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Markets Insight: Phoney QE peace masks rising risk of instability

Profound tensions lurk beneath surface calm

Are the markets going mad? That is a question many investors might have asked in recent weeks, as stocks in the UK, eurozone and US have soared – even as bond spreads decline.

But, if you want another sign of how peculiar market patterns now seem, take a look at a report recently compiled by Matt King, an analyst at Citigroup. For what is most striking about the current market trends, Mr King argues, is not simply those dazzling equity and bond prices; instead the really notable issue is how many long-standing data patterns have broken down*.

Take a look at the link between unemployment and equity markets. Between 1997 and 2011 the level of unemployment in the eurozone was always inversely correlated to the Stoxx index. However, since 2011 the eurozone jobless rate has jumped from 10 to 12 per cent – even as the Stoxx has risen 10 per cent.

Corporate earnings are another case in point. In recent decades, US earnings revisions have tracked swings in the stock market. But since the start of 2012 there have been net downward earnings revisions – while US stocks have soared. So too with credit spreads and leverage rates. In the past two decades, spreads on investment grade companies have always widened when corporate debt levels rose. But since 2011 the leverage ratio of eurozone companies has risen from 1.4 times to 1.7 times, while spreads have declined from around 210 basis points towards 120bp. A similar pattern is at work in the US.

It is the same story for market measures of economic uncertainty, drawn from business surveys. Indices of uncertainty used to track credit spreads. But while uncertainty has (unsurprisingly) remained elevated since 2011, spreads have tumbled. Or to put it another way, the behaviour of credit and equity markets has moved the opposite direction from fundamentals – on multiple data points.

It is easy to identify the reason for this: as this data has gone haywire in the past couple of years, western central banks have been unleashing an estimated $7tn worth of quantitative easing. This has lowered interest rates on government bonds, forcing investors to search elsewhere for yield. But what has intensified the crunch is that, while central banks have been gobbling up bonds, the supply of assets has declined.

Citi calculates, for example, that net issuance in the US fixed income markets has tumbled from around $2tn in 2007 and $1.5tn in 2010, to a mere $250bn in 2012. Little wonder, then, that spreads have been tightening and investors grabbing at equities; in macro-market terms this is tantamount to a giant, two-pronged squeeze.

However the crucial question now is just how much longer these bizarre conditions can continue. Right now the betting among most analysts I have recently spoken with in London and New York is that these distorted conditions will remain in place far longer than most people expect. The markets apparently agree: measures of volatility are currently running at very low levels, suggesting continued calm.

But while that bet of continued peace is probably correct – particularly given that central banks seem unlikely to abandon QE any time soon – there is an important caveat.

Back in 2007, Mr King sometimes used the image of “a ball in a bowl” to explain how markets behaved during the credit bubble. Between 2001 and 2007 there was such a huge volume of liquidity in the system that markets seemed able to weather small(ish) shocks; just as a ball will roll back into the centre of a bowl if gently shaken, the financial system rebounded quickly from blows like the 2005 downgrade of General Motors.

However, this calm was fragile: beneath the surface there lurked profound contradictions and tensions. Thus when a big shock hit in 2007, the markets hit a tipping point and collapsed – just as a ball will fall out of a bowl, not roll back, if shaken violently.

Mr King suspects that metaphor is an apt description of markets now, and I agree. For while the flood of central bank liquidity is enabling the system to absorb small shocks, it is also masking a host of internal contradictions and fragilities that could surface if a shock hits. Or, to echo a point often made by Nassim Taleb, precisely because central banks are trying to pursue stability at all costs, the potential for a future violent instability is rising apace; “tail risk”, as statisticians say, is growing.

That does not mean a shock will necessarily occur soon; this phoney peace may last months, if not years. But as those equity markets soar, investors would do well to ponder on the data dislocations. Nobody can afford to feel complacent, least of all if they sit in a western finance ministry – or central bank.

*Mind the gap; investing in repressed markets, Citigroup

By Gillian Tett, Financial Times