Charles Stanley envisages financial Krakatoa in the making

“Profound structural imbalances“ in the global economy and highly-leveraged private equity activity are risks to the stable growth of world stock markets, Jeremy Batstone, Head of Private Client Research at Charles Stanley, warned clients today.

Although speculation about the next private equity buyout target is currently boosting the value of investors’ holdings, there is a risk of the “irrational exuberance” of previous stock market bubbles repeating itself, he warns in his weekly newsletter for Charles Stanley clients, Week in Preview. The newsletter aims to make readers aware of investment risks to Charles Stanley’s base case for investing: that global economic activity continues to grow and in a more balanced fashion than over the past decade or so; that underlying inflationary pressure is likely to ease over the coming months; and that company profits are continuing to grow.

Jeremy Batstone writes: “The past decade has seen so much irrational exuberance it makes one’s head swim. Many, this writer included, thought that the emerging markets crisis, the collapse of Long Term Capital Management and the bursting of the dot.com bubble might make a difference … The massive US trade and fiscal deficits are deeply unnerving physical manifestations of profound structural imbalances in the global economy, but we turn a blind eye like 19th century fishermen going about our daily business in the Sunda Strait, in the shadow of Krakatoa.

“Equally unnerving is the current craze for leverage, achievable only because borrowing on such a vast scale can be achieved at very favourable rates. But the stakes are high and the risks enormous … Deals involving synthetic bonds … are entirely dependent on the assets of the target business behaving in a reliable and stable way over sufficient a period until the cash flow derived from that target is itself sufficient to pay down aggressively high gearing to more manageable levels. Remove the stability of the underlying asset and you’ve got a crisis. Think it will never happen? Think split capital investment trusts and multiply the impact 1,000-fold!”