Monday, December 10, 2012

Bank for International Settlements: global economic fundamentals do not support market prices

The Guardian reports that the Bank for International Settlements has issued a warning about the growing disconnect between prices for stocks and bonds and the underlying economic reality.

This warning effectively undermines the central assumption supporting current monetary policies like zero interest rates and quantitative easing.

These policies are justified by central bankers by the wealth effect argument.  Under the wealth effect argument, the high stock and bond prices that result from pushing investors out on the risk curve are suppose to make investors feel "wealthier" and as a result they will increase their spending.

Clearly, this has not happened.  Anyone not trained as an economist immediately recognizes that the wealth effect the central bankers are hoping for relies on amnesia.  Investors have to forget that the markets collapsed in 2008/2009.

If investors don't have amnesia, then they see the gains in their investments as temporary and not something that can be spent.

Asset prices are rising to levels not seen since before the crisis despite continuing long-term risks to the markets, the Bank for International Settlements (BIS) has warned. 
The warning should ring alarm bells across the world as the Swiss-based organisation can claim to be one of the few organisations that saw the financial crash coming
In its quarterly report, the bank said: "Unusually, equity and fixed income gains coincided with a weakening of the global economic outlook. In the past, falling growth forecasts have usually been associated with rising expected default rates and higher bond yields." 
It noted that equity prices had risen even as the outlook for companies deteriorated. 
Companies' earnings expectations have dropped and "an unusually high proportion of firms warned that future profits could fall short of analysts' forecasts". 
The bank said investors were taking on more risk for lower returns – driving prices higher – in the hunt for returns in a world where central banks are keeping interest rates at record-low levels. 
"Numerous bond investors said that they felt less well compensated for risk than in the past, but that they had little alternative with rates on many bank deposits close to zero and the supply of other low-risk investments in decline." 
In some cases that has caused asset prices to reach levels that no longer reflected the risk involved. "Some asset prices appeared highly valued in a historical context relative to indicators of their riskiness," it said....

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