Beware broader bubbles created by monetary stimulus

EQUITY markets continue to go from strength to strength and, if the current uptrend remains intact, there’s an-ever increasing chance that the FTSE 100 will record a new all-time high very soon. It’s impressive to see this marked increase in risk appetite, which is pushing indices ever higher against what seems to be a very steep gradient. From a macro perspective, the economic data itself would hardly make you want to rush into risk assets.

There’s no question that monetary easing, currently being undertaken by several of the world’s most important central banks, is playing its part in fuelling the flow of funds into equities. Momentum seems to be supported by an expectation that, should all the money printing pay off, and real growth returns, then the cyclical stock play will come back and extend the rally further.

As with any stock market cycle, however, there are sectors that are loved and unloved. The banks, for example, were nobody’s friend a year ago before suddenly becoming the flavour of the moment again. For now, it remains to some extent the mining and energy stocks that are rather out of favour. If growth starts to pick up again, particularly in the Bric countries, then those sectors might start playing a more prominent role in investors’ portfolios once again. Being able to see these trends is what gives professional investors and successful active fund managers the edge, especially during bull markets.

But all good things come to an end at some point, and it’s the ability to spot when a bubble is just about to burst that makes heroes out of those clever investors. Then the bears will have their day again. There will be signals that will pre-empt the end of the party, with one of the most obvious being the withdrawal of central bank liquidity and winding down of quantitative easing. In fact, it is so obvious that it’s unlikely to be this that actually bursts the bubble. But it won’t stop investors from listening very carefully to what central bankers have to say in the coming months. Ben Bernanke is a case in point, and tonight he will continue with his thoughts on the state of play for the US economy. In particular, he will give further indications about how the Fed’s monetary stimulus is going and when it might end.

What we’re yet to see from all this quantitative easing is the higher inflation that is likely to be the result. Despite yesterday’s lower than expected inflation data from the UK, with all this excess liquidity flying around, inflation could still remain stubbornly high in the near-term. At some point this will need addressing with the normalisation of interest rates. The prospect of higher interest rates may be music to the ears of savers, but will send shivers up the spines of businesses and home owners. This has the potential to not only trigger an equity market crash, but a bond market crash as well. When this bubble bursts, it has the potential to dwarf those that came before it.

Angus Campbell is head of market analysis at Capital Spreads. You can follow him on Twitter @angusjmcampbell

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