As hopes of a deal to lift the debt ceiling in the US grew last week, equities bounced. Even before that, stocks hadn’t slid far, as we noted last week.
Investors seem to be betting that stupidity will not prevail, as John Authers puts it in the FT. And there’s another comfort blanket that investors have been able to cling to for almost five years now: a never-ending tide of easy money.
As Bank of America Merrill Lynch points out, central banks around the world have cut interest rates 515 times in the past six years and boosted liquidity by $12trn (around a sixth of global GDP). Printed money has fuelled hopes of economic recovery, while much of the cheap or free money has found its way into asset markets.
And the party is set to endure. When the US Federal Reserve merely signalled in May that it might print less money in future, traders panicked and sold off stocks. Bonds also fell, sending bond yields upwards and thus raising long-term interest rates, undermining growth. So the Fed backed down.
“The markets have now accepted the circular logic of the Fed,” says the FT’s Henny Sender. “A whisper of the prospect of tapering leads to financial conditions tightening, which the Fed then cites as the excuse not to taper.”
The Fed has made it clear that “it will not tolerate a decline in asset values”, as one fund manager told Sender, so investors are loath to sell in the face of quantitative easing, or money printing. Expectations of tapering have been pushed further and further back, especially with the fiscal stand-off threatening to hit growth.
If investors stopped and thought about all this logically, they would be far less bullish. After all, years of quantitative easing haven’t led to a self-sustaining US recovery: the Fed was worried that the US economy couldn’t cope with slightly higher, but still historically low, long-term interest rates.
And the Fed seems trapped in this “merry-go-round”, as Paul Singer of Elliott Management puts it. So we could face the prospect of bubbles forming and bursting; a surge in inflation from all the money printing; or a nasty slide if banks actually do start tightening. And the US could yet default.
Given the unusually uncertain outlook, the best thing to do is buy markets that are historically cheap and try to ignore all the volatility. We continue to like Europe, especially Italy, and Japan.