Warning signs are beginning to emerge in financial markets. They are not big and nor are they concentrated in any particular area. But, it is worth mentioning the few canaries in the coal mine that have stopped singing. Before we start tracking the canaries that have stopped singing, let us be under no illusion about the global nature of the asset bubble we are facing.

Last week, the auction of a painting by Leonardo da Vinci fetched $450 million when it was expected to fetch only $100 million. Prior to that, Christie’s had sold many impressionist era paintings for a record sum of $479 million.

This is the backdrop to the warning signs of the breakup of the bubble mentality in select pockets.

One is the share price of Tesla motors.

Tesla was Teflon-coated, until now that is. The market capitalization of the economy that has had no profits to show and has been a cash guzzler is still $50 billion. The market correction has barely started. However, the stock was down nearly 30% from its peak of $383 in June this year before making a small recovery in recent days.

The next canary in the coal mine is the high-yield bond spread.

In the US, the option-adjusted high-yield bond spread to the US Treasury has spiked somewhat in the last week or two. Of course, it has happened twice before this year—once in August and once in March. It remains to be seen if it would be a case of third time “lucky". It is important to note that the spread was almost as high as 9% as lately as in February 2016. Such has been the extent of liquidity infused into global markets by China in the last year and more.

The third canary in the coal mine is the yield curve in the US.

The spread between the US 10-year and two-year Treasury yields has been a reliable predictor of economic recessions two to three quarters hence, when inverted. That is, when the spread turns negative (two-year yield being higher than the 10-year yield), a recession follows shortly thereafter. In the four previous recessions, the yield curve has inverted. The spread is still positive but it is at its lowest since 2007.

As the Federal Reserve continues to tighten monetary policy in the months ahead and if inflation remains quiescent, then it is highly likely that the yield curve inverts in the second quarter or in the second half of 2018.

Financial markets are anticipating only one rate hike of 25 basis points in 2018 after a rate hike in December. They are being too complacent. Regardless of the inflation developments, the Federal Reserve is clearly worried about financial stability risks as many signs of irrational exuberance abound. Inflation remains a risk.

Further, a pick-up in the inflation rate cannot be ruled out. The price of crude oil has bottomed out recently. The West Texas Intermediate crude oil began the year at $40 per barrel. Now, it is quoting at $56.7 per barrel. Recent developments in the Persian Gulf region point to upside risk for crude oil. Indeed, we would include the developments in the Persian Gulf as another (fourth) canary in the coal mine.

Is China another canary in the coal mine?

Recently, Zhou Xiaochuan, the governor of the People’s Bank of China (PBoC) warned of China’s financial system becoming significantly more vulnerable due to high leverage. According to a story in Bloomberg (“China’s Central Bank Chief Warns Of ‘Sudden, Contagious And Hazardous’ Financial Risks"), he wrote in a lengthy article for the website of PBoC that latent risks were accumulating, including some that were hidden, complex, sudden, contagious and hazardous.

Finally, while we had mentioned the US Treasury yield curve and the jump in the domestic high-yield bond spread as two canaries, the divergence between stock prices and corporate earnings is a canary too.

Even as the market capitalization of US stocks has increased in the last two years, corporate profits have declined. Between the third quarter of 2015 and the third quarter of 2017, stock market capitalization went up by $8.3 trillion. Total corporate profits declined $52 billion during this period while domestic profits declined $95 billion.

The schizophrenic price action accompanied by a marked rise in volatility in bitcoin is another sign of nervousness that accompanies unreasonable price action.

In recent times, the US stock market has managed to levitate at high levels on the fond hope and belief that substantial corporate tax relief is on the cards.

That is not a given as the Republicans are unable to agree among themselves on the financing of the tax cut. The House and Senate versions of the Tax Bill are different.

Further, there is a possibility that ongoing investigations by the special counsel into allegations of Russian interference in last year’s presidential elections could cripple the president’s effectiveness further, causing Republicans to distance themselves further from him. Hence, both domestic and geopolitical risks cannot be taken too lightly.

The last word on the global bull market in stocks should go to Steph Pomboy who tweeted thus on 16 November: “As I’ve been calling it: it’s a Harvey Weinstein market. Old, bloated but if you don’t snuggle up to it ill (sic) cost you your career—until one day, for no apparent reason, its egregious transgressions finally matter."

V. Anantha Nageswaran is an independent consultant based in Singapore. He blogs regularly at Thegoldstandardsite.wordpress.com. Read Anantha’s Mint columns here.

Comments are welcome at baretalk@livemint.com

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