In a note released this morning by Macquarie's Viktor Shvetz, the bank's stunned head of global equity strategy looks at what has become a "world without risk" and makes several observations, the key of which is absolutely spot on: "Investors are probably suffering extreme mental exhaustion. Historically low volatilities and risks, coinciding with high valuations, would make anyone nervous." The reason for this underlying dysphoria, is that "investors understand that there is nothing normal in the current environment of unprecedented financialization and economic disruption. The deadweight of US$400 trillion ‘cloud’ of financial instruments (backing into assets that are either worthless or are declining in value) must be supported by ongoing financialization.
This implies that liquidity must continue to grow, volatilities must be controlled and neither demand nor supply can yield higher cost of capital. Thus, risks facing investors are that either CBs and/or China misjudge extent to which reflation is dependent on inflating asset values and China’s fixed investment.
Indeed, one look at risk assets shows that spreads are at all time tights, a market that is more complacent than it was in the summer of 2007.
And yet, therein lies the rub, because in the near-term, liquidity will not be growing at the same pace as it has in recent years, in fact, it is rapidly slowing down. Shvets looks at the global reflation that was kick started by China in 2Q’16 (shortly after the "Shanghai Accord") and which remains strong (revised OECD leading indicators have stabilized after deflating for several months), even as China’s momentum is slowing, as the catalyst for this liquidity slowdown, i.e. central bank balance sheet tapering:
While backward indicators, economists and International Agencies are also starting to revise forecasts for ‘17, and by implication for ‘18-19. This in turn means that pressure on CBs to maintain liquidity might decline, as money velocity presumably improves. Also, as shocks either diminish or become less pronounced, the ‘safety value’ of US$ might continue to drop. Hence, the expectation is building that the global economy will remain in the ‘goldilocks’ or nice balance between growth, inflation, cost of money and direction of US$, for longer.
Does Shvets agree?
"Unfortunately", the analyst does "not see evidence that velocity of money is improving and neither are there signs that sectoral balances are moving towards sustainably higher private spending while core inflationary pulse remains weak."
"We continue to view China’s leveraging and CBs’ injections of liquidity and suppression of volatilities as the key drivers of global reflation. We also maintain (here) that it is unlikely that the Trump administration policies will lead to any sustained gain in either consumption, investment or CA deficits."
The bottom line fromthe Macquarie analyst is a paradoxically optimistic one: the status quo must continue, as the alternative is inconceibable:
We remain constructive on financial assets, not because we believe in a sustainable recovery, but because we back the perpetual leveraging ‘doomsday’ machine.
What he means here is that with the bulk of economic consumption supported by artificially inflated asset prices in a world where savings are approaching all time lows, central banks simply have no choice but to perpetuate QE, even as they take an occasional temporary, and well choreographed detour into "normalization."
Below we excerpt from Macquarie's analysis of why investors are slowly going insane in a world that - according to the market - is "without risk" and where investing is as easy as pie:
Loose liquidity and no risks anywhere
Investors seem to be residing in a world without any notable perceived risks. It is an extraordinary and unprecedented situation, particularly given unresolved issues of over leveraging and associated over capacity as well as profound disruption of business and economic models, which are not just depressing inflation but also causing extreme political and electoral outcomes while feeding Maslowian-type disappointments across labour markets.
What can explain such lack of concern regarding potential risks?
In our view, the only answer is one of investors’ perception that, as we discussed in our preview of 2H’17, ‘slaves must remain slaves’ and hence, neither Central Banks nor other public institutions can afford to step aside but need to continue to guarantee asset price inflation. In its turn, this can only be achieved by ensuring that volatilities are contained (as they are the deadliest enemy of an ongoing leveraging) and liquidity is expanding at a sufficient pace to accommodate nominal demand.
The optimists would argue that the productivity slowdown that the world experienced over the last decade was primarily caused by the global financial crisis (GFC) and that we are starting to turn the corner. Hence, optimists argue that velocity of money is likely to improve, and this would allow Central Banks to gradually (and very carefully) withdraw liquidity and rate supports. While this is the ‘dream outcome’ from Central Banks’ perspective, we don’t see any convincing evidence that this is occurring. We maintain that the best explanation for investors’ perception that risks are low is that a combination of Central Banks’ liquidity (still running at ~US$1.5-2.0 trillion per annum), an assumption that Central Banks would swiftly reverse their policies at the slightest sign of volatility reemerging, and China’s real estate and infrastructure investment, act as ‘risk buffers’. Investors seem to believe that liquidity cannot be withdrawn, volatility must be arrested and cost of capital cannot go up, and hence, financial assets are in many ways underwritten. While Central Banks would like to have a little bit more volatility and a little bit more price discovery, they would be highly averse to shocking what is the highly financialized and leveraged global economy.
While it is hard to back what is essentially a long-term ‘doomsday’ machine, nevertheless, the above describes our view. We remain constructive on financial assets (both equities and bonds), not because we expect a return to self-sustaining private sector led recovery and growth but because we believe that an ongoing financialization is the only politically and socially acceptable answer. In our view, therefore, the greatest risk is one of policy miscalculation.