World Economy as Vulnerable as It Was in 2007

[courtesy Google Images]

Telegraph

“The world economy is just as vulnerable to a financial crisis as it was in 2007, with the added danger that debt ratios are now far higher and emerging markets have been drawn into the fire as well.

“Jaime Caruana, head of the BIS, said investors were ignoring the risk of monetary tightening in their voracious hunt for yield.  ‘Markets . . . have become convinced that monetary conditions will remain easy for a very long time, and may be taking more assurance than central banks wish to give.’”

In other words, although the central banks’ business is to inspire investors’ confidence in the markets, it’s not the banks’ business to inspire too much confidence. The BIS is warning that the central banks’ easy money policies may have inspired an irrational level of confidence that prevents investors from recognizing the real levels of “risk” in their investments. I.e., there’s more risk in the markets than most investors realize and therefore the markets are over-priced.

The danger is that the over-confident investors, convinced that they can’t lose, become highly vulnerable to market corrections that, rationally, are inevitable—but in the current “irrational exuberance”—seem virtually impossible.

“Mr. Caruana said the international system is in many ways more fragile than it was in the build-up to the Lehman crisis. Debt ratios in the developed economies have risen by 20 percentage points to 275% of GDP since then. . . . 40% of syndicated loans are to sub-investment grade borrowers, a higher ratio than in 2007, with ever fewer protection covenants for creditors.

“The BIS warned in its annual report that equity markets had become “euphoric“. Volatility has dropped to an historic low.”

Volatility is a measure of investor confidence. When volatility is high, prices are uncertain, confidence is low, investors distrust everything and constantly search for, and argue about, “real” value.   There’s little consensus as to an investment’s current and, especially, long-term value.

For example, during a period of high volatility, I might say the price of a particular stock should be $23, you might say $20, and someone else might say $18. The price would fluctuate dramatically as the market tried to “discover” a stable price.

When volatility is low, confidence is so high that investors can be described as “complacent”. They don’t distrust. They don’t search for more evidence of value. They simply accept that whatever value is today, will always be and then “relax”. In that complacency, investors become ignorant and therefore vulnerable.

You, me and the other guy might all agree that the price is $23 and sure to steadily rise to $30—even though the fundamentals suggest that the price must fall to $15.

“The BIS says prolonged monetary stimulus in the US, Europe, and Japan has led to a leakage of liquidity, contaminating the rest of the world.”

By “liquidity” they mean “currency”. Thus, our excess printing of fiat currency has “contaminated” the rest of the world. (Interesting choice of words, no? We “contaminated” the world with too many fiat dollars.)

Under the guise of Quantitative Easing, the Federal Reserve gave US banks billions of dollars that would presumably be loaned to US businesses, entrepreneurs and consumers. However, the Fed also set interest rates so low that the banks preferred to lend to foreign markets paying higher rates of interest.

Result? World markets have been “contaminated” by easy money flowing from the Fed and other central banks to foreign countries that paid higher interest rates.

In pursuit of higher interest rates (“yields”), some of the Fed’s money “leaked” from US banks into foreign countries. Rather than stimulating the US economy, the Fed’s low interest rates pushed American capital overseas and “stimulated” foreign economies including foreign stock markets.

Like US markets, these foreign economies and markets also became overly dependent upon the easy money flowing from the US, EU and Japanese central banks. Now that QE is beginning to dry up, so will the “irrational exuberance” that’s been driving markets higher. Thus, the BIS warns of a coming decline in stock market prices that may be global in extent.

“European equities have risen 15% in a year despite near zero growth and a 3% fall in expected earnings. Overall, it is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments [realities] globally.”

Although its language is somewhat convoluted and understated, the BIS is expressly warning that stock markets globally are not merely “overpriced” but are “irrationally overpriced”. By implication, the BIS warns that rationality will inevitably prevail. When it does, there’ll be a significant decline in the prices of equities markets around the world, and that decline could start soon.