By Invitation

2018: Temper that exuberance

Despite a recent asset markets rally, the year ahead is risky for already overpriced stocks and bonds.


Temper that exuberance. 2018 will likely be more difficult for stocks and bonds.

An "Indian summer" - an unseasonably warm spell in late autumn - seems to have convinced some pundits that we now have perpetual spring.

Investor optimism in the United States for example, measured by the Wells Fargo/Gallup Investor and Retirement Optimism Index, is now higher than before the global financial crisis 10 years ago and close to levels just before the Nasdaq crash of 2000.

But there is still a cycle. Of that I am certain. And this one is approaching nine years old.

Yes, the global economy is now running at its fastest since 2010. And the growth momentum is synchronised across the big four economies of the United States, euro area, China and Japan.

But much of that growth has been force-fed by state intervention - fiscal stimulus by governments and monetary stimulus from central banks. That is, governments spending money they don't have, and central banks printing money to finance the spending that governments can't afford. And all that in a world swimming in debt.

Total global debt (all sectors) hit US$217 trillion (S$290 trillion) or 327 per cent of gross domestic product early last year, according to data from the International Institute of Finance. This is up 46 per cent from just before the global financial crisis, when total debt stood at US$149 trillion or 276 per cent of GDP.


This is important because it questions the sustainability of this burst of "Indian summer" optimism, and with that, the soundness of the recent bullishness in asset markets.


Debt constrains growth. You are not just borrowing from a saver, you are borrowing from future growth. But ironically, debt fuels asset markets. So, much of the recent bullishness speaks of dysfunction rather than healing. Indeed, while plentiful, cheap money has been driving almost everything from stocks to junk bonds to cryptocurrencies, the private sector remains reluctant to invest in the productive capacity that would build sustainable growth. So-called "investment intensity", or investment growth relative to GDP growth, remains well below the 30-year average among OECD economies.

Indeed, growth in US and European corporate debt has been far outpacing growth in productive capacity for more than two decades, according to the Organisation for Economic Cooperation and Development. A lot of the debt appears to have gone into share buybacks, boosting earnings and dividends per share, and share prices. But share buybacks at least in part reflect pessimism about future business prospects. And this could be self-fulfilling as they perpetuate the structural downshift in productivity and economic growth experienced in advanced economies over recent decades.

Meanwhile, the high and, in many instances, growing levels of indebtedness has first, made many countries vulnerable to financial and economic shocks; and second, undermined the sustainability of growth over the medium term, the OECD warned in a recent report.

In a similar vein, the International Monetary Fund (IMF), in its October 2017 World Economic Outlook report, warned of the "need to guard against a build-up of financial stability risks in a global environment of easy finance and monitor the risks from volatility as advanced economies' central banks gradually withdraw stimulus.

"A decompression of risk premiums and higher long-term interest rates would expose fragilities, including by worsening public debt dynamics," it said.

And there's nothing new in this.

Debt constrains growth. You are not just borrowing from a saver, you are borrowing from future growth. But ironically, debt fuels asset markets. So, much of the recent bullishness speaks of dysfunction rather than healing. Indeed, while plentiful, cheap money has been driving almost everything from stocks to junk bonds to cryptocurrencies, the private sector remains reluctant to invest in the productive capacity that would build sustainable growth.

Former Bank of England governor Mervyn King, in his 2016 book The End Of Alchemy, described how the savings glut that emerged from Asia over the decades leading to the global financial crisis had suppressed interest rates, resulting in rapid growth of asset prices, credit and banks' balance sheets in the advanced economies - all of which ended in grief in 2008-2009.

"With interest rates so low, financial institutions and investors started to take on more and more risk, in an increasingly desperate hunt for higher returns, without adequate compensation," he wrote.

Lord King, writing in The Wall Street Journal last September, asked rhetorically whether we were now any wiser than before the global financial crisis? His answer: "Wisdom does not seem to have been on an upward trend."


