Financial market storm brewing as 2014 winds down

[October 01, 2014]  By Mike Dolan

LONDON (Reuters) - After a year in which world markets have sailed effortlessly through wars, invasions and geopolitical ferment, a storm of their own making may well be brewing.

Investors have mostly held their nerve as headlines lurched from a new 'Cold War' in eastern Europe to conflict and Western intervention in the Middle East, the threatened breakup of the United Kingdom and secessionist risks in Europe.

More prosaic 'shocks' - a weather-related first-quarter slump in the United States, grinding deflationary angst in Europe and China's spluttering, unnerving slowdown - have largely been shrugged off too.

With the exception of commodities, the swollen sea of liquidity pumped out by central banks has once again buoyed all boats. Ultra-safe U.S. and German government bonds compete favorably with riskier Wall St, Shanghai or frontier stocks for best performing asset of the year so far.

And even as the U.S. Federal Reserve halts its bond buying later this month and the Bank of England talks of higher interest rates, the market narrative has been that the European Central Bank and Bank of Japan will keep the global pool full by turning up their cash taps as the others stop and drain.

But even if that proves correct in time, there is anxiety that the coming months may uncover rocks just under the surface.
 

The first problem is that the complete reversal of a monetary regime currently comprised of an expanding Fed balance sheet and a contracting ECB equivalent - however appropriate policywise - can only come about with a seismic shift in the world's main exchange rate.

That's already underway as we head into the fourth quarter, with euro/dollar near two-year lows and the dollar's broad index rocketing to four-year highs - depressing oil, commodities and many emerging markets and boosting cross-border financial volatility across the planet.

And for many of the biggest trading firms, this move is just beginning. Goldman Sachs, Barclays and Morgan Stanley reckon the euro/dollar rate could fall a further 20 percent, to parity, even if the baton is passed smoothly between the central banks.

BNP's head equity strategist Gerry Fowler reckons there's a chance of a considerable monetary hiccup before the year is out.

"The market is currently complacent enough to be surprised by a lull in liquidity in the coming months," he warned clients.

COMPLACENCY

Fowler's argument is that while the Fed turns off the taps this month, significant net new liquidity from the ECB, BoJ or even the People's Bank of China may not materialize until 2015.

"The tailwind of new money is likely to be dramatically lower for a few months."

Combine this with a surge in supply of private sector securities this year - including Chinese internet firm Alibaba's record $25 billion new equity sale last month, or talk that Anheuser-Busch Inbev may finance a possible $122 billion bid for rival brewer SABMiller with loans and bonds - and you have a recipe for repricing of already historically expensive assets.

Data compiled by Thomson Reuters shows worldwide equity capital market deals - from flotations to rights issues - totaled $678.1 billion in the first nine months of 2014, a quarter more than the same period last year and the highest since 2007. European deals hit their highest since 1980.

Initial public offerings stole the limelight, almost doubling from last year to hit $176.1 billion worldwide.

Total global bond issuance was up 2 percent to $4.4 trillion in the first nine months, with corporate bond sales up 6 percent to $2.5 trillion and new emerging market debt already more than in the whole of 2013 at $456 billion.

At the very least investors fear volatility is on the rise if a Fed retreat from quantitative easing is not quickly matched by the other central banks. And these gyrations by themselves could hasten a pullback from riskier assets, including pricey equity, junk bonds, emerging markets and even government bonds.

Only European equities, which could get a badly-needed earnings lift from a weaker euro, might dodge the bullet - but even these markets may well see U.S. funds retreating.

If investors are surprised by financial storm, it won't be because they weren't warned. Financial watchdogs have been waving a red flag about overstretched markets for the past year and stressed concerns again this month.

"There are increased signs of complacency in financial markets, in part reflecting search for yield amidst exceptionally accommodative monetary policies," Bank of England governor Mark Carney said last week, citing conclusions of the G20's Financial Stability Board which he chairs.

"Volatility has become compressed and asset valuations stretched across a growing number of markets, increasing the risk of a sharp reversal."

(Graphics by Vincent Flasseur; Editing by Catherine Evans)

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