Europe’s markets regulators are worried. About everything 

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Before the summertime tans had even faded on the continent, the cheerful souls of the European Securities and Markets Authority dropped a 110-page report, dedicated in part to outlining risks to investors based on observations from the opening half of this year.

Most bears have already thrown in the towel, chucked away their prognoses of doom and learnt to love, or at least accept, a rally in risky assets that seems impervious to grim news, patchy data and elevated valuations. Esma seems less willing to gloss over the cracks.

“We expect to continue to see a prolonged period of risk to institutional and retail investors of further — possibly significant — market corrections and see very high risks across the whole of the Esma remit,” it said. 

Most market predictions come from people with skin in the game: investors wittingly or otherwise talking up their book, analysts at banks wedded to house views from which it is awkward to diverge, and so on. So it is useful to entertain analysis from a body disinterested in the direction of stocks, bonds or whatever, as long as market participants play by the rules and the financial system functions properly. With that in mind, here goes.

Esma of course has noted the obvious. The first half of this year brought a stunning continuation of the recovery in risky assets that started after the initial Covid shock in 2020. The global economy has bounced back, pumping up commodities prices.

Valuations for stocks in the EU have pushed above the levels that prevailed before the pandemic hit, and even riskier “high-yield” corporate bonds are flying high, despite a rise in borrowing by companies. Such bonds arguably need a new name given their average yield of 2.4 per cent in Europe, according to an index run by Ice Data Services covering debt with a duration just over three years.

But threading this all together is the ascent of not-obviously-healthy risk-taking behaviour, most evident in episodes like the GameStop retail share-trading frenzy in the US at the start of this year and the ups and downs of the cryptocurrency market. 

Given the naked pursuit by market neophytes of upward-sloping important-looking charts, it is hard to believe that either meme stock trading or fizzing crypto excitement can end well. But Esma name-checks victims of excess in the wholesale market too: supply-chain finance firm Greensill, which filed for administration in March, and private investment house Archegos, which imploded in the same month.

Taken together, these episodes “raise questions about increased risk-taking behaviour and possible market exuberance”, Esma said. “Hence, concerns about the sustainability of current market valuations remain, and current trends need to show resilience over an extended period of time for a more positive assessment.”

The issue here is that Esma has answered its own question. These trends have indeed shown themselves to be resilient all year. Fund managers can easily find red flags around every corner, and it is a worthwhile endeavour for regulators to keep an eye on them, but none of them matter — yet — as long as markets just keep motoring higher.

It is not alone in these warnings, naturally. Also this week, Richard Bernstein, chief executive of Richard Bernstein Advisors described the current market environment as “maybe the biggest bubble of my career”. 

“So when is the bubble going to burst? The answer is nobody knows. Our portfolios remain focused on the conservative side . . . energy, materials, financials, industrials, and smaller capitalisation cyclicals. The entire market doesn’t necessarily seem at risk, but momentum strategies focused on the market’s bubble leadership seem very risky to us,” he said.

Despite an inflation scare at the start of this year, slowing growth, the Delta variant of coronavirus, a disruptive clampdown on foreign-listed stocks by Beijing and a rewrite of US foreign policy, the S&P 500 benchmark index of US stocks has dropped by more than 2 per cent in a day a grand total of three times this year, and not at all in the past four months.

Central banks, led by the Federal Reserve, have made it clear they are alert to the risks of inflation rushing above target levels and staying there, but they are in no hurry to withdraw monetary support unless they are convinced the economic data demand it.

Some investors are growing a little more nervous. The use of borrowed money to juice up returns from bets in the US has declined for the first year since the pandemic shock last year. Exchange traded funds designed to do well in tougher economic or market environments have drawn in unusually robust demand. Now institutional money managers are also increasingly writing options on their own holdings or portfolios, allowing others to bet that stocks can keep marching higher. Essentially, this is a method for fund managers to say they do not want to sell, but they also think the quick gains are in the rear view mirror.

But this is mostly tinkering around the edges. The more cautious voices are shouting in to the void.

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