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Debt-saturated markets may soon face a ‘Minsky’ moment

City of London
City of London

Markets are once again at a possible inflection point – and a deeply negative one at that.

Last week’s sudden escalation in hostilities in the Middle East, and the equally abrupt recalibration of interest rate expectations that followed the release of worse than expected US inflation figures, may be the final straw.

In combination, they amount to a potentially deadly cocktail with wide ranging implications for financial markets made doubly vulnerable by asset price valuations that have been stretched to breaking point and a global economy awash with debt.

Many of the ingredients seem to be there for another Minsky moment, named after the US economist Hyman Minsky – the point where markets and economies, overwhelmed by debt, suddenly collapse.

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Minsky’s abiding economic insight is the idea that stability in financial markets breeds instability. The longer things remain settled and predictable, the more oblivious to risk financial markets become, until eventually the whole edifice comes tumbling down.

Hyman Minsky
US economist Hyman Minsky warned that the accumulation of debt pushes economies towards crisis

You’d have thought that more expensive money alone would be enough to force open the cracks and fragilities in the system, but so far markets have taken it in their stride, riding the tightening cycle relatively unscathed.

But for how much longer? For now, complacency remains the order of the day.

Bizarrely, markets chose not to react to the weekend’s events, but instead focused on the positive – efforts to prevent them from escalating into outright war. Any negative consequences ought to be digestible, is the view, with policymakers standing in the wings to address mishaps.

It’s part of a pattern where every adversity is met with a shrug of the shoulders, and “oh well, it could have been worse” insouciance. Even the oil price failed to react.

Even so, things look poisonous enough; what hitherto had seemed a relatively contained, if horrific, conflict now shows every sign of turning into a wider regional conflagration, perilously drawing in Israel’s Western allies.

It’s possible – now that “honour” has been satisfied – that things will settle back into the uneasy standoff that presided before last weekend’s drone and missile attacks.

Neither Israel nor Iran have any real interest in widening the conflict; they don’t want outright war, and nor do Israel’s allies. Everyone is scrambling to prevent it.

Yet the risk of matters spiralling out of control is high.

It all looked so different just a week ago. Central banks had seemingly pulled off the impossible in engineering an economic soft landing. The inflationary pressures of the past two years appeared to be abating fast, and both households and businesses seemed to be coping well with still high interest rates.

Last year’s banking turmoil, moreover, was well contained, with little evidence of wider systemic damage.

All good then. Normally, a monetary tightening of the speed and size of the one applied over the last two years would have resulted in a significant recession.

It’s true that there have been mild, technical recessions in a number of European economies, including the UK, but there’s been virtually no rise in unemployment, and growth is now returning, albeit in stubbornly subdued form. As for the US, it hasn’t even flirted with recession, and is now growing in a way which is the envy of the world.

Yet the absence of a more significant economic correction has left financial markets badly exposed, with stretched valuations – particularly in tech related stocks – and narrowing spreads that pay scant regard for underlying credit risks.

There is little or no room for further shocks or policy errors. Well now we have two of them in short order – a sudden ramping up in geopolitical tensions, and a pronounced shift in the expected trajectory of inflation and therefore interest rates.

Lots of households, businesses and property developers were banking on a steep fall in interest rates to dig them out of a hole.

This now looks likely to happen more slowly than anticipated. Many will struggle to refinance themselves on reasonable terms.

And that’ll especially be the case if energy prices spike anew, as seems possible given the turn of events in the Middle East. Higher than anticipated inflation will keep rates higher for longer, punishing the highly indebted, including governments already teetering on the brink of fiscal crisis.

In any case, the anticipated soft landing may turn out to be just another case of wishful thinking.

Sell in May and go away, says the old stock market adage. Maybe that should be brought forward a week or two this time around.