets face inflation and financial stability risks due to liquidity surge

For a stock market rally largely driven by a gush of easy money than fundamentals, the received wisdom was that more stimulus meant more upside. However, investors are now talking about the flip side.

A quicker recovery aided by government stimulus and increased spending could pave the way for higher inflation, for instance.

Also Read | How India tightened the noose around OTT

The latest bout of correction in equities, which was triggered by rising bond yields, is a reminder that equity investors are unnerved by inflation making a comeback.

The fear factor
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The fear factor

It would mean a reversal in the accommodative stance of global central banks. However, some analysts caution that there could be another fallout of this flood of liquidity, which could be a greater risk than inflation. This is the risk of financial instability.

“With an estimated $1.1 trillion in excess savings currently sitting in checking and savings accounts, it is possible that some of that money finds its way into financial markets, further stretching valuations... If that happens, it’s possible that it exacerbates financial stability risks," global investment management firm Pimco said in its latest market blog.

In its January meeting, the US Federal Reserve staff noted risks such as elevated valuations of corporate bonds, equities, and industrial, and multifamily properties, poor balance sheets of small- and mid-sized business, and worrisome leverage at hedge funds.

Pimco adds, in particular, “the recent social media-driven price action in single-name stocks, although not systemic, offers a clear example of the potential boom-and-bust behaviour that could ensue. This, coupled with other concerns, could compound the risks to financial stability."

Retail participation in stock markets globally is at record levels and has surpassed levels seen during the dot-com boom. The Financial Times pointed out last week that retail traders accounted for almost as much volume as mutual funds and hedge funds combined in the US equity markets.

The astronomical surge in small-cap stocks recently is far above any logical expectation of future earnings and economic growth, analysts at US-based RIA Advisors said in a note dated 13 March.

“Adopting a YOLO (you only live once) mentality, speculation (has been rife among) retail traders with little historical market perspective, and even less micro (individual company) knowledge. Using Robinhood and other commission-free platforms and ‘Reddit’ as their investment research and communities, this is now spreading and is morphing into an institutional experience and phenomenon," the note said.

In January, a short squeeze of American video game retailer GameStop shares caused large losses for short sellers and put some hedge funds on the brink of bankruptcy. This unified action was primarily driven by users of the subreddit r/wallstreetbets, an online forum on the social news website Reddit.

“With increased liquidity, the chances of frequent occurrences of such instances rise," said Sahil Kapoor, chief market strategist, Edelweiss Securities Ltd.

Closer home in Asia, shares of AirAsia have been on a tear after it got a mention in the online community by Bursabets, a Malaysian version of Reddit’s WallStreetBets forum.

Not just stocks, in February, prices of silver hit an eight-year high influenced heavily by social media speculation. Some analysts worry that increased speculation could add to irrational behaviour and bring financial stability issues to the fore.

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