Investors face a conundrum: The world is experiencing a record synchronous growth phase, but an increasing number of assets are becoming overvalued just as fundamental risks lurk in the background. Should investors continue to dance to the tune of central bank stimulus and low volatility, or prepare to exit?
What appears to be a Goldilocks economy could in actuality conceal a low-volatility trap, a situation where excessive monetary stimulus keeps asset prices rising and volatility low across markets even though real-economy risks are rising. On one hand, central bank stimulus directly lowers risk premiums and volatility in rates and credit markets, pushing investors into riskier assets to generate sufficient returns. On the other hand, politics have become less stable as inequality rises, as the recent elections in the United States, United Kingdom and Europe show, and the number of geopolitical hotspots continues to rise. And yet, markets continue threading higher and volatility remains at record lows.
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A prolonged environment of low volatility and low interest rates can promote asset bubbles, as European Central Bank President Mario Draghi said a few days ago. A number of markets show not only elevated valuations, but also irrational behavior on the part of investors, including a suspension of traditional valuation models, an increase in trading volumes or “flipping” in the hopes of quick gains, and financial engineering. Potential bubbles can be found in emerging-market debt, technology stocks, U.S. high yield bonds, some sovereign debt, cryptocurrencies, properties — even art and collectibles.
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It is becoming clearer to economists and central bankers that even though we may be experiencing a long phase of growth, stretching the cycle with monetary stimulus inspired by crisis-era toolkits may be bringing several collateral effects. These include not only asset bubbles, but also a worsening of wealth inequality and a misallocation of resources.
Persistent low interest rates in the past have helped to roll forward an increasing amount of private and public debt to future generations, but this is no longer working. Economic fundamentals are different from the post-war period. Technology is deflationary. Demographics are no longer a tailwind, as there are fewer young people able to carry a higher debt burden in the future. The generation of so-called millennials is the first that will likely be poorer than their parents in the post-war period. Productivity is low as the economy suffers from hysteresis: a financial boom-bust cycle that can leave large swathes of the workforce out of the job market.