This "movie" looks familiar. The Shiller Cyclically-Adjusted Price to Earnings (Cape) ratio for US equities is now around 32 times. This is a popular measure of stock valuation based on the average of the previous 10 years' earnings and adjusted for inflation. It is now 15 per cent above where it was before the global financial crisis; has just slightly exceeded the level before the Great Depression; and is more than 25 per cent above its post-1982 average. This level of valuation has been exceeded only once - before the Nasdaq crash of 2000.

But if stock valuations look "frothy", have a look at bonds. Real (inflation-adjusted) yields for US Treasury bonds have been hovering around zero - hence the relative attractiveness of holding equities for dividends.

Corporate bond yields are trading at cyclically low spreads over equivalent government bonds. With spreads between corporate bond yields so close to government bond yields, any rise in the latter will bring the price of corporate bonds down to make them more attractive in yield terms relative to the safety of government bonds .

Now here's the worry: Over the first nine months of last year, the 10-year US Treasury yield declined despite rising Federal Reserve rates. And that would have contributed to a lot of the asset market bullishness over the course of the year.

This divergence could have been due in large measure to the Federal Reserve's soothing, "gradualist" language on rate rises and unwinding its quantitative easing-bloated balance sheet.

The Bank for International Settlements (BIS) noted research into the "various ways in which predictable central bank actions, by removing uncertainty about the future, can encourage leverage and risk-taking." Indeed, it noted how US margin debt had surged in 2016-2017 despite rising rates and a shrinking Fed balance sheet. Margin debt is investor borrowings for capital market trades. An environment of rising central bank rates and rising bond yields should encourage less risk taking , not more.

The trillion-dollar question is how much longer can this low-volatility/soporific condition continue as central banks tighten monetary conditions?

It can continue a bit longer. Indeed, US tax cuts could power another leg-up in already overvalued markets. But nothing lasts forever - not bull markets, not bear markets.

That was what I said in October 2007, when I produced a quarterly market outlook report for a regional bank. The report, entitled "Dangers of Flying Too High", featured a drawing of Icarus with his wings on fire. I then said: "I don't know if this is the top of the market. But I do know markets are very expensive."

I would say the same today.

I would agree that outright bear markets are unlikely absent in an economic recession or a non-economic shock such as war. And while nobody knows how the Korean peninsula tensions will resolve, it is clearer that the global economy will continue to grow in 2018.

But markets price assets ahead of economies. And if markets reckon - as I do - that 2018 will be as good as it gets in this cycle, relatively minor disturbances could cause outsized reactions.

Bear in mind also that while the 10-year US Treasury yield had been declining over the first eight months of last year, the two-year yield had been rising steadily through the year.

If the Fed is right in its bullishness about the economy, the 10-year yield should follow the two-year yield upwards. And indeed, the 10-year yield has started to move up following the Fed's announcement of its plan to shrink its balance sheet. And given the role of low rates and yields in the recent bullishness, this could be a spoiler this year.

Note also that we now have the "flattest" US Treasury yield curve since 2007. Granted, the curve could "steepen" again as a result of the rising 10-year yield. (The US Treasury yield curve is said to "flatten" when the spread between the 10-year yield and the two-year yield declines. It is said to "steepen" when the reverse happens.)

But given where we are today, if you take another 50-60 basis points off that spread, you would have conditions ripe for a US recession and bear market. Typically, the market starts to sell down as it approaches a flat or inverted yield curve - that is a zero or negative spread between the 10-year over the two-year yield.

Lord King, referring to the building of bubbles, writes that "the first law of financial crises" is "an unsustainable position can continue for far longer than you would believe possible".

But the "second law of financial crises" is "when an unsustainable position ends, it happens faster than you can imagine".

•Lim Say Boon is a management consultant and a company director. In a 26-year career in banking and finance, he was chief investment officer and chief investment strategist at two different regional banks.

A version of this article appeared in the print edition of The Straits Times on January 02, 2018, with the headline '2018: Temper that exuberance'. Subscribe