Article published on LinkedIn on 16 June 2014

Comforting economic news and low levels of the ‘fear gauges’ in markets reflect a peaceful environment, yet investors feel unease. This is healthy and should prolong the bull market.

Peaceful

The cyclical environment looks peaceful. The US should continue to grow at a satisfactory pace, European business and consumer confidence have picked up and Japan is digesting its VAT rate increase rather well. More interestingly, the IMF opined in early April that the downturn risk in developed economies is near zero. In addition, tensions in financial markets, as shown in an index calculated by the Federal Reserve of St Louis, continue to hover around extremely low levels.

Unease

Yet several factors are creating a feeling of unease. First, lacklustre growth in developing countries and in particular China continues to be a source of concern. Two, Wall Street has been on a rising trend for a long time. While this does not automatically imply that the party is about to end, the awareness that all good things come to an end, means that concern is quite understandably, rising . Three, some of the excesses seen during the credit boom before the Global Financial Crisis of 2008 have made a surprisingly swift comeback. The terms of covenants governing bonds issued by corporates are becoming distinctly more favourable to the borrower than the lender. Fourth, people still struggle to understand why, against almost all expectations, government bond yields have declined so much this year: are bond investors sensing a structural slowdown that equity investors fail to see? Finally, Wall Street’s fear gauge, the VIX (an index which reflects the implied volatilities of S&P500 options) is at very low levels – just like its more elaborate peer mentioned above, the stress index of the Federal Reserve of St Louis. Without going into the technical details, when fear gauges give low readings, it means investors are quite relaxed about the market outlook. Yet, the longer this lasts, the more often you will hear the comment that ‘this cannot last’ and indeed historically we have seen big jumps in risk levels after long periods of calm.

Absence of euphoria

The multi-million dollar question is ‘what could cause these peaceful uneasy times to make way for turmoil?’. The sheer length of a bull market is not an answer. I would even argue that the slow US recovery, which is getting into its sixth year, implies that it will take a further several years before the usual tensions of mature business cycles manifest themselves: excessive build-up of productive capacity, excessive home building, inflation, rising real Fed funds rate, etc. These tensions eventually develop into a crisis and trigger a recession. This means that we’re in a long business cycle and in a long stock market cycle – provided the Fed doesn’t spoil the party (it seems unlikely to) and that the market does not get ahead of itself, meaning that it doesn’t rise more than earnings.

Indeed the biggest risk for the longevity of the current business cycle is that investors get too excited about it. There is a silver lining in the proliferation of articles arguing for caution. It reflects a certain risk awareness and an absence of euphoria. This is comforting and should stop expensive asset classes ending up in bubble territory. The price to be paid is many articles about dark clouds even though the sky looks blue to me.

 

William De Vijlder

Vice – Chairman of BNP Paribas Investment Partners