The measure of a true financial crisis is that money itself comes into question. The global financial crisis began 10 years ago this week, when a French bank suspended three money-market funds. What savers thought was money turned out to be merely credit, and the realization rapidly trashed U.S. money-market funds and the global banking system.
There is little risk of a repeat any time soon. While there is plenty of financial innovation going on, the amounts being parked in modern money alternatives are relatively small, at least outside China. Cryptocurrencies like Bitcoin and peer-to-peer lenders are obviously more risky than the money-alternatives of 2007.
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So much for the good news. The bad news is that it doesn't take a once-in-a-lifetime financial crisis to put a big dent in your savings, merely a perfectly ordinary mismatch between expectations and reality. The way markets are being priced suggests there is just such a mismatch -- and even if nothing bad happens, investors could still be disappointed.
The near-universal expectation is that inflation will stay low, central banks will be cautious about tightening monetary policy, corporate debt costs will stay low and profit margins will stay high. If the assumption proves right, long-term returns will be much lower than in the past. If the assumptions are wrong, short-term losses could be very nasty indeed.
The problem isn't with reality, where the global economy continues to hum along and nuclear apocalypse probably won't be triggered from one of President Donald Trump's golf courses.
The danger is that investors are complacent to an extraordinary degree, lulled into a false sense of security by the extraordinarily calm markets. There is no margin of error, and if investors turn out to be wrong it will be a nasty shock.
It isn't just that volatility is very low, although it is. Options on the S&P 500 suggest less than a one-in-10 chance of a 20% rise or fall in the market over the next year, lower than any time since at least the start of 2007, according to calculations by the Federal Reserve Bank of Minneapolis. The markets are pricing almost no risk of big moves in bonds or gold, either.
Behind the sense of security is a belief that deflation is behind us and there is no risk of inflation. Derivatives known as inflation caps and floors are pricing the lowest risk of U.S. inflation being out of the Fed's comfort zone in the next five years -- that is, above 3% or below 1% -- since the financial crisis hit.
Economists are similarly confident that U.S. inflation will be well-behaved, with much less variation than usual around the average forecast for next year of 2.08% collected by Consensus Economics.
Of course, just because markets are priced for perfection doesn't mean bad stuff will happen. But even in a really good scenario, the outlook for returns is pretty dismal.
U.S. government bonds offer 2.23% for 10 years. U.S. equities are richly valued, at a time when profit margins are already exceptionally high and the corporate sector heavily indebted. Future returns are likely to be weaker than in the past, unless a speculative bubble pushes prices into the stratosphere.
Corporate bonds offer little protection against a rise in defaults, either. The top-rated U.S. junk bonds yield just 2.2 percentage points above Treasurys, according to a Bank of AmericaMerrill Lynch index of BB-rated bonds, the lowest since the day the BNP Paribas money-market funds were suspended.
We don't know what unexpected events will happen in future, by definition. But we can be pretty sure that the future will hold surprises, and the markets aren't ready. It makes sense to be more cautious than usual.
Write to James Mackintosh at James.Mackintosh@wsj.com
(END) Dow Jones Newswires
August 10, 2017 17:18 ET (21:18 GMT)