Futuríveis

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What elements of today’s markets might look ridiculous with the benefit of hindsight? Not fundamentals: the economic cycle is now mature but growth, inflation and corporate earnings look sound. And equity valuations are reasonable. Yet not everything passes the sanity test.

First, a mispricing of credit risk is certainly occurring. In five years investors may blush when they recall this week’s $45bn private equity buy-out, reportedly using gearing of more than 80 per cent, of TXU, a historically volatile power generator; or the fact Ecuadorian bonds yield 11 per cent in spite of a government openly threatening default. Second, the big economic question remains of when America will control its borrowing – or its creditors stop lending. Finally, the explosion of alternative investment vehicles and credit derivatives suggests huge hidden leverage in the system, partly funded by the yen carry trade.

In terms of corporate defaults, today’s “Goldilocks II” economy can probably weather a rise in credit spreads. A gradual slowdown in the US (as suggested by Wednesday’s revisions to fourth quarter growth) could even allow an orderly easing of global imbalances. But the great unknown is whether, given the unprecedented degree of leverage within the financial system, even a modest and necessary adjustment of interest and exchange rates could seriously destabilise asset prices.

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