The Coming Storm for Global Financial Markets
Global growth is weak. Oil prices are low. The world has excess capacity and a wage-depressing labour surplus. Corporate profits are shaky. Deflation is laying bare the impotence of central banks. So where would you expect financial markets to be going, given that economic, financial and political environment?
You’d expect to see increased demand for safe-haven US Treasuries, a soaring dollar, falling commodity prices, and increasing investor aversion to junk bonds, emerging market debt and equities and other low-quality securities. But that’s not the case.
The 10-year Treasury yield has been flat for months, as has the dollar against the euro. Commodity prices in general and oil in particular have risen. Money has poured into emerging market bonds as well as junk bonds, depressing their yields. How can current security prices be justified in the face of the fundamental picture?
The most likely outcome is a major market correction to bring prices back into line with economic fundamentals. Distortions in many countries suggest that things are out of alignment, and that the resolution may be a painful process. Investors may take comfort once the US presidential election is settled.
There’s also the prospect of a fiscal stimulus program to revive growth. With even central bankers admitting that monetary policy has failed to generate economic growth, the pressure on politicians to do their bit will grow, in the Eurozone as well as the US.
If spending in the US increases after the election, investors may still be too relaxed about the outlook. The VIX index remains at historically low levels.
But Europe offers an example of what might happen if things reverse. The region’s Stoxx 600 Index is down more than 5% this year, erasing almost all of 2015’s gains. In this environment, investors should hold universally large cash positions until there’s a clearer picture of what comes next.