In a recent poll of Morgan Stanley's top clients, not a single investor thought the world economy would rebound with any strength later this year. However, the same investors are overwhelmingly bullish on stocks and property. These actions seem entirely based on the assumption that QE and central banks will keep the game going, flooding the asset markets with liquidity.
By Ambrose Evans-Pritchard
Last updated: May 21st, 2013
The latest poll of Morgan Stanley's top clients from across the world says it all.
Chief economist Joachim Fels tells us that not a single investor at the bank's Florence forum thought the world economy would rebound with any strength later this year.
Just a quarter expect a return to trend growth. Some 57pc think there will be no escape from the "twilight" conditions afflicting the western world, and 20pc expect an full-blown global recession. That is a remarkably bearish set of views. Yet the same investors are overwhelmingly bullish on stocks and property.
This schizophrenic exuberance seems entirely based on the assumption that QE and central bank largesse will keep the game going, flooding asset markets with liquidity. Indeed, 80pc think the ECB will cut rates again, and half think it will have to swallow its pride and join the QE club in the end.
Four fifths think equities will gallop on upwards over the next year. Complacency is rife. "It became very clear – and many investors were quite explicit about this – that markets are lulled by the lure of liquidity resulting from negative real interest rates and global QE," said Mr Fels.
This then is the bull market of May 2013. Remember the infamous words of Citi's Chuck Prince in July 2007. "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing."
I defy anybody to explain what liquidity is. At the end of the day, it is really just risk appetite. It can vanish in a second. (If people mean the quantity of money, that is a different story, and not uber-bullish right now).
Stephen Lewis from Monument Securities says markets seem to think they are in a "no-lose" play: if the economy gains traction, stocks will rise: if it doesn't, central banks will pump in more money.
Mr Lewis said they overlook a nasty possibility that the Fed will start to wind down QE before the US economy has fully recovered. He cites the minutes of Fed's 19-20 March meeting showing growing worries about a new asset bubble, a worry shared by the BIS and the IMF: "A number of participants remained concerned about the potential for financial stability risks to build".
The concerns were spelt out in a landmark paper for US Monetary Policy Forum published by the Fed in February: "Crunch Time: Fiscal Crises and the Role of Monetary Policy".
The paper was by co-written by former Fed Governor Frederic Mishkin, Ben Bernanke's alter ego. It warned that the Fed could struggle to extract itself from QE from 2014 onwards. The longer it goes on, the more dangerous it becomes.
It argued that rising long rates could lead to a bond market rout, inflicting big losses on its $3 trillion portfolio. This could "wipe out" its capital base several times over.
Mishkin said the Fed is badly exposed because it has stretched the average maturity of its bond holdings to 11 years, and the longer the date, the bigger the losses when yields rise. Trouble could compound at an alarming pace by the middle of the decade, with yields spiking up to double-digit rates by the late 2020s.
By then Fed will be forced to finance federal spending directly to avert the greater evil of default. By then, the US really will be facing the sort of hyperinflationary denouement long-feared by QE sceptics.
Just to be clear, this the Mishkin concern, not mine. I think exit risks are greatly exaggerated. The Fed extracted itself from Great Depression policies without any losses, and such losses are in any case irrelevant. They are an electronic accounting fiction. There may be many good reasons for opposing QE, but fretting about the Fed's capital base is not one of them.
But this is the view of several Fed governors and regional presidents, so it matters. And it may have got under Ben Bernanke's skin as well.
As for the Morgan Stanly investors who think that central bank policy is "expansionary", they are wrong. Market monetarist Scott Sumner reminds us in this self-described rant that global money is in fact tight, especially in Europe.
There seems to be a near universal assumption – shared by most governors at the ECB – that low rates necessarily mean loose money. This is antediluvian. Japan had near zero rates for sixteen years, yet descended ever deeper into deflation and an as asset slump. Zero means nothing.
Milton Friedman taught us long ago that zero rates can be extremely tight, which is why central banks then have to step in to expand the broad money supply (M2 in his day, now M3). And what do you know? Eurozone M3 has contracted over the last three months (M-on-M), and US M3 is no longer growing briskly.
We will find out tomorrow from Ben Bernanke's testimony to Congress whether he aims to "taper" QE sooner or later. The markets are all on one side betting that it will be later. They are probably right, but they had better be.
As Warren Buffett said, it will be the shot heard around the world the day Bernanke hints at anything else. By the way, Mr Buffett is not dancing right now. Berkshire Hathaway is sitting on a record $49bn in cash. Speaks for itself.
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