Authored by Thorsten Polleit via Mises Canada,
Perhaps, one of the most striking features of current financial market price action is the conspicuous absence of investor risk concern. Stock market price volatility, for instance, has bottomed out on the lowest level since the early 1990s. At the same time, stock prices have reached all-time highs, and the valuation level has gone up substantially (with, say, the PE ratio standing now well above its long-term average). Investors are apparently quite confident that corporate earnings will continue to go up and a stock price correction is nowhere near.
Is it because we have finally left the worldwide economic and financial crisis behind us? Well, there are quite a few reasons to express some doubt. For example, total debt levels have not come down since the 2008/2009 crisis – on the contrary, they have grown further. At the end of 2007, global debt (public and private non-financial sector) stood at 212% of the world GDP, according to data provided by the Bank for International Settlement. By the end of 2016, the global debt-to-GDP ratio stood at 265%. So, what could be the reason that has put investor risk concern to rest?
Central banks come to mind because not only have they beat interest rates down to hitherto unseen low levels. They have also created a ‘safety net’ – not officially, but through the very policies they have implemented in the last decade. Investors have noticed – and expect central banks to stand ready to fend off any adverse developments in the real economy and financial markets again should it become necessary.
Having little to fear in terms of systemic risks, investors feel encouraged to engage in risky investments: investments they would not be making if central banks hadn’t put out a safety net.
As investors expect interest rates to remain suppressed or even be lowered further, if and when the economy or financial markets get hit by an adverse shock, asset prices keep going up, and lenders happily continue extending new loans. Consumption and investment are expanding, indeed suggesting that the recovery is growing stronger. However, the safety net provided by central banks is distorting interest rates, financial asset prices, and the cost of capital significantly.
As long as the safety net remains in place, we can assume that the effectiveness of central bank actions (such as, e.g. increasing short-term interest rates and unwinding bond purchases) is greatly diminished, because market agents have little reason to expect a final exit from the excessively loose monetary policy if such an attempted exit jeopardized the strengthening recovery and asset price inflation.
With the ignorance and under-pricing of risk – in the credit as well as the equity markets – central banks have orchestrated something that might best be referred to as “the great complacency”. They have created the illusion of stability and returning prosperity. To prevent the painful awakening, central banks keep interest rates and the cost of capital low and to fight any new trouble in the economic and financial system with an even looser monetary policy.
The political attempt in preventing yet another credit crisis – in which borrowers default on their payment obligations and the economy and financial markets nosedive – paves the way towards an increasingly inflationary environment. The relentless rise in asset prices, be it stock or housing prices, unmistakably shows how dependent the economic and financial system has become already – a dependence that will only get greater in times of “The Great Complacency” brought about by central banks.
via http://ift.tt/2zcDJZ8 Tyler Durden