According to the Robert Shiller “crash confidence index”, more investors today fear a repeat of the Great Crash of 1929 than at any stage since the survey began.

The Yale professor’s “cyclically adjusted price to earnings” ratio similarly judges US stock market valuations to be higher than at any time since the dot.com bubble at the turn of the century, and higher, moreover, than they were just before the 1929 crash.

You would imagine that soaraway valuations alongside record levels of anxiety would be a pretty deadly combination, the more so in the midst of a health emergency as economically devastating as Covid. Buoyant stock markets sit awkwardly alongside the worst recession in living memory.

Stock prices tend to look forward, not backwards; they supposedly reflect the world as it is expected to become, not as it is, so the mismatch might not be as crazy as it seems. It is also true that vaccines promise eventual salvation from today’s grimly dispiriting news, together with the prospect of a fairly swift bounce back. All the same, even for constructs as unpredictable and often irrational as stock markets, it looks a pretty odd state of affairs.

To add to the sense of unreality, we see some quite clear cut examples of tulip mania – Bitcoin, Tesla and even Pokémon cards. In the past year alone, Tesla shares have risen eight-fold.

Even acknowledging that Elon Musk is a genius with huge ambitions for his company way beyond the limitations of vehicle manufacturing, is it really credible that Tesla should be worth more than all the other major global car companies put together? The case can just about be made, admittedly, but suspending your disbelief doesn’t even begin the degree of faith required.

None of this necessarily means that stock prices are about to crash. The “greater fool theory” makes it perfectly fine to pay too much as long as there is a greater fool willing to pay even more. We all know it’s a bubble, but we carry on buying in the belief that there is always someone willing to pay even more.

It’s the old Chuck Prince refrain. “As long as the music is playing, you’ve got to get up and dance,” said the former Citigroup boss shortly the before the balloon went up on the financial crisis. “We’re still dancing”.

In any case, as long as the central bank printing press keeps whirring, providing abundant liquidity with nowhere else to go other than asset prices, it is hard to see why stock markets would suffer significant attrition.

It is this lack of alternatives that has long provided the most important form of support for equities.

In an age of ultra-low inflation and interest rates, shares offer at least some degree of return. Long gone are the days when government bonds would routinely yield more than equities. That relationship was reversed at around the time of the financial crisis, and it hasn’t returned since. The upshot is that relative to bonds, equities continue to offer reasonable value.

But hold on; what’s this? Since the turn of the year, the yield on the US 10-year government bond has risen from just over 0.9pc all the way up to 1.172pc. Similarly, the 30-year bond yield has risen from 1.642pc to 1.901pc.

These may not look like big rises, but in the context of today’s ultra-inflated government bond markets, they are significant. If things carry on like this, it would eventually undermine the relative attractiveness of equities.

So what’s going on here? It’s the old “push me, pull me” story of inflation versus deflation. After years in the shadows, the “inflationists” are beginning to get the upper hand again. Higher inflation would mean higher interest rates, and that’s precisely what some investors are anticipating.

There are at least some reasons to suppose they may be right. A strong bounce back in the economy in combination with the sheer quantity of fiscal and monetary stimulus applied during the pandemic could indeed prove inflationary. Add to that Joe Biden’s clean sweep in Congress, and the likelihood therefore of a lot more US fiscal stimulus to come, and it is easily possible to envisage a future in which inflation creeps up again.

It is, of course, just as easy to make the deflationary case; with abundant spare capacity and rising unemployment, upward pressure on wages would seem unlikely. But this might change if governments continue to add stimulus. The political pressure on them to keep doing so is almost irresistible. Warnings against “premature austerity” abound, from both the Right and Left.

This in turn brings a further factor into the mix – that of credit risk. With returning inflation would come higher interest rates. The higher they go, the less affordable it becomes for governments to borrow. Thanks to central bank asset purchases, it has been possible to fund pandemic-related borrowing at next to no cost.

If the age of free money is drawing to a close, many governments are going to be in a lot of trouble. They therefore have a positive incentive to engage in so-called “financial repression” and “fiscal dominance” in order to keep interest rates low.

Such policies are almost bound to end in an excess of inflation. A certain amount of inflation is generally quite good for equities, which unlike bonds offer a degree of protection against rising prices. If rising inflation and interest rates reflect a growing economy, then that ought to be a boon for corporate profits.

But runaway inflation would ultimately prove as bad for equities as it is for bonds, undermining economic confidence in the round. Some sort of repeat of the inflationary 1970s, when governments chose easy money over painful structural reform, is all too possible.

Some obvious cracks are beginning to emerge in the edifice of buoyant equity prices, but thus far, the pandemic has failed to puncture them; the big tests are still to come.

– Telegraph Media Group

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