For years, pundits have been warning of a stock market bubble and its “inevitable” bursting. The reasoning behind such predictions is simple. Western economies have grown at a modest pace, restraining the profit-making ability of large corporations. Moreover, inflation has remained low, even though the West and Japan have engaged in expansionary monetary policies. All this liquidity has fed stock markets, inflating stock prices far beyond any reasonable level.
You might also be interested in:
For example, since 2013, Germany’s DAX stock market index has risen by 83 percent, while the Dow Jones Industrial Average in the United States has increased by 65 percent. During the same period, the nominal gross domestic products (GDP) of Germany and the U.S. have both increased by about 11 percent. As soon as investors realize that companies are worth much less than the stock markets suggest – so the story goes – a crash will occur.
Finally, low interest rates have pushed bonds prices up and yields down, encouraging investors to buy stocks in hopes of achieving higher returns. When interest rates rise and bonds become attractive again, experts believe that investors will dump stocks and flock back to bonds.
It is clear that Western economies no longer need massive injections of liquidity
All of this sounds reasonable in theory. It is true that U.S. firms’ average price-to-earnings ratio is now about one-third above its long-term average – this means profits are too low, relative to the value of the companies’ shares. So, stocks are overpriced and there is plenty of room for big corrections. Yet so far, nothing of the sort has materialized. Will these predictions come true? If so, when? Future scenarios will be determined by two variables: interest rates and expectations. We shall examine them in turn, and draw some conclusions.
Interest rates are gradually rising in the U.S. and may rise sooner than expected in Europe as well, despite low inflation. Economic growth rates are relatively low – the International Monetary Fund predicts 3.5 percent GDP growth for the world in 2017, but only 2 percent for rich countries. However, it is clear that Western economies no longer need massive injections of liquidity.
This does not mean that there are no vulnerabilities. For example, the European banking industry remains fragile. However, banks and insurance companies perform better with higher interest rates, and higher borrowing costs are certainly preferable to rescue plans. The only major victim of a less generous monetary policy would be public finance. However, most European countries seem reasonably well-positioned to deal with slightly tighter conditions.
The conclusion to draw is that the slow rise in interest rates is unlikely to wreak havoc on the equity markets. Investors have already factored in this possibility over the past year, and stock prices have not cooled off. In fact, higher interest rates could have the unexpected effect of further driving up valuations. In recent years, the weak spot of Western economies has been the financial sector. If higher interest rates boost profits in banking and insurance and do not threaten public debt, the bulls will rejoice. The bubble could get even bigger.
Predicting the future of expectations is dicey. Investors are currently monitoring four variables. One is inflation. Observers take it for granted that the inflation rate in the dollar and the euro areas will not exceed 3 percent. The rule of thumb they follow is simple: if inflation is between 2 percent and 3 percent, they celebrate; if price growth is between 1.5 percent and 2 percent, they stay alert; anything below 1.5 percent is a cause for worry. Inflation is currently seen as a predictor for monetary policy, rather than as a phenomenon that can damage the economy and redistribute wealth.
Given the prevailing approach to central banking, inflation will probably not drop below 1.5 percent for more than a quarter or two. On the other hand, it could move beyond the 3 percent threshold before long, especially if people forget about the latest crisis and turn their liquidity into consumer spending. If this were to happen, uncertainty would prevail: Will monetary policy become tighter to quench inflationary pressures or remain neutral to enhance growth?
Expectations about GDP will also play an important role, but they appear less problematic. The West’s current 2 percent growth rate is slower than many would like, but it is what investors expect and they seem satisfied with it. The only surprise could come from China, where a severe slowdown could stoke pessimism worldwide. However, those who had predicted a Chinese collapse are now silent. Certainly, Beijing remains burdened by bad banking and an inflated real estate market – a slowdown will occur in the coming years. But for the time being, a soft landing seems more likely than a crash.
Brexit has been a blessing for Brussels. It has shown how difficult it is to leave the club
The European Union is also providing investors with good news: it is no longer on the verge of collapse, and in the past months it has attracted large amounts of investment from the U.S. Rather unexpectedly, Brexit has been a blessing for Brussels. It has shown how difficult it is to leave the club and how expensive it could be. Moreover, the difficulties met by Prime Minister Theresa May illustrate that even the most experienced bureaucracies are unable to elaborate a plan that goes beyond regulating or taxing.
Brussels’ ambitions for superpower status have vanished, but investors do not need a new superpower. They want stability, and today the EU guarantees that. The only question mark is Italy. The country has a large, unsustainable public debt, suffers from populist tensions and is growing at a snail’s pace. Its public deficit seems under control, but only temporarily. It could easily explode. If Italy goes broke, the entire EU could become a region that investors avoid for years. Stock markets will suffer badly.
Finally, public indebtedness could surprise careless investors. As mentioned earlier, investors are behaving as if inflation is bound to stay low for decades. Something similar applies to government finances. If one looks at the price of insuring against default, the probability of this event appears relatively small, despite the recent case of Greece. Yet, the overall situation deserves attention. Higher interest rates and slow growth could easily generate worrisome tensions.
No crash ahead
If one looks at corporate profits and market values, shares are certainly overpriced. If investors who moved to stocks revise their strategies due to tighter monetary policy, bonds will become attractive and share prices will drop. There is no reason to expect a crash, however. A new financial crisis is not around the corner, especially if higher interest rates help strengthen the balance sheets of banks and insurance companies. Pessimists could be right, but their predictions will come true only if economic instability emerges.
Although protectionism remains a (distant) threat, world leaders have stopped their drumbeating
Two major sources of trouble have already receded, at least for the time being. Although protectionism remains a (distant) threat, world leaders have stopped their drumbeating and are sticking to healthy free-trade principles. Moreover, neither the EU nor the eurozone seem on the verge of disintegration. There are possible flash points – Brexit, Catalonia’s vote on secession from Spain, Italy’s flirting with disaster – but unless these trouble spots become much worse, they will not prick the bubble.
Three other sources of trouble could trigger panic: a Chinese crisis, a sudden burst of inflation followed by panicky monetary reactions and a banking crisis in the EU. These events cannot be ruled out. The Chinese economy needs reform, there is too much liquidity around and European banks are saddled with too many nonperforming loans. Nonetheless, all these potential troubles do not seem imminent. If this relatively sanguine scenario plays out, the stock bubble will not burst. Shares might fall, especially if interest rates rise and investors move to bonds. But there will not be panic. Instead, it will be a reaction to new opportunities and more reasonable monetary conditions.