A Warning from the Bank for Central Banks

Dear Reader,

In late 1996 the then Federal Reserve Chairman Alan Greenspan thought up the term ‘irrational exuberance’ while taking a bath.

Greenspan thought the markets were too hot at the time. So, he decided to cool them.

Twitter wasn’t around yet, so he used the term during a televised speech. In it, Greenspan posed a simple question (emphasis added):

Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?

This rhetorical question sent the markets into turmoil. But the effect didn’t last long, and markets pushed past the jitters quickly.

It wouldn’t be until 2000, with the popping of the dotcom bubble that the market collapsed.

Markets are showing some signs of ‘exuberance’ again. It’s something the Bank of International Settlements (BIS) admitted in their Annual Economic Report released this week.

If you are not familiar with the BIS, it’s the bank for central banks. I always try to make time to read their reports, since they are usually quite upfront about the challenges we face.

According to the report, the pandemic is a ‘defining moment of the 21st century’.

In a brand new report, market expert Vern Gowdie warns of the dangers waiting in a post-COVID-19 world. Plus, he outlines the steps you should take now to protect your wealth. Learn more.

A global crisis

It’s a truly global crisis, affecting every country. One that has forced an unprecedented and complete stop to the world economy.

As economies collapsed and unemployment surged, central banks were quick to respond by flooding the system with money to keep liquidity.

But the move MORE THAN appeased the markets, as the report noted (emphasis added):

Just like the virus, the crisis has been evolving. In some respects, the success of central banks in calming markets and shoring up confidence has even helped spark some market exuberance: at the time of writing, equity prices and corporate spreads in particular seem to have decoupled from the weaker real economy. Even so, underlying financial fragilities remain: this feels more like a truce than a peace settlement.

It’s something Agustin Carstens, the BIS’s general manager also echoed in his speech:

Financial markets may have become too complacent — given that we are still at an early stage of the crisis and its fallout. The outlook for the world economy is still highly uncertain. At best, we have only just overcome the liquidity phase of the crisis in the countries that are now relaxing restrictions. In many others, the health crisis is still acute. And the epidemic could flare up again anywhere.

This may have started as a health crisis, but the truth is that things weren’t that great before.

We were at the tail end of a long bull market. There were still problems with liquidity as the Fed tried to taper off all the stimulus from the last financial crisis…remember the repo crisis?

There was also high corporate debt and interest rates were stuck at record lows. At the same time, asset prices were at record highs, which had driven up household debt levels.

And then COVID-19 hit…

Investors left markets in record droves, as you can see below (right figure), jumping back when central banks injected liquidity.

The Rum Rebellion

Source: BIS

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But things are from over.

The crisis has fuelled an increase in downgrades, as you can see in the graph on the left above.

As the BIS continued in the report:

[M]ore fundamentally, what first appeared to be a liquidity problem, more amenable to central bank remedies, is morphing into a threat to solvency. A wave of downgrades has started, alongside concerns that losses might cause widespread defaults.

So far markets seem to have recovered. The NASDAQ is trading above 10,200 at time of writing; higher than before the pandemic. The S&P 500 Index is trading above 3,100.

But there are a couple of problems ahead.

The Wall Street Journal reports that more than 40% of the companies in the S&P 500 have withdrawn their guidance because of too much uncertainty.

And all this central bank stimulus isn’t translating into jobs yet.

Markets may be cheering unemployment falling to 11.1% this week, but this is still a far cry from the unemployment level back in February of 3.5%, a 7.6% drop.

Higher unemployment means less consumer spending.

Markets may be plodding higher but investors are ignoring the most important driver of stock prices in the long run — that is, earnings.


Selva Freigedo,
Editor, The Rum Rebellion

Selva Freigedo is a research analyst for The Rum Rebellion.

Born in Argentina, her passion for economic analysis started at a young age. Her father was an economist for the Argentinean governments and the family used to discuss politics and economics at the dinner table.

Argentina is a country with an unusual economic history. Growing up there gave Selva first-hand experience on different economic phenomena such as hyperinflation, devaluation and debt default.

Selva has also lived in Brazil, Spain and the USA.

Back in 2000 she was living in the US as the dot com bubble popped…
And in 2008 she was in Spain as the property market exploded and then collapsed…

She has seen first-hand what happens when bubbles burst.

Selva joined Fat Tail Investment Research’s team in 2016, as an analyst. She now writes from her vantage point in Australia, where she settled in 2015.

The Rum Rebellion