There are clear signs that that bubbles are forming in financial markets thanks to huge levels of liquidity from the world’s central banks, according to Andrew Milligan, head of global strategy at Standard Life, but investors can afford to be “cautiously optimistic” on equities over the short to medium term. 
In order to revive their economies and markets following the global financial crisis, central bankers instigated ‘emergency’ monetary policies such as slashing interest rates to historic lows and pumping large-scale stimulus into the system via quantitative easing (QE).
These unorthodox policies have been viewed as being the major driver of the rally in risk assets since the crash.
However, six years on from the crisis, interest rates have not budged in the US or UK and the quantitative easing tap in Europe and Japan is still very much turned on as the authorities have not felt comfortable tightening policy as a result of the anaemic economic backdrop.
Milligan says given the anomaly of a weak economic recovery since the crisis which has coincided with a period of barnstorming returns from risk assets, there are now signs that bubbles are beginning to form.
“There are noticeable signs that in a world of slow economic activity, low interest rates and sizeable central bank intervention, certain markets are in the early stages of forming a bubble,” Milligan (pictured) said.
“The most obvious example is the Chinese equity market, but residential property in some cities, such as London, and government bond prices are being inflated as well. At a time of limited trading liquidity and congested positioning, air pockets can appear, enabling very sharp drops in prices; for example this occurred to German bonds in recent weeks.”
The Chinese equity market has been on somewhat of a roller coaster ride over the past 12 months as the Shanghai Composite Index is up 90 per cent over the last 12 months as result of the recent Stock Connect and easing measures from its central bank, but is down an eye-watering 26 over the last month.
Performance of indices over 1yr
Source: FE Analytics
The Chinese authorities have all taken measures to try and stop the rot, but many experts expect the falls to continue.
German bunds, on the other hand, have been in recovery mode over recent weeks thanks to the uncertainty surrounding Greece’s future. Nevertheless, yields on German 10-year government bonds spiked substantially from their lows of below 0.1 per cent earlier in the year due to a kick back against negative real rates and a lack of liquidity – causing a rout across global fixed income markets.
Performance of index over 1yr
Source: FE Analytics
Milligan added: “Investors should beware that financial engineering does not mean that the prices of assets move too far from the underlying fundamentals.”
Milligan is by no means alone in his views, with many notable industry experts such as the team at Ruffer, Sebastian Lyon and FE Alpha Manager Iain Stewart all warning that some of the “biggest bubbles of all time” are developing thanks to the unprecedented levels of central bank intervention.
Nevertheless, the global head of strategy is relatively pragmatic in his immediate outlook.
“The ‘House View’ remains cautiously optimistic about the outlook for equity and property markets. There is positive cashflow from the corporate sector, not only an attractive level of dividends but also the benefits of considerable share buybacks,” Milligan said.
“Steady, if historically low, rates of economic growth can drive forward demand for real assets such as commercial property, especially in an environment where new developments are constrained in many – by no means all – markets due to constraints on the functioning of the banking system.”
Therefore, while Milligan says there are clear and large risks facing investors over the longer term as a result of excessive central bank stimulus investors can afford to be “cautiously optimistic” on equities for the time being.
“On balance, the ‘House View’ has modestly lowered the risk levels in its multi-asset portfolios, although it definitely remains pro-risk.”
“Our analysis continues to find that imbalances, such as inflation, current account exposure or debt levels, are not yet building which would normally be serious enough to bring the current business cycle to an end.”
For those who want to up their exposure to equities, Milligan and his team currently prefer the liquidity-fuelled European and Japanese markets.
“The favoured equity markets are Europe and Japan. Both benefit from a cyclical recovery in their economies, central banks keen on creating the conditions for a depreciating currency, somewhat healthier banking systems and, in Japan’s case, a shift in corporate governance so that a large number of companies are taking action to improve their return on equity.”
The Nikkei 225 has been one of the best performing indices so far this year as prime minister Shinzo Abe’s super majority at the polls in late 2014, QE, pro-reform policies and a massively weakening yen have pushed prices higher.
It has been a similar situation in Europe as the ECB’s QE programme, as well as signs of an economic recovery, pushed up the MSCI Europe ex UK index in the first half of the year – only for it to fall more recently as a result of the ongoing Greek debt negotiations.
Performance of indices in 2015
Source: FE Analytics
Nevertheless, Milligan isn’t overly concerned about the impact of Greece’s future on the wider continental market.
He added: “The situation in Greece is only expected to cause short-term disruption to the economic recovery.”
One area he says investors should be avoiding, however, is the US – which has led the both the recovery in the global economy and financial markets since early 2009.
However, given that the S&P 500 has broken its historic record on a number of occasions over recent months and hasn’t posted a negative year since 2008 (along with other contributing headwinds) Milligan says investors should look to take profits.
“The ‘Heavy’ position in US equities has been lowered to Light; the rationale is that company profits are coming under more pressure from a mix of the dollar’s appreciation, deterioration in unit labour costs and the impact of lower commodity prices, especially in the oil sector.”
