Stock and bond bull runs show bubble-like qualities

David Oakley considers the consequences of quantitative easing and ultra-low interest rate policies

“We are part of the biggest financial experiment in world history and the consequences are yet unknown.”

These were the words of Lord Rothschild, scion of the Rothschild banking dynasty and chairman of RIT Capital Partners, the investment trust, last month in his semi-annual financial statement to investors.

This financial experiment has distorted markets and propelled equity and bond prices to record highs. Central bank quantitative easing and ultra-low interest rate policies have fuelled simultaneous bull runs in stocks and bonds.

It is hard not to jump to the conclusion that these bull runs have bubble-like qualities. In other words, some asset prices have gone up too much and must burst at some point.

Valuations in two particular markets look extremely stretched: US large-cap equities and government bonds.
The biggest companies in the US are trading at historically high valuations last seen in July 2015, just before the market plunged because of worries about China’s economy, says OTAS Technologies, the data company.

Of the top 500 companies in the US, the median valuation is trading at an 18 per cent premium to the 10-year average.

The risks of a violent reverse, therefore, may be in the large US companies on the S&P 500, which is trading around all-time highs, rather than other markets. Valuations in small and medium-sized US companies and European stocks are well below their peaks.

James Maltin, investment director at Rathbones, the wealth manager, says: “There is a wide gap in valuations between the large-cap US stocks, and the mid-caps and smaller companies. QE [quantitative easing] has driven the big stocks higher.

“It is the US large-caps where the valuations are artificially stretched by QE. If you scratch below the surface to the smaller stocks, you will find value.”
Although he is not warning that these large US stocks will sell off, he is not buying them at these prices and valuations.

Other fund managers are more worried. The speed of the upwards move in equities since the UK voted to leave the EU in the June referendum has taken them by surprise. Matthew Beesley, head of global equities at Henderson, the investment group, says: “Equity markets are on a giant piece of elastic that could snap at any moment.”

Adding to the chances of a sudden reverse are a large number of equity investors who are doubling up on high share prices by selling put options too, says OTAS.

This commits them to buying the shares should prices fall. These investors are exposed to an equity market sell-off through both their ownership of the stock and the recently written put options.

In bonds, valuations look just as stretched, particularly in the sovereign markets, where the biggest price distortions can be found because QE programmes have largely involved buying government debt.

Government bond yields, which trade inversely with prices, have been driven down to record lows by QE purchases and ultra-low interest rates. According to Andy Haldane, the chief economist at the Bank of England, interest rates might be at the lowest levels since the beginning of civilisation, 5,000 years ago.

Some fixed income investors are also issuing apocalyptic warnings. Bill Gross, the lead portfolio manager at Janus Capital and co-founder of bond house Pimco, says inflated fixed income prices and ultra-low yields have created a “supernova that will explode one day”.

Mr Gross may be painting an overly pessimistic picture. It is difficult to forecast where the financial experiment might lead us.

As Lord Rothschild also said in his financial report last month: “We are in uncharted waters and it is impossible to predict the unintended consequences of very low interest rates.”

However, the sensible fund manager should take some form of defensive action. In the case of Mr Maltin, he has taken on his largest position in gold bullion.

Trading 30 per cent below its 2011 peaks, gold looks good value. It is the ideal hedge against market volatility and inflation, which the great financial experiment may one day unleash.

David Oakley is the FT’s corporate affairs correspondent