Bull markets, it is said, climb a wall of worry. There are certainly plenty of reasons to worry. But markets are no longer climbing, which indicates the bull market is dead. As markets are already highly valued, that would not be surprising.
Standard & Poor's composite index of the United States market has, in effect, marked time since June 2014. According to Professor Robert Shiller's cyclically adjusted price/earnings ratio, the US market has been significantly more highly valued than it is at present only during the disastrous bubbles that burst in 1929 and 2000. Prof Shiller's well-known measure of value is not perfect. But it is a warning that stock market valuations are already generous and that a continued bull market might be dangerous.
Still more important, a portfolio rebalancing is under way. The most important shift is in the perceived economic and financial prospects for emerging economies. As a result, capital is now flowing out of emerging economies. These outflows are driving the strong dollar. Given that, the US Federal Reserve's decision to tighten monetary policy looks like an important blunder.
In its new Global Economic Prospects report, the World Bank brings out the extent of the disillusionment with (and within) emerging economies. It notes that half of the 20 largest developing country stock markets experienced falls of 20 per cent or more from their peaks last year. The currencies of commodity exporters (including Brazil, Indonesia, Malaysia, Russia and South Africa), and of big developing countries subject to rising political risks (including Brazil and Turkey), fell to multi-year lows both against the US dollar and in trade-weighted terms.
Global investors withdrew about US$52 billion (S$75 billion) from emerging market equity and bond funds in the third quarter of last year. This was the largest quarterly outflow on record. Net short-term debt and bank outflows from China, combined with retrenchment in Russia, accounted for the bulk of this; but portfolio and short-term capital inflows dried up elsewhere in the third quarter of last year. Net capital flows to emerging and frontier economies even fell to zero, the lowest level since the 2008 to 2009 crisis. An important feature is not just the reduction in inflows but also the sheer size of outflows from affected economies.
What lies behind this? The pull from the expected tightening of US monetary policy is one reason. Another is the impact of falling commodity prices on a number of emerging economies, including Russia, Brazil and South Africa. Yet another factor is geopolitical instability, notably in the Middle East. Corruption scandals tend to emerge when the economic tides go out; it is not surprising therefore that Brazil's leadership is embroiled in a big and spreading scandal. China's President Xi Jinping is seeking to clean the stables - but such a pursuit of corruption itself damages confidence.
Yet the most important reason of all is realisation of the deteriorating performance of the emerging economies - in cyclical and, more significant still, structural terms. Of the five in the Brics (Brazil, Russia, India, China and South Africa) group, only India is experiencing a revival. Worse, on average, about a third of the slowdown among the 24 largest emerging economies between 2010 and 2014 was structural. A particular concern is the decline in the rate of growth of "total factor productivity" - a broad measure of efficiency. Also worrying is the slowing growth of trade, itself partly a result and partly a cause of weaker growth. Globalisation is losing dynamism.
China is much the most important emerging economy. Market turmoil has reduced confidence in the competence of its leadership. But it is vital to understand that its problems are not amenable to any quick technocratic fixes. The economy is extremely unbalanced, with incredibly high savings rates, wastefully high investment rates and high debt.
A natural way to solve this problem might be to allow capital outflows, a big depreciation of the yuan and so a re-emergence of large current account surpluses. But such a "solution" would threaten the stability of the rest of the world economy, particularly since the euro zone and Japan have already chosen much the same option. Beijing is resisting the pressure: gross foreign currency reserves have fallen by US$660 billion (17 per cent) since June 2014. Yet, if this continues (and it surely will), the authorities will have to tighten outflow controls, which would undermine reforms; or let the exchange rate slump, which would destabilise the world.
What is happening in developing economies directly affects the lives of many billions of people. It is also of global economic importance. Another set of credit bubbles, that in emerging economies, is loudly popping. This is going to leave a legacy of financial shocks and, if mishandled, bad debt.
Yet, cleaning up the aftermath of financial mistakes - a depressingly familiar experience - is just a part of the challenge the world confronts. Equally important is finding a powerful new engine of demand as old ones splutter and die.
It is not at all obvious where this is to be found. But the rest of the world is hoping, probably over-optimistically, that the US will provide what it seeks. Unfortunately, it will not do so. It would not have done so even if the Fed had chosen not to tighten. The adjustment ahead for a world economy so addicted to credit bubbles is going to be difficult. It will probably be no outright disaster. But it is not going to be much fun either.
THE FINANCIAL TIMES