What are the key risks for global markets at these levels?
During the week the market cap of all listed stocks in global exchanges briefly touched a high of $100 trillion. This is a record level, especially considering that the world market cap had fallen to a low of $28 trillion in the aftermath of the Lehman crisis in early 2009. So what explains the story and what are the key risks to this equity story
Great liquidity story
Since the onset of the Lehman crisis in late 2008, central banks across the world have literally competed with one another to infuse liquidity into the economy. Between the US Fed, Bank of England, ECB and the Bank of Japan, these central banks infused over $10 trillion worth of liquidity into the global economy. When too much money starts chasing the same set of asset classes, then the obvious outcome is a literal explosion in asset inflation. Ironically, central banks pushed liquidity into the financial system to bring consumer inflation back. Instead, it resulted in asset inflation cross the board. Without a proportionate rise in productivity and output, only thing the liquidity could really do was to inflate asset prices across the world. That explains why equity markets across the world created trillions of dollars in paper wealth. But this wealth has been predicated on two factors viz. low yields on debt and almost unlimited supply of liquidity. Now both these assumptions are under a serious threat. Here is why!
Assumption of liquidity – Sorry!
One has to only see how the balance sheet of all the 4 key central banks has expanded in the last 10 years since Lehman. That expansion has reached a stage where there is not enough debt left in the market to absorb. The US could be the first to take the lead in reversing the liquidity cycle and the other central banks could follow suit. The moral of the story is that if all the central banks start reversing the liquidity cycle then there could be a perceptible contraction of liquidity in the global financial markets. For a market that has long been driven by liquidity that is not great news. The risk-off trade that we are seeing in emerging markets is an indication of that!
Assumption of Bond Yields – Sorry!
For over 10 years, investors preferred equities due to the TINA factor. That was because debt yields were irrationally low and liquidity was pushing equities higher. With the interest rate cycle reversing, debt yields could once again become attractive and the relative attractiveness of equities may gradually fade. Globally, equity investors need to be really wary of rising bond yields and tightening liquidity conditions. This combination has never been good news for equities. With bubbles like Bitcoin adding to the confusion in global markets, equity investors need to be cautious on risk! ©