On a day when the US's S&P 500 index hit a new record high, the head of Hong Kong’s securities regulator issued a statement saying that global equity prices are out of touch with reality and the traditional role of capital markets has been compromised.
Ashley Alder, chief executive of the Securities and Futures Commission (SFC), said stock price fundamentals had been sidelined by continued unconventional central bank policy. He made the comments at a roundtable for institutional investors hosted by the Hedge Fund Standards Board.
For a financial regulator to voice concerns openly about global markets is unusual. But then the world economy is in uncharted territory on a number of fronts, with negative interest rates, unprecedented quantitative easing and the European Union set for the exit of a member state.
While regulators and the financial industry are often seen to be on opposite sides of the fence, noted Alder, the current "disconnect from fundamentals means that we are pretty much in the same boat”.
Loose monetary policy has not restored growth, or inflation close to target, he noted. “As market regulators, we are concerned about how low or negative interest rates, quantitative easing and related policies have distorted asset prices, affected basic investment decision-making and corporate behaviour and led to an overall mispricing of risk.”
A commonly heard opinion, said Alder, is that central banks have used fixed income as a policy tool to such an extent that the market is no longer a true measure of market expectations. In this world view, he noted, central bank policy is overwhelming valuations and prices do not really reflect investor views of the underlying economy or of corporate equity or debt.
He quoted a recent article in the Financial Times, which said “stock market valuations imply a future of rosy profits and economic optimism”, but “at the same time, sovereign bonds are priced for a stagnant world of diminished opportunity and minimal inflation”.
Equally worrying, noted Alder, is that “equity valuations are reaching highs even when corporate earnings continue to fall, companies hoard cash, many companies borrow cheaply to fund buybacks and many cut down on investment and innovation”.
In mid-February this year, the S&P 500 was just above 1,800 and despite considerable global market uncertainty the US benchmark index closed yesterday at 2,152.
Moreover, Japan’s Nikkei 225 has soared from 8,500 four years ago to close at 16,095 yesterday. Healthy earnings growth is a contributing factor, but investors should remember how the Japanese equity has corrected sharply several times in the past 20 years.
With Europe suffering post-Brexit turmoil, the region's stock markets are not showing much in the way of real earnings growth, so any buoyancy in local and regional indices could be masking a host of problems.
Still, some investment specialists take the view that the current demand for stocks is understandable.
Mark Tinker, Hong Kong-based head of Asian equities at Axa Investment Managers’ Framlington strategies, said: “Government policy has turned investing fundamentals on their head – with quantitative easing on the one hand buying up bonds, while macro prudential regulations are seemingly preventing that liquidity going into anything except fixed income.
“Bonds are being bought (with leverage) to generate returns, while equities are being bought with cash to generate yield,” added Tinker. “While the latter makes sense, to me at least, the former makes me nervous."
Meanwhile, Northern Trust chief investment strategist Jim McDonald said that while share prices were not compelling, stocks yielding 2-5% still looked attractive relative to fixed income with negative yields. “We think this relative-value comparison will continue to support equity allocations over the next year,” he added.
What all this means, suggested Alder, is that the tenets that form the bedrock of investing – fair value, time premium, risk premium, mean reversion and diversification – have become less important. Instead, much investing is about second-guessing central banks’ next moves.
Ultimately, capital markets are meant to help transform savings into productive investment by individual businesses, he said. And, in most markets, the purpose of regulation is to support this core purpose through efficient, reliable disclosure, pricing and settlement mechanisms, noted Alder.
Unfortunately, he said, these assumptions have been tested severely since the financial crisis. “The traditional role of markets helping to allocate savings efficiently and price risks properly is compromised.”
This is doubly important now because, as banks pull back under the weight of regulation, said Alder, litigation charges and structural reform, market-based finance is supposed to pick up the slack to help fund real economies.
Alder became chairman of the International Organization of Securities Commissions this year, and such issues are naturally of core interest to the supranational regulatory body.
“In particular, he said, “there is much discussion about the trade-offs between the desirability of renewed growth, the need to ensure that systemic risks are contained and the larger role for capital markets in Asia as well as in Western markets.”