Posts Tagged ‘markets’

In a column “Balancing Good, Bad Finance” in Wednesday’s Wall Street Journal, David Wessel asks a provocative question: “How much finance is good?”

His thesis in the column is the growth in the financial sector that led to the financial crisis was caused by too much risk taking and borrowing by financial institutions. The financial sector came to be too large of a part of the economy. Too much of the growth in the system fueled the expansion of financial firms themselves, rather than funding overall investment.

So what amount of finance, in what doses, would benefit the global economy without the financial sector careening out of control and creating another financial crisis? There are several external and internal issues that I’ll identify and elaborate on in future posts:

  • Without prudent globally-consistent regulation and enforcement, the tendency of the financial sector will be to grow in an unconstrained, risky way, courting further financial crises
  • When financial institutions are being subsidized by the government via bailouts and safety net subsidies (deposit insurance, anyone?) they have a responsibility to act in a more ethical and restrained manner, especially when it comes to risk
  • Time horizons: corporate management, financial markets and government regulators have become insanely short-sighted. The viewpoint seems to be to either take the money and run because someone else will be there to take the fall later or deal with whatever issue is on the table with the easiest, most short term solution possible.

All of these factors are leading us right down the road into the next global financial crisis. It may not happen for a year or a decade. But I believe it’s inevitable without serious regulatory, political and philosophical reforms of the financial sector and financial regulation on a global level.

With the stock market closing in on new highs, there are legitimate questions about the market being overbought in that it seems to be disconnected with economic fundamentals in the U.S. and overseas. On the heels of that, PIMCO’s Bill Gross is raising new questions about valuations in the credit markets, which he calls “somewhat exuberantly” priced.

First, the stock market: while there is certainly cause for optimism for the growth prospects for the U.S. economy this year versus the past couple of years, optimism is just that. True, housing markets are on the rebound, the job market is inching forward and consumer and business confidence is decent. OTOH, the upcoming sequestration and debt ceiling dramas (the sequester on the table now and the debt ceiling again in August) could potentially trim economic growth and dampen consumer confidence and events in Europe aren’t anything to write home about. Most EU economies are in active recession, even “official” unemployment numbers are alarming and voters are actively rebelling against austerity (see Italian elections).

I honestly don’t see where all this optimism is coming from and what is driving the stock markets to new heights, outside of the fact that the Fed’s low interest rate policies are driving investors into risk assets and overt speculation.

In terms of the bond markets, as interest rates have fallen and stayed at rock bottom lows during the past several years, various sectors have had their time in the sun, most recently, as Gross states, corporate credit and high yield. Before that Treasuries were on fire. He views the bond market at a six on a scale of one to 10 in terms of overvaluation.

The real shadow over the bond markets is the prospect of higher interest rates and inflation. Various pundits have been predicting inflation, followed by higher rates, for years but it hasn’t happened yet. There does seem to be more incipient inflation in the economy this year than in recent years and any inflation spike that is extended could force the Fed to raise interest rates sooner than expected.

All in all, both U.S. stock and bond markets seem to be in frothy territory, where asset prices aren’t supported by fundamentals. Time to be wary…