Hard to imagine with financial markets still buoyant and newspapers full of tales of bonus greed, but there is still the possibility that captialism will end.  At least there is according to prestigious investment consultants Watson Wyatt in their latest study called "Extreme Risks".

The firm listed the demise of the system of private ownership as one of 15 threats to investors and the global economy that probably won't happen but which it reckons are worth worrying about anyway. The idea behind the report is that such things as climate change, the break up of the euro zone and war are always worth being included in an investment risk management process.

As for the future of capitalism:

In our view, the most likely scenario is moving along from one end of a spectrum where market is king (minimum regulation) towards the other end, where we could see more onerous regulations and government intervention in, and control of, the economy. The extreme risk, however, is the demise of the capitalist system and the end of the market as the primary means of resource allocation.

And the impact:

The economy would be likely to run a higher risk of failure and economic growth would be sluggish in the long run due to lower productivity.  Centrally controlled economies tend to be characterised by shortages, which are inherently inflationary. Private investment activities would collapse or even be terminated. The end of capitalism is simply the ultimate extreme risk. The economy is likely to be associated with extreme uncertainty and a large amount of wealth destruction during the transition period.

Watson Wyatt does try to give its free market clients some hope, suggesting that buying gold may be one way to hedge against the propect of capitalism's demise. But it admitted that in such a circumstance investors would probably be more concerned about the return of their investments rather that the return on them.

(Illustration called The Communist Party, from Threadless)

-Jane Foley is research director at Forex.com. The opinions expressed are her own.-

The discrediting of the efficient markets theory in the aftermath of the financial crisis appears to have been accompanied with growing support for the view that rather than efficient in nature, financial markets are predisposed towards the formation of bubbles.

A bubble can simply be defined as an occurrence that begins when the price of an asset has been driven significantly above it "fair" value. According to the efficient markets theory this would not happen.

If bubbles are a natural outcome of financial market activity it is relevant to ask whether the very loose fiscal and monetary policies of many central banks and governments are presently sowing the seeds of the next bubble.

Even though the real economies of the U.S., UK, Eurozone and Japan continue to be defined by expectations of rising unemployment and falling real wages, access to cheap money has already helped restore the profitability of many investment banks.

In turn, this has fed risk appetite which is evident in the rally in stocks since the spring, increased demand for "risky" currencies and a recovery in commodities prices. Brent oil has rallied by 128 percent from its 2009 low. The ability of oil to rally despite the existence of oil supplies well above the seasonal average suggests there is already speculative element in this market which could be in danger of driving prices above their fair value.

This week’s meetings of the Federal Reserve, the Bank of England and the European Central Bank have focussed attention not so much on rates, but on the extraordinary policy decisions taken by these central banks in the wake of the financial crisis and whether conditions are ripening in favour of a gradual withdrawal of some of these policies.

The Fed last week ended its $300 billion treasury bond purchasing plan, though it will carry on buying mortgage backed securities. The Bank of Japan last week announced that it will stop buying corporate bonds at year end. The Reserve Bank of India also removed emergency support measures last week.

This week there is speculation that the ECB could announce that it will hold no more 12-month cash tenders next year. By contrast the Bank of England is expected to increase quantitative easing at the November 5, Monetary Policy Committee meeting. Supporters of quantitative easing continue to stress that the lack of clear inflation pressures suggests there is room for these plans to be extended.

However, the lack of response in either money supply or inflation indices could equally be illustrating that these plans are not having a significant impact on the real economy and are therefore no longer appropriate. The paring back of these plans are likely to have an impact on the ability of some banks to turn an easy profit and thus should rein in risk appetite and limit speculative and "bubble" forming activity.

Unfortunately, a bubble can only be truly confirmed after it has burst; a characteristic with clear destabilising consequences. If bubbles are natural phenomena within financial markets, the need for tighter regulation and ongoing reviews of processes that oversee the financial system are absolutely necessary.

This conclusion, while in complete contrast to the implications of the efficient markets theory, ties in very well with the political desire to reform the banking regulatory framework in order to protect the tax payer from future hefty bank bail-out costs. The banking landscape, while already vastly different from just two years ago could continue its transformation for years.

researchEMEA@forrex.com

– Neil Unmack and Agnes T. Crane are Reuters columnists. The views expressed are their own —

By Neil Unmack and Agnes T. Crane
When some of the most influential financial thinkers of our time failed to call one of the biggest bubbles since the Great Depression before it burst, a little skepticism about the recent run-up in stocks is a healthy antidote to the cheerleading that typically accompanies big gains.

Given the enormous size of the last bubble, the current round of inflation in financial markets perhaps should be called by another name — maybe “bubblette” would better suit the times.

The hallmarks, though, are similar: Access to cheap credit helps re-inflate depressed prices, but eventually the explanations for extended gains start looking flimsy. Stocks started entering that territory in August when many pointed to better-than-expected earnings to justify the surge in prices that have taken major gauges to their best levels for the year.

The price-to-earnings ratio for the S&P 500 currently stands around 26.5 based on operating earnings for 12 months through June. That’s well above the historical average of 19.26, according to S&P senior index analyst Howard Silverblatt.

To get back to normal, the economic recovery will have to be powerful enough for earnings to meet more optimistic expectations. The price-earnings ratio for the FTSE 100 is still just below its historic average, but nevertheless stands at its highest since July 2004.

There are good reasons to rejoice about the recovery in stocks — for one, they make last year’s losses less painful. But there are also plenty of reasons to think the market will pull back in the near term, and to foresee a rude awakening if the much talked-about V-shaped recovery fails to deliver.

