There is an old saying about the dangers of pulling a brick on a piece of elastic. You can tug and tug for ages and nothing will happen. But strain too hard and the brick might leap up and hit you in the face.
One day, something similar will happen in the financial markets. Ever since 2009 the markets have been helped by massive central-bank intervention; short-term interest rates have been pushed down to record lows while asset purchases have depressed bond yields. Despite occasional wobbles, equity markets have steadily headed higher; by the autumn of 2017, the American stockmarket had enjoyed its second-longest bull run of all time (after 1987-2000), according to Bank of America.
Central banks are now slowly starting to withdraw the amount of stimulus they offer. The process is painstaking; central bankers do not want to pull on the elastic too hard. The Federal Reserve first raised interest rates in December 2015; it is just starting to reduce the size of its balance-sheet. The European Central Bank is scheduled to reduce its monthly asset purchases in 2018.
The withdrawal of monetary stimulus reflects a confidence that the world economy is growing at a decent pace, with the imf forecasting a 3.7% GDP increase for 2018. Emerging markets are leading the way, after the troubles caused by a fall in commodity prices earlier in the decade. So the big question is whether that growth can be sustained without the help of the central banks.
Much will depend on China, where the authorities are trying to engineer cuts in manufacturing capacity and a switch to a slower growth trajectory without causing financial distress. As for American policy, when Donald Trump assumed the presidency in January 2017, optimists hoped that tax cuts and infrastructure spending would boost economic growth while pessimists feared that his protectionist tendencies would dent it. As it turned out, he achieved little in either direction. But with the congressional mid-term elections due in November 2018, the Republicans may feel pressure to deliver some measures for their base; a crackdown on immigration or on trade would not be welcomed by investors. And an investigation by the Department of Justice into the 2016 presidential election, led by Robert Mueller, may yet throw up some surprises.
Geopolitics could also move markets. Potential flashpoints include the nuclear programmes of Iran and North Korea, disputes between China and its neighbours over various island groups and the drawn-out wars in Syria and Yemen. In Europe there is the danger that the Brexit talks dissolve into acrimony and that the Italian election brings anti-EU parties into power. The defeat of Marine Le Pen in the French presidential election of May 2017 convinced some investors that the high-water mark of populism had passed, but the Austrian and German elections in the autumn suggest that view could be premature. Ever since 1990, investors seemed to have concluded that political factors may loom large in the short term but then they fade; the history of the rest of the 20th century showed that this is not always the case.
A Dickens of a year
Every year the financial markets have to climb a “wall of worries” and 2018 may turn out to be another in which they succeed. But it will become more difficult to surmount. One day bond yields will start to rise, and bond prices will fall, creating potential problems for the corporate-debt market; investors have piled into this market in search of income but it may not be liquid enough to allow them to get out again. The American market is trading at valuation levels, in terms of the cyclically adjusted price-earnings ratio, that have only been seen before in the late 1920s and 1990s (see chart). Crashes followed on both occasions. There have been signs of overexuberance, notably in the market for initial coin offerings, a new form of investment in which tokens are issued on an indelible distributed ledger, or blockchain.
The bullish case for 2018 is that global economic growth continues; inflation is not a sufficient threat for central banks to tighten policy excessively; and profit margins remain robust. Analysts are forecasting 10% annual profits growth in the first half of 2018 for companies in the S&P 500 index, according to Société Générale, a French bank. The chances are that investors will start the year with that optimistic view but valuations suggest they are taking too much on trust. To misquote Charles Dickens’s Mr Micawber: “Something will turn down.”
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