The sharp slide in share prices was either a blip in the road to recovery or a sign that the unwinding of quantitative easing will lead to disaster. Our writers argue it out

REASONS TO BE WORRIED

Central banks may be pumping billions of dollars into the world's financial markets through quantitative easing, but by artificially inflating the prices of stocks and bonds they're just storing up an almighty crash for the future.

That's the argument of City bears, who warn that while last week's slide may be reversed in the days ahead, the sharp fall in share prices that spread from Tokyo to Wall Street and London was a foretaste of the reckoning that will inevitably come, once QE starts to be unwound. "This is a liquidity-fuelled rally in stock prices. It's clear that the world economy has not been performing as well as stock prices say it has," said Neil Mellor of BNY Mellon.

Pessimists cite several reasons to be nervous about whether the rally that took share prices in the US to record highs before the blip can be sustained.

The first is China: a weak reading on the purchasing managers' index survey for the country – a barometer of its manufacturing sector – was one of the factors that fed Thursday's decline.

Growth in the world's second-largest economy has long been expected to slow from the double-digit pace that was the norm before the world recession of 2008-09. But there are serious concerns about the health of China's banks, which are thought to be sitting on a growing pile of bad loans. "It's clear that a lot of banks are in an awful lot of trouble," said Mellor.

Demand from China is critical for a number of major economies, including Japan, for which China is a huge export market, and Australia, which is heavily reliant on its natural resources. Any sign that the Chinese economy was slowing sharply, or worse still, facing a financial meltdown, would have knock-on effects right across the world's financial markets.

A second reason to worry is the eurozone. While the mood has been quieter since the Cyprus bailout was agreed in March and a rate cut from the European Central Bank boosted confidence, the crisis is far from over.

The eurozone economy remains deep in recession, and there is a long list of countries, from Slovenia to Spain, with unresolved problems that could spiral rapidly into a major crisis.

Third, Japan: markets have been supercharged in recent weeks by the radical policy of "Abenomics", named after new prime minister Shinzo Abe, which involves deregulation and a boost to public spending as well as the "shock and awe" quantitative easing announced last month.

Even if the policy works well, however, it is unlikely to be the overwhelming success that would be required to validate the 25% jump in share prices seen since the end of last year.

The final reason to be nervous is a more general one: as central bankers themselves have warned, extended periods of cheap money tend to create market distortions, as investors take the money and use it to fish around for better returns, in a "search for yield".

In the bond markets, for example, countries that would usually find it impossible to attract foreign lenders are finding investors falling over themselves to buy their bonds. Rwanda's $400m (£265m) bond issue in April was more than seven times oversubscribed, while middle-income countries such as Turkey, Mexico and Brazil have seen their borrowing costs slide. That's great news for the governments in question, but smacks of what Fed chairman Ben Bernanke recently referred to as "excessive risk-taking".

Whatever the outlook, "jittery Thursday", as analysts at City consultancy Fathom called it, underlined the fact that investors should brace themselves for a period of increased volatility.

"This bout of market jitters has laid bare the twin distortions imposed by a combination of near-zero interest rates and unconventional monetary policy, namely an excess sensitivity to small changes in the data and an unhealthy addiction to doveish central banks," they said.

Heather Stewart

REASONS TO BE CHEERFUL

People who buy shares are by nature optimistic. They make a profit when the stock market goes up, so they want it to go up forever.

Until last summer – after two years of crisis in the eurozone about the single currency – European investors were wary about the prospects for the global economy. The 2008 banking crash had been a disaster, as shares lost almost half their value on the big European exchanges. Then governments soaked up bank debt and themselves grew vulnerable.

But then European Central Bank chief Mario Draghi said he'd do "whatever it takes" to save the euro. That pledge, plus the renewed money-printing from the US Federal Reserve and the Bank of England, was a message that delighted investors. Since June 2012, the German Dax index has soared from around 6000 to almost 8400, before dropping back a little last week. The same story is told by the other major European exchanges, including the FTSE 100, which jumped from 5260 to a peak of 6723 earlier this week – a 28% gain in less than a year.

Some economists argue that stock exchanges are riding for a fall. They say fundamental building blocks of growth are missing. In the major economies, investment remains low and consumer confidence is lacklustre, especially while high unemployment is rising and wages are frozen in real terms.

However, there are three good reasons why stock markets, a few blips aside, will continue to grow for some time: central banks are scared; there is lots of money waiting to be invested; and returns on all other assets are low.

Many analysts blamed the sharp falls in stock market values last week on a hamfisted performance by Federal Reserve chairman Ben Bernanke, who initially gave little hint that the Fed's QE measures might be scaled down only to say later that several members of his committee thought the time might be ripe in the next few months.

The Fed has injected more than $3tn of freshly minted money into financial markets and is supposed to be increasing the total by $85bn a month until unemployment comes down to 6.5%. It is 7.5% at the moment. The hint that Fed funds would stop early sent markets into a spin, but it was not new. Bernanke had said the same in January.

And the Fed must stay the course because households and businesses across the US and Europe are still paying back debt from the boom years. Only central bank funds are keeping economies afloat. The Bank of England remains steadfast and the Bank of Japan is ramping up its QE programme. Bernanke will stick with his original plan.

Stock markets are also being buoyed by the huge reserve of funds sitting in the Middle East, in Asia, and in western pension funds. Fund managers want to bet the trillions they are keeping on the sidelines on the stock market, should it feel safe. Central banks will continue to make it feel safe.

The third driver comes from the low returns elsewhere. Sovereign wealth funds and pension funds have used large amounts of their spare money as loans to governments and big companies. But buying bonds earns them only a small return. Lending to the German government is such a privilege that investors lose money on the deal.

Strapped to these three rockets, the market can still soar. Of course, Spain could yet go bust or China grind to a halt. There could be a natural disaster, an act of terrorism or war. History tells us a bust is waiting down the track, but while the world economy recovers and governments and central banks maintain their pledge to keep printing money, we should expect prices to rise.

Phillip Inman