AN UNSETTLING vision swam into view last week as stock markets around the world tumbled: that of a bubble encountering a pin.
In New York, the S&P 500 fell 1.4 per cent over the week and dropped 2.6 per cent below the record high struck on Wednesday. In the UK, the FTSE 100 retreated like a scalded cat from a 12-year high, falling 2.1 per cent on Thursday, its biggest one-day slide in a year.
But it was Tokyo that suffered the biggest thunderclap, tumbling 7.3 per cent on Thursday and ending the week 3.5 per cent down.
An all-too-predictable correction? Many might say so, after a six-month run that drove the Nikkei 225 up by a breathtaking 71 per cent. The Tokyo market, long the graveyard of investor hopes, had enjoyed a spectacular run on the prospect of massive capital injections by the Bank of Japan – the centrepiece of prime minister Shinzo Abe’s determination to reflate the country’s moribund economy.
After such a massive advance in so short a period, profit-taking was bound to set in.
But what sparked the sell-off? And why was it not confined to Tokyo? There is a darker interpretation that suggests something more worrying. For the past 18 months, stock markets have been underpinned by a conviction that the monetary authorities were committed to policies of monetary easing to stave off the threat of deflation and stimulate their domestic economies. Programmes of quantitative easing (QE) were embarked upon. But how long would it last? How much QE would be necessary?
Many assumed central banks knew the answers to these questions. But there is a gnawing suspicion that they don’t. Indeed, some doubt whether they are in as much control of events as they think they are.
The sharp sell-off on Wall Street followed remarks by Federal Reserve chairman Ben Bernanke to a US congressional committee. These were seen to hint that the Fed would soon begin to taper its bond purchases, widely known as QE3.
He said: “A premature tightening of monetary policy could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further.”
But what exactly was he trying to convey? It was a remark that evoked the Delphic utterances of his predecessor Alan Greenspan who once quipped: “If I’ve made myself clear, you must have misunderstood me.”
It is surely no part of Bernanke’s agenda to slow or halt America’s nascent recovery. So it would be natural to assume he was signalling that he was against an early withdrawal of the support the central bank was giving.
But then he spoke about the risks relating to the Fed’s asset-buying. Here the reference was a reminder that such support would at some point end. Were markets being gently reminded that the Fed’s bond purchases had this element of conditionality, and that they ought to be prepared?
Stephen Lewis, economist at Monument Securities, detected the onset of jitters among Wall Street’s flighty traders. He wrote: “Like buffalo on the range, red-eyed from cactus juice, they are liable to stampede at every stirring of the breeze, real or imaginary.”
Whether Bernanke had said too little or too much, it catalysed a mood of doubt about where QE is going – and where and how it is going to end. Given the role it has played in driving up asset prices in America, Europe and Japan, how are the feet to be taken off the pedals without a consequent sharp drop in the asset prices that have been driven up?
That could switch off those flickering recovery lights. In Tokyo, unnerving spikes in Japanese government bond yields have investors fretting about whether or not the Bank of Japan really knows what it is up to.
Here in the UK there has been a consensus expectation that incoming Bank of England governor Mark Carney will be “softer” than the current man in the chair, Sir Mervyn King, in targeting inflation and that Carney will resort to further QE on top of the £375 billion already undertaken. That certainly seems to be the firm expectation of a desperate government.
But the central bank is supposed to be independent. And at some stage, the Bank of England and other central banks need to regain authority over markets and prevent the rise in asset prices from developing into a fully-fledged – and catastrophic – asset bubble and bust.
Quite how this will be done is by no means clear. And that uncertainty is likely to keep markets on edge this summer. Endless bouts of monetary easing are no substitute for the difficult structural reforms that economies have to undertake – reducing public spending and borrowing and promoting productivity improvement.
In the 1970s, inflation became so entrenched that controlling it was like grabbing a tiger by the tail – it is feared that monetary stimulus may become this generation’s tiger.
Investors are desperate to protect their capital and have charged into equities as the best available defence against negative real rates of return on fixed-interest savings. But they need to take care that equities are not being driven to heights that earnings growth is unable to sustain.
Those who bought in at lower prices (and higher dividend yields) should not be panicked out. But caution and patience are now the watchwords. Corrections can take time to complete, and this one may not be over.