For his bets to be profitable, however, timing will matter a great deal. And that has been particularly difficult to get right in markets that are so heavily influenced by the words and actions of central banks.
There was further confirmation last week that the improbable and unthinkable can easily become reality in financial markets these days. Interest rates continued to fall around the world, as Germany’s10-year bond closed just millimeters from negative rates and the average rate on the stock of government debt went below zero for the first time. In Japan, the nominal rate on the 15-year government bond joined its 10-year counterpart in negative territory.
The cascading decline in yields amplified the recent relentless flattening of yield curves — often a sign of an impending recession, according to historical experiences (though in previous cases, without the degree of central bank involvement that has characterized this period). Still, despite selloffs on Friday, some equity markets, including those in the U.S., flirted with all-time highs and oil had a relatively solid week.
These anomalies — and many before them — have fueled fears of trouble ahead. But past warnings have tended to fall on deaf ears, and understandably so. A winning strategy in recent years has been to bet on the ability and willingness of central banks to repeatedly intervene to repress financial volatility and boost asset prices — often at levels that are well beyond what is warranted by economic and corporate fundamentals.
Most agree that there is a limit to how far central banks can decouple asset prices from fundamentals. There also is broad agreement that, without some improvement in the political system’s ability to enact comprehensive policies that ease the over-reliance on central banks for growth, it will be hard to validate existing asset prices and push them higher in a sustainable fashion.
But this state of affairs isn’t sufficient to ensure that bets against the current valuations of stock markets around the world will be highly profitable. Timing matters — particularly when it comes to pinpointing events that could be catalysts for a correction.
So, starting from the premise that either a policy dislocation or a market accident could have this transformative role, here are six major events to assess and monitor in the weeks ahead.
- A vote in favor of the U.K. leaving the European Union in the June 23 referendum could have adisruptive impact on markets, especially if that outcome is not followed quickly by credible institutional alternative, such as a free trade-association agreement, that would maintain access to European markets.
- A major slip by China as it tries to implement financial policies aimed at balancing liquidity support for the economy with the orderly management of a credit boom, soaring internal corporate indebtedness and excesses in the equity markets.
- Indications that the isolationist tone of the U.S. presidential primaries is more than just rhetoric and posturing, but signals a decisive change in decades of U.S. leadership for economic and financial globalization.
- Large exchange rate moves that, by reflecting wider divergences in the world’s multispeed economic and policy conditions, spread volatility to financial markets as a whole.
- A renewed scare about the European banks that have lagged in raising capital and strengthening internal operating approaches and have yet to put behind them the legacy of a period of excessive risk-taking.
- Greater risk aversion among market participants who — acting on their confidence that central banks are prepared to continuously step in to ensure stability — now have taken on significant mismatches of maturities, assets to liabilities, benchmarks or currencies in their search for higher returns. And this is occurring in markets that have tended to experience periodic bouts of relative illiquidity.
Mohamed A. El-Erian
