InvestmentsDec 4 2017

Goldilocks investors warned on equity bubble

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Goldilocks investors warned on equity bubble

The Bank for International Settlements (BIS), a central bank of central banks, has warned that interest rate rises are adding to the bubble-like conditions in equity markets.

The BIS said investors continue to enjoy “Goldilocks” conditions in markets, with an improving outlook for global GDP growth, and low inflation.

Claudio Borio, the head of the BIS, said central banks might need to look at how they talk about interest rates or how fast they raise them, to make investors realise the potential dangers.

“The vulnerabilities that have built around the globe during the long period of unusually low interest rates have not gone away. High debt levels, in both domestic and foreign currency, are still there. And so are frothy valuations.

“What’s more, the longer the risk-taking continues, the higher the underlying balance sheet exposures may become. Short-run calm comes at the expense of possible long-run turbulence,” he said.

The pick-up in economic growth is broad based and exists in both emerging and developed markets.

The Bank for International Settlements said it is a “paradox” that while interest rates have been rising, the market for risk assets has continued to rise.

Conventional economic theory states that rising interest rates should be bad for equities and riskier bonds. This is because higher interest rates boost the returns available on assets with less risk and volatility than equities and high yield bonds, notably government bonds and cash.

As a result, investors would be expected to move out of equities and towards government bonds as the yields on the latter rise.

But the BIS note that yields on government bonds have hardly risen since the US began to raise rates, while equity markets have performed well.

The likelihood is this is because global inflation expectations have risen alongside growth, with the result that assets such as government bonds continue to yields less than the rate of inflation.

The central bank said the turning point for inflation expectations was the election of Donald Trump as US president.

Mr Trump’s populist economics, spending plans and tax cuts are viewed by the market as being likely to lead to higher inflation emanating from the US.