The recent strong performance of most equity and bond markets may not be justified, according to Bank of England governor Mark Carney.
Speaking at the Local Government Association's annual conference on July 2, Mr Carney said investors pushing investment markets higher despite deteriorating economic conditions were showing "notable faith" in the power of central banks to fix the global economy, which may be misguided.
This comes after the S&P 500 index of US shares hit an all time record high in recent days, while the MSCI World Index has returned 17 per cent this year to date.
Mr Carney said markets have rallied in 2019, despite economic data worsening, because investors now believe interest rates will fall. This, he said, pushed the discount rate lower, and so pushed equity markets higher.
The discount rate is one method used by investors to value equities, as they compare the interest rate with the typical return available from shares, so as the discount rate lowers, those investors buy shares.
Mr Carney also said investors may be wrong in their expectation of the extent to which rates could fall, as for this to be justified, the global economy would have to be in a much worse state.
The governor said: "Concerns are contributing to sharp reductions in corporate earnings expectations, though for the time being the falls in expected policy rates have cushioned the impact on equity prices. The markets’ faith in the power of monetary policy is notable."
He added: "Over the past year, the global economy has shifted from a robust, broad-based expansion to a widespread slowdown, with the proportion of the global economy growing above trend falling from four fifths to one sixth.
"Business confidence has fallen across the G7 to its lowest level in five years with sentiment among manufacturers particularly weak.
"Households have also become gloomier about the general economic outlook, though they remain relatively upbeat about their own financial situation, likely reflecting robust labour markets.
"This is a similar pattern to that which emerged in the UK following the referendum. As a consequence, the quality of global growth has deteriorated.
"Across the G7, the growth rate of business investment has almost halved since its peak in late 2017, leaving the global expansion more reliant on consumer spending and reducing its resilience."
He said the impact on the global economy of the trade dispute between the US and China was similar to the impact that Brexit had on the UK economy.
Guy Miller, head of macroeconomics at Zurich, said the market had faith that global central banks would cut interest rates and that this would boost economic growth.
But he is skeptical that this will happen, as he said central banks' primary concern was to manage inflation, not to achieve higher economic growth.
He said he was skeptical that central banks would take the actions the market believes are necessary to ferment a higher level of economic growth.
He added there must be some doubt as to whether more of the measures used by central banks since the financial crisis, such as cutting interest rates or instigating the bond buying programme known as quantitative easing, will be effective, given how low interest rates already are.
Lower interest rates typically boost share prices in the short-term, because they push down the returns available on safe haven assets such as government bonds and cash, making the returns available from equities relatively more attractive.
david.thorpe@ft.com
