SPECTATOR COVER: Are we on the brink of a new credit crunch?
When I think about global stock markets these days, the image that springs to mind is the final scene of The Italian Job – the iconic 1969 original, not the tacky 2003 remake. “Hang on a minute, lads,” says Charlie Crocker, Michael Caine’s heistmaster-in-chief, as he and his rogue brethren balance precariously in a bus loaded with gold on the edge of an Alpine cliff. “I’ve got a great idea”.
The film ends ambiguously, of course. As the credits roll, viewers are left guessing as to whether the gang gets the loot and to safety, or plunges into the depths of a rocky ravine. Well, I’m similarly ambiguous about the state of global markets and the related prospects for the world’s large economies, not least the UK. It strikes me, in fact, that the whole economic shebang is balanced on a knife-edge.
There’s no shortage of commentators (and stockbrokers) insisting the outlook is rosy and shares prices will keep on rising. And almost all political punditry assumes the UK economy is fast-improving and, as the May 2015 general election approaches, will get better still.
Yet alarming evidence is amassing that the global recovery is shaky, stock markets are over-hyped and the large Western banks, for all the talk of reform, remain a serious liability. The reality, and it gives me no pleasure to write this, is that we could see a re-run of the ghastly credit crunch of 2007/08.
America, still the world’s largest economy by far, contracted sharply during the first quarter of 2014. US GDP fell at an annual rate of 1pc on official figures, the first drop we’ve seen since the dark days of 2011. The Eurozone, meanwhile, remains on the brink of recession, with GDP across the 18-nation currency zone expanding a mere 0.2pc.
Despite this lack of growth, stock indices in the US and across the Western world have repeatedly hit all-time highs in recent months. No matter that GDP is contracting or that America’s first quarter corporate earnings were down 3.4pc. The bellwether S&P500, the world’s most watched stock index, has chalked-up over 20 record daily closes this year, as it has ratcheted up and up.
The reason, of course, is the Federal Reserve’s money-printing machine. Since “quantitative easing” began in response to the late-2008 collapse of Lehman Brothers, the Fed has created thousands of billions of virtual dollars, with the Bank of England chipping in hundreds of billions of similarly computer-generated pounds. Much of this has found its way into global stock markets, sending equity prices sky-high. Designed as an emergency measure, QE has since become a life-style choice, the financial and political equivalent of crack cocaine.
While the Fed has lately been “tapering”, slowing down the rate of its de facto money-printing, the scale of QE remains vast – some $45bn a month. That’s driven the absurd “bad news is good news” mantra that still dominates the thinking of investors on Wall Street and other major equity markets. Weak GDP numbers make it more likely the Fed will relent and slow down or even reverse its tapering exercise, the thinking goes, turning up the funny-money dial, and thus stock prices, even more. Forget economic growth and forget corporate earnings. It’s all about the Fed.
This blatant rigging of Western equity markets has gone on for several years now, with stocks soaring despite weak economic fundamentals. While everyone in financial circles knows this, to say as much out loud is to guarantee pariah status – and I should know. But eyebrows are now being publically raised by genuine insiders, with the Swiss-based Bank of International Settlements, an umbrella organization for the world’s leading central banks, warning of “euphoric” equity valuations. “It is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally,” the BIS argues in its annual report published earlier this month.
Systemic global risks today may be greater than before the Lehman crisis, the BIS warns, as debts have actually risen. Across the developed world, the average combined public and private debt ratio is currently 275pc of GDP, compared to 250pc in 2007. And no less than two-fifths of new syndicated loans are now sold to dodgy “sub-prime” borrowers, the BIS adds, above the pre-Lehman high.
With QE having pumped-up credit markets across the developing world, as Western investors have “searched for yield”, many of the large emerging markets are now in the throes of a dangerous credit boom. Such countries have taken on over $2,000bn of foreign currency debt since 2008, the BIS points out. Having helped stabilize the global economy after the last credit crunch, even helping to pay for Western bail-outs, the big emerging markets now themselves pose systemic risks.
It’s undeniable, for those willing to look, that numerous technical stock market indicators are now flashing red. For one thing, the S&P500 sports an average cyclically-adjusted price-earnings ratio of 25.6, according to Professor Robert Shiller of Yale University. That’s way above the historic average of 16.5, suggesting prices are unsustainably high.
Trading volumes, meanwhile, are wafer thin, with just 1.8bn shares trading daily within the S&P500 over recent months – that’s a 6-year low. High valuations and low volumes amount to classic crash conditions. Yet still the rally continues – because investors can’t quite bring themselves to believe that the Fed will fully implement the planned end of QE in October as planned, or raise interest rates from ultra-low levels any time soon.
