Before Mark Carney's rates comments last week, the FTSE had been on a smooth upward trajectory with a remarkable lack of volatility.
Carney's warning rates will rise 'sooner than expected', combined with the political tensions in Iraq, have stoked volatility in markets without quite causing a ‘Minsky moment’.
American economist Hyman Minsky won acclaim for his research into financial crises where periods of serenity are followed by collapses.
His theories were based on the philosophy that in boom time excess private sector flows move into increasingly speculative investments. When the resulting bubble bursts banks and lenders are forced to tighten credit availability - even to those solvent firms - causing the economy to contract.
The current placid attitude to risk among investors is giving some cause for concern.
‘The serene progress of equity markets so far this year, and indeed for much of the last two years, continues to worry those trying to call the short term - the absence of things to really worry about is, in itself, worrying,' Barclays head of equity strategy EMEA William Hobbs says,
Meanwhile Bank of America Merrill Lynch (BofMA) points out that more than five years after the global financial crisis this remains a ‘lukewarm ‘ recovery.
‘The “fire” of zero interest rates & central bank liquidity continues to be doused by the “ice” of consumer and corporate deleveraging and the deflationary disruption of increased regulation and tech innovation. We are not living through an era of big economic growth upgrades,' the investment bank said.
Yet asset prices keep rising, with the speed and magnitude of the US stock market recovery from the 2009 lows only ever surpassed by the recovery from the 1932 lows.
What is more surprising is the fall in government bond yields, with this decline proving extremely positive for financial markets.
'The “dogs” of 2012 & 2013, government bonds, global emerging markets and gold have all rallied, carry trades have rocked (CCC high yield bond yields have fallen to an all-time low of 7.9%) and there has been little interruption to the upward momentum in stock and credit markets,' BofMA points out.
There are plenty of catalysts for volatility at the moment, ranging from the Iraq crisis, a Chinese property market correction and the situation in Eastern Ukraine.
Hobbs believes the strongest trigger for volatility is the normalisation of monetary policy, although hebelieves this turbulence should be used as an opportunity to increase equity exposure.
‘We don’t see rising interest rates, at least in the early stages, as upsetting the economic apple cart and we suggest that investors use any volatility to position for further upside in equity markets,' the bank says.
With this in mind Hobbs intends to retain the bank's overweight position in US and continental European financials. ‘We’ve liked US banks since the middle of 2012 and, though the shares have performed well over this period, we still don’t think that valuations look particularly demanding in the context of a firmer economy and housing market and the likely start of a more helpful monetary backdrop for banks.’
Ultimately BofMA believes the case for summer melt-up remains stronger than for a summer melt-down as the high liquidity, low growth backdrop forces investor's cash levels down.
This is underlined by the fact that this week we are on course for the largest inflows to equities since early February (roughly $13 billion). When combined with a 7.4% return on the S&P since the turn of the year, it is easy to argue the case for a temporary pause.
Yet BofMa finds plenty of rationale for more upward momentum based on findings in its fund manager survey. These include institutions holding a relatively high 4.4% in cash, with portfolios showing their lowest levels of risk since October 2012.
The greatest risk
BofMA believes the greatest risk of all is that the longer it takes for growth and rates to normalise, the bigger the risk of speculative excesses. This could ultimately lead to a policy response aimed at curbing speculation in asset markets before the economy has fully healed.
‘We are a buyer of volatility into fall when correction risks rise significantly: either Q3 growth is +3% confirming recovery and causing rates to rise or speculative excesses appear causing central banks to start "talking down" asset prices,' BofMA says.
‘Until then be long but watch credit, the epicentre of the speculative fervour.’
Hobbs adds: 'We don’t doubt that volatility will rise from here and investors won’t need long memories to remember how uncomfortable this can feel, or how rapidly carefully laid investment plans can go out the window.'