Dangerous complacency

Following the recent rally in global stock markets, the prevailing mood is one of dangerous complacency. Markets are so enamored by the prospect of continued and escalating stimulus that they forget the desperate economic circumstances that make bailouts, stability funds and other support operations necessary. There are two things we find particularly troublesome with this perception. First, the mantra that “conditions are so poor that policy makers will have to continue to stimulate, and therefore poor conditions are good for my portfolio” is deeply flawed. If it continues to enthrall investors, capital will be misallocated in ever greater amounts—instead of flowing to productive purposes, it will create price bubbles in various asset classes. This could initially be good for quality stocks, but their explosive appreciation would likely be followed by a spectacular crash. The second thing that worries us is that a return to more prudent policies, in which deep structural reforms might replace mega-stimulus, would cause a serious market correction. Right now, armies of professional and amateur investors perversely hope that growth will somehow stay weak enough to spur more government action. If policy makers decided to abandon the bailout approach, despite low economic growth, panic could easily ensue. These reasons, and a host of political uncertainties which could alter the fiscal and monetary background further, mandate a significant liquidity position.