Is market 'euphoria' a risk?

TIM HUNTER
Last updated 05:00 06/07/2014

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OPINION: If institutions had personalities, the Bank for International Settlements would be the type to flick cold water on your belly as you sunbathe on the beach.

There you are, basking in the golden glow of record high equity markets, when along it comes with talk of euphoria and dangerous overconfidence.

The Swiss institution's comments were largely overlooked in New Zealand, but they triggered a ripple of anxiety elsewhere.

So they should.

The BIS employs a bunch of brainy economists to help central banks around the world with their monetary policy. On June 29 it held its annual meeting in Basel at which general manager Jaime Caruana gave a speech warning that the world had not escaped the shadow of the financial crisis.

Its content was heavily economic but its portent was clear enough - we're not out of the woods.

Past economic growth had relied heavily on debt, he said, but "it is hard to see how additional debt-driven demand can help".

While financial markets had become convinced interest rates would remain low for a long time, "such overconfidence is dangerous".

If that sounds ominous, what really caught the attention was a phrase in the BIS annual report describing financial markets as "euphoric".

The remark is reminiscent of US Federal Reserve governor Alan Greenspan in 1996, who mentioned in a long, dull and typically enigmatic speech that asset values could be inflated by "irrational exuberance".

His words were interpreted as prophetic when the soaring equity market fell to earth in the dotcom bust of January 2000.

Today you don't have to look far to find euphoria. The Standard & Poor's 500 index is hovering around an all-time high after an almost continuous run of gains since early 2009.

New Zealand's sharemarket has also been a happy place of late. The NZX50 index is above 5000, the IPO pipeline is flowing and money is pouring in.

The problem BIS sees involves the ineffectiveness of economic policy tools to encourage sustainable growth built on productivity and investment rather than debt-fuelled demand, like an engine with a slipping clutch.

"Growth has disappointed even as financial markets have roared: the transmission chain seems to be badly impaired."

The question for investors is "should we be worried?" Or maybe, "how worried should we be?"

Harbour Asset Management's Andrew Bascand, a former central bank economist, is not concerned that equity markets are overpriced.

"Where is the euphoria? If anything it's in the bond market. It doesn't look to me as if global equities are priced extraordinarily highly at all. They're fairly priced on most measures."

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In previous peaks, such as the dotcom boom of the late 1990s, one sector was driving the market, said Bascand, but currently the growth was broad-based.

"That's not a characteristic of a market about to hit the skids."

There could be a 10 per cent "correction" he said, but a major drop was unlikely.

JBWere strategist Bernard Doyle said it was premature to see current conditions as setting the scene for the next crisis.

"This is a low-return world, not a negative-return world."

With equity markets so high, investors should understand the outstanding performance would not continue, he said.

"We'll look back at that 2009 to 2013 period quite fondly as the post-[global financial crisis] rebound." Given the current higher level of household borrowing compared to a decade ago - a factor that has helped fuel growth - there was less upside in the market.

"From this starting point of somewhat elevated valuations, there is only so much you can dream about where your next few years' returns are coming from.

"We've eaten tomorrow's lunch."

This combination of confidence and wariness was captured in a poll of 51 fund managers published by Reuters on Monday, which found a small increase in recommended exposure to global equities, from 50.8 to 51 per cent of balanced portfolios.

At the same time, Reuters quoted some words of caution from Rob Pemberton, investment director at British wealth manager HFM Columbus.

"I am becoming uneasy about the increasing correlation between what are now fully valued asset classes and also by the gradual fall in volatility in equity, bond, commodity and FX markets to dangerously complacent levels," he said.

In this situation, it's reasonable to assume that signs of central banks raising interest rates significantly could give sharemarkets quite a turn.

But while the BIS wants to see policy alternatives to continued low interest rates, some commentators have other ideas.

In an International Monetary Fund working paper published last month, researcher Laurance Ball advocated setting inflation targets at 4 per cent rather than the usual 2 per cent, a mark also targeted by the NZ Reserve Bank.

The idea is that the higher inflation wouldn't hurt and it would help central banks avoid interest rates of close to zero, which make policy ineffective.

Bascand likes the idea.

"All bets are off if inflation begins to rise. Having said that, if the IMF take on things gets some airtime it may well be quite a glowing period for equities going forward, like the 1950s or 1960s, when inflation was allowed to gradually drift up but we had the advent of new technology brushing through markets."

In my view the orthodoxy on inflation targeting would be tough to shift but, if nothing else, the policy debate implied by the BIS and IMF should warn investors to stay on their toes.

- Sunday Star Times

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