So we’re now in a situation were US stocks have gained over 200pc since 2009, despite the lack of a convincing economic recovery. Last year, the S&P500 rose no less than a third. European equities have surged 15pc in 12 months despite practically no growth and a 3pc cut in expected earnings. Western share prices generally have ballooned amidst slow profit growth and still deep-rooted concerns about where the world economy is actually going. As such, global equities valuations are detached from reality and propped up by printed money.
Authoritative figures are now speaking out, going further than the BIS ever can in explicitly criticizing central banks and pointing to the dangers still posed by a largely unreformed Western banking sector, particularly if QE-primed equity markets collapse.
“I would be extremely wary of stock markets right now,” says Professor Michael Dempster, co-founder of the Centre for Financial Research at Cambridge University. “The last crisis was caused by cheap money and it’s happening again via QE – which is very, very worrying,” he says. “QE started as a way of priming the pump, but no-one knows how to turn off without causing financial havoc”.
Dempster is particularly concerned about the growth of derivatives, designed for the legitimate hedging of risk but famously dubbed “weapons of financial mass destruction” by American investment guru Warren Buffett.
“Derivatives are now all about playing games, creating confusion to hide losses,” says Dempster. Total global derivatives outstanding currently amount to $620,000bn, he calculates, a jaw-dropping ten-times global GDP and back above the pre-Lehman total.
“Credit derivatives were a major cause of the last crisis, but now the Fed and Bank of England are pushing banks to buy them again,” he says. “The central banks are also encouraging securitization again, [the pooling of debt into tradable instruments], all the things that originally got us into trouble”.
Anat Admati, Professor of Finance at Stanford University, is similarly concerned. “Derivatives allow significant risk to build within the financial system, and with extreme opacity,” she says, “exacerbating the fragility of the system”.
Admati points also to the failure of policymakers to reform the “too-big-to-fail” Western banks at the heart of the worst economic collapse in almost 80 years. “Our financial system remains bloated, inefficient and reckless,” she says. “It endangers innocent citizens unnecessarily and distorts the economy to benefit the few. This recklessness isn’t only tolerated but, perversely, encouraged and rewarded by flawed policies and ineffective regulation”.
Admati pillories the official attempts to fix our banking system. “Supposed tough reforms are just tweaks to the previous rules that failed spectacularly, maintaining key flaws,” she says.
Dempster concurs, observing that “nothing much has been addressed in terms of bank reform”. He points to “an awful lot of gaps in Dodd-Frank” – the legislation at the heart of America’s renewed attempt to control its biggest banks. “And the Vickers reforms don’t go nearly far enough,” Dempster adds, referring to UK safeguards, to be implemented by 2019, that rely on Chinese walls between the retail and investment banking arms of large UK banks.
“Chinese walls don’t work,” says Dempster. “Glass-Steagall should never have been taken down,” he argues, referring to US legislation that, between 1933 and 1997, kept such activities in separate companies, insulating taxpayer-backed deposits from risky investments. “It was the reason we had a reasonably stable banking system for almost 70 years”.
The balance sheets of the six largest Western banks totaled $14,600bn at the end of 2012, compared to $10,700bn in 2007. In March, the International Monetary Fund admitted such banks still receive annual implicit subsidies of $590bn, with creditors judging state bail-outs will indeed be forthcoming when reckless, highly-leveraged investments go wrong. This flies in the face of political rhetoric that the problem is solved and reforms mean taxpayers will never again have to bail-out bonus-fuelled traders.
Both Admati and Dempster complain the closeness of our political and financial classes is stymieing genuine banking reform. “There’s a lack of political will to challenge bank lobbies,” says Admati. “If I was Obama, I’d tell Goldman to get lost,” ventures Dempster. “But that’s not how the world works”.
This autumn, as the end of Fed “tapering” and rising interest rates loom larger, over-valued Western stock markets will come under intense pressure. Our largely unreformed, debt-soaked, loss-hiding banks mean a sharp asset price correction could spark a systemic crisis, involving not only the “advanced” world but the large emerging markets too. I don’t want it to happen, but there’s a good chance it might.
As The Italian Job ends, viewers are left with a strong impression Charlie Croker’s “great idea” will somehow resolve his gang’s predicament, using the same nous that outsmarted the Turin police. That’s where the analogy ends.
Liam Halligan writes the Economic Agenda column in The Sunday Telegraph.