Perfect storm is brewing to capsize recent markets rally

We have seen a strong rally across financial markets in recent months, with both risk and safe haven assets making ground.

There have been good gains by stock markets, marked declines in bond yields, a rebound in oil prices and some recovery in emerging markets and their currencies.

The oxygen for the rally is being supplied by central banks via a further relaxation in monetary conditions. Ironically, a very weak US employment report for May, which followed on from less than stellar job growth in April, has been greeted positively in the financial markets.

The reason is that an expected increase in US rates this summer has now been put on the long finger. Fed chairwoman Janet Yellan indicated in a speech last week that the Fed is now likely to keep policy on hold until a clearer picture emerges on the economy.

Meanwhile, the ECB’s quantitative easing, or bond purchase programme, is getting into full swing as it begins to buy investment-grade euro corporate bonds to supplement its large purchases of government debt. The ECB continues to indicate that it is prepared to loosen policy even further if required.

Last week saw a surprise rate cut from the Bank of Korea, following on from an earlier unexpected rate cut in Australia.

China has continued to loosen policy this year, while there are expectations that further policy easing could be announced by the Bank of Japan as early as this week.

The very loose monetary conditions may not be doing much in terms of lifting the world economy out of a prolonged period of sluggish growth and low inflation, but it is leading to quite stretched valuations in some financial markets.

Yields on German government bonds are now negative out to nine-year maturities, with the yield on the benchmark 10-year bund hitting a record low of 0.01% late last week. The yield on 10-year Japanese bonds has fallen to a record low of -0.15%.

This is driving investors into higher yielding bond markets. 10-year UK gilt yields are at a record low of 1.2%. There has been a resurgence of flows into emerging markets and non-government paper.

European corporate bonds have been a strong performer, with yields turning negative on short-dated investment grade paper, helped by the ECB’s bond buying.

The extremely low level of bond yields is driving some stock market valuations to very high levels, despite a quite challenging economic backdrop that is putting pressure on corporate earnings. Price/earnings ratios are close to decade highs in the US and UK.

Indeed, the US stock market is up by 15% from its lows earlier in the year.

The elevated levels of markets leaves them very vulnerable to downside risks and shocks. Indeed, we have seen nervous stock markets lose ground in the past couple of days.

The OECD has warned about the dangers of what it terms the “extreme pricing” in many bond markets and “inherently challenging” stock market valuations.

It is concerned that an “abrupt and simultaneous” unwinding of these excesses could cause major disruption in financial markets and have considerable negative implications for the world economy.

The most immediate risk for markets is the clear possibility, judging by recent opinion polls, that the UK could vote to leave the EU in the upcoming referendum on June 23.

We have been warning for some time that currency and equity markets are in no way prepared for the turmoil that would follow a vote by the UK to leave the EU.

A second risk is if it becomes apparent that central banks in economies which are now close to full employment, such as the US and UK, have delayed too long in tightening monetary policy. Growth could reaccelerate in these economies later this year, forcing their central banks to raise rates at a much quicker pace than markets expect.

Another risk is renewed turbulence in emerging economies and markets, most notably China, with rising debt defaults and a tightening of credit conditions leading to a re-pricing of risk globally, impacting world financial markets.

All in all, there could be some nervous times ahead for markets.

* Oliver Mangan is chief economist at AIB.