The air is becoming treacherously thin for global asset markets at the peak of the cycle and investors should cut their exposure before central banks shut off emergency stimulus, Citigroup’s star economist has warned. Willem Buiter, the bank’s chief economist and a leading theorist on monetary policy, said: “There are clearly signs of late-cycle froth in financial markets, in everything from equities to corporate credit and real estate, especially in the US. There is the risk of an overdue correction.”
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The stand out listings traded on the ASX captured at key moments through the day, as indicated by the time stamp in the video. He added: “We are reluctant to call an end to the bull market in risk assets just yet but a considerable degree of caution is now warranted. Downside risks are rising as the business cycle matures.” Prof Buiter said seven of the biggest central banks would raise interest rates this year, while quantitative easing would go into outright contraction. Net bond purchases would fall to zero over the coming months as the “great taper” gathered force, down from $US180 billion ($229.6 billion) a month in mid-2016.
The US Federal Reserve is leading the charge, with plans to shrink its balance sheet at an accelerating pace, reaching $US50 billion a month by the end of this year. “Tighter monetary and financial conditions are a major risk. We think the direct effect of global tapering on the real economy is limited, but major asset market corrections could trigger or cause a global slowdown,” Prof Buiter said. Renowned “value investor” Jeremy Grantham last week told GMO clients to jump in with both feet, predicting a Wall Street “melt-up” of more than 50 per cent in the near term – followed by a full-blooded crash later.
Nikolaos Panigirtzoglou from JP Morgan said excess global liquidity – which measures how far the M2 money supply has risen beyond the needs of the real economy – has reached a record $US10 trillion and is still rising. This creates a huge pool of money looking for a home in asset markets. This is doubly powerful at a time when corporate share buy-backs and a paucity of new share issuance have slashed net equity supply to near zero. He argues that commercial banks will step into the QE breach by creating money themselves. Central banks in emerging economies are back to their old game of accumulating foreign reserves to hold down their currencies, in effect carrying out a disguised form of QE themselves.
Prof Buiter, a former UK rate-setter and professor at the London School of Economics, said the Trump administration’s package of tax cuts and extra spending came at exactly the wrong moment in the economic cycle and could make matters worse, leading to a blow-off boom that forces the Fed to slam on the brakes. There are clearly signs of late-cycle froth in financial markets, in everything from equities to corporate credit and real estate, especially in the US. There is the risk of an overdue correction.
Citi’s Willem Buiter
“The stimulus is completely unwarranted. The Fed may have to shed its pacifist, dovish cloak and become much more aggressive, and could easily ‘murder’ the expansion,” he told London’s The Daily Telegraph. Citigroup estimates that net fiscal stimulus this year from the Trump tax cuts will be 1 per cent to 1.5 per cent of GDP. There may be a further 1 per cent in pre-electoral spending on infrastructure and “pork barrel” projects for Congress. The combined effect risks pushing the US fiscal deficit towards 5.5 per cent of GDP. This is an exorbitant level at a time of full employment, when the economy is hitting capacity constraints. It implies that the deficit could rocket into double figures in the next downturn. Prof Buiter said the policy was so egregious that it might ultimately cause global investors to question US solvency. “At some point people could start looking at the financial position and there could be fears of forced monetisation of the deficit,” he said.
Prof Buiter said the greatest worry was that today’s benign “Goldilocks” conditions might give way to a “plateau phase” of slower growth in which corporate earnings stagnate and credit deteriorates. “There is very little left in the arsenal to counter it. Monetary and fiscal space is more limited than in any previous late-cycle, and it is almost zero in the eurozone and Japan,” he said. Matt King, Citigroup’s credit strategist, said the wafer-thin return on corporate yields in both the US and Europe could no longer be justified. “Is it worth the risk you are running to get such a meagre return?” he asked.
For the past two years central banks have been soaking up the global supply of safe-haven bonds, pushing investors down the ladder into riskier forms of credit, leading to a compression of risk spreads. Mr King said QE tapering would cause a net supply of $US1 trillion in 2018, which might be enough to rattle the markets. Previous such shifts in bond purchases correlate closely with bouts of stress in credit and global equities. Most investors seem to think they are shrewd enough to “try to identify the catalyst for the regime change and then hope to be in front of everybody else rushing for the exits”, he said. It is rarely so easy when the moment comes.
We are in uncharted territory. Central banks have never conducted QE on a mass scale before and they have never tried to reverse it by selling bonds back into the market, least of all when global debt is a record 332 per cent of GDP and the system has never been more sensitive to shifts in monetary policy. Former Fed chief Ben Bernanke – the author of America’s QE – warned last year that the institution was tempting fate to attempt to unwind QE, saying that there is no need to do so. It would be much wiser to leave the balance sheet alone and focus on raising rates instead. The Fed decided to press ahead anyway, insisting that the bond sales will be as dull as “watching paint dry”. The truth is that nobody knows.