The financial markets continue on their remarkable bull run despite facing many threats. Geopolitical instability, potential weaknesses in the global economy and the bursting of an asset price bubble are all real risks to investors. If any of these events occurs, what has been a golden era for the markets would come to an end in a disastrous fashion. Yet investors appear to be unfazed.
Markets have shown incredible resilience at the times when the probability of such events occurring suddenly rose over the past two years. Investors have rationalised this situation by pointing at the strength of the global economy, which is recognised by the most authoritative sources.
However, few would deny the endemic weaknesses of the global economy. Sluggish productivity growth is apparent across the developed world. Central banks have supported the global economy by easing conditions in the financial markets, but they have indirectly fuelled further growth in debt.
This complex situation yields a healthy debate on the state of the markets. If we focus on the credit markets, optimists point out a few known facts. The corporate default environment is benign, inflation is low and the economy is growing.
The unwinding of quantitative easing (QE) programmes is advertised so clearly by central banks that investors should not be caught out.
The pessimists contend that valuations are stretched and lending standards are weakening, leaving investors more exposed to losses in case of a spike in defaults or rising interest rates. It is evidently true, however, that most corporates have been much more sensible with their balance sheets since the financial crisis.
Both sides could be right at the same time. But the point is that, much like before the last crisis, the problems that surfaced and ignited the crisis were scarcely understood. In other words, it is likely that the next crisis will be sparked by a set of conditions that are difficult to identify at present. It is a case where the idea of ‘unknown unknowns’ works particularly well.
This does not mean investors should drift away from the market now. As we have learned, timing the market is hardly worth the effort. However, markets have kept hitting new highs and investors are right to start questioning how long this can continue. The situation simply commands extreme caution. Investors should apply sound risk management while trying to exploit the few remaining opportunities in the credit markets and other asset classes.
Carlo Svaluto Moreolo, Senior Staff Writer