- The consumer is key. Still buried under a mountain of debt and daunted by the prospect of joblessness, consumers aren’t likely to return to their old spending habits. More saving and less spending means low growth, excess capacity, and falling prices, all of which are bad news for equities.

- Unprecedented fiscal and monetary stimulus are distorting reality. While some markets have returned to their levels before Lehman Brothers collapsed a year ago, much of the stimulus behind the recovery is still in place to keep money flowing into even some of the riskier asset classes, such as high-yield debt and stocks.

Start taking the various props away, which will begin to happen this autumn, and investors’ appetite for risk will diminish.

- Ridiculously low government bond rates and rock bottom interest rates in the developed world have pushed investors to look elsewhere for yield. But this can’t last forever. Eventually central banks will raise rates, while increased borrowing needs still lurk as a potential flash point for bond vigilantes who want to be compensated for the risk of future inflation.

- Funding markets, while much improved, still aren’t working properly. While many companies have been able to refinance their short-term debt, borrowers in real estate markets are still facing a funding void left by the collapse of the shadow banking system.

High-yield companies in the United States and Europe face far higher borrowing costs, and must also refinance or pay down a wall of debt falling due in coming years. Commercial real estate, in particular, faces daunting maturing debt.

Unless more sources of alternative funding can be found, the result will be higher borrowing costs, more defaults and bank losses, and more corporate failures. Companies in general will focus on keeping their creditors sweet, rather than doling out cash to shareholders.

Stock buybacks have sunk to their lowest level since 1998, when Standard & Poor’s first started tracking the data.

- Unemployment rates are expected to stay high. Economists view unemployment data as a lagging indicator, but this time may be different. A persistently high unemployment rate will likely keep anxiety high among consumers who stretched themselves thin during the boom years. Even if it steadies, the unemployment rate could keep consumers on the straight and narrow.

- Follow the smart money. Insiders, such as company management, are selling at the highest rate since before the crisis kicked off in 2007. Sure, the sellers may have their own personal reasons for dumping stock, or they may know what is going on better than anyone.

Some of these arguments were equally true in March — since then the FTSE has gained 45 percent. Investors who avoided stocks for sound fundamental reasons back then have been dealt a cruel hand by the recent upswing.

The cheap liquidity and confidence that drove the rally may well persist for some time, or even carry the market higher if third-quarter earnings beat expectations.

Still, investors who missed the equity market party should be doubly wary of joining in now that the good times may be over.

It's hard not to be cynical about what the markets are supposedly telling us this week.

Don't get me wrong, I think markets can be a good barometer for sentiment and a leading indicator for trends before they bubble to the surface.

But their behavior this week suggests that the few traders and investors working during these dog days of summer are more interested in pushing prices around for short-term gain than making a bet on where the economy and financial markets are heading.

It's nothing new that trading desks are thinly staffed in the last weeks of summer, but after last year's rude interruption of summer holidays, more are taking advantage of the relative calm this year to soak their feet in the ocean rather than man the phones.

That's caused some interesting cross-currents that are making the message a bit of a muddle. Today, for example, oil prices rose early on hopes of an economic recovery while gold, a haven for those seeking a safe harbor, marched toward $1,000 per ounce as investors grew more cautious.

And Treasuries, after two days of solid gains despite better than expected economic data, fell today as investors continued to look to the stock market rather than data for clues.

Treasury yields, in fact, had been threatening to break back to lows seen in May even though the government has flooded the market with new notes -- $70 billion more to come next week -- and the economy has improved markedly since then.

Manufacturing is expanding, the rate of job losses, though still uncomfortably large, has slowed and the housing market that got the U.S. economy in such a mess in the first place is no longer in freefall.

And then there's the influence of the Chinese stock market. A 4.8 percent gain in the Shanghai Composite index got the ball rolling for global equities earlier today, but was the catalyst a data point or signs of better days ahead? No, it was a regulator telling investors that the market was healthy.

Earlier this week, the turning of the calendar to September -- a month that now strikes fear into even the most rational investor, after last year's meltdown punctuated what had already been a historically bad month for stocks -- did the trick.

Suddenly, investors worried about the health of the banking sector, even though the rally since March has been wedded to its supposed recovery.

Even Friday's jobs report, one of the most influential economic indicators, may not be enough to infuse much meaning. It comes ahead of a long holiday in the United States that brings an unofficial end to summer. That should make it even easier to push and pull prices around.

This should begin to change next week as holidays end and liquidity returns. That doesn't mean investors will like the message, but hopefully it will be clearer.

– James Saft is a Reuters columnist. The opinions expressed are his own –

The recession will soon be dead, laid to rest alongside the idea of the “Great Moderation”, a set of hopeful assumptions that underpins expectations about economic growth and asset valuations.

This, when investors, bankers and executives ultimately realise it will cause them to pull in their horns, take less risks and be less willing to pay high prices for assets.

Economists, observing that since the 1980s recessions have been mild and short and expansions long and robust, developed the theory that better economic management, namely cutting rates in the aftermath of bubbles, globalisation and, get this, improvements in financial markets, had led to a sort of best-of-all-possible-worlds “Great Moderation”, in which economic volatility fell and with it the risk premia required for holding financial assets.

This little theory has, needless to say, come somewhat unstuck during the current downturn which has been great but far from moderate.

This raises the uncomfortable possibility that the last 25 years of good times were just a bit of luck, or even worse, an artificially engineered consumption binge with central banks and governments playing a role similar to what Chicago tavern keepers used to do — opening up early so last night’s patrons can have a quick nip to take the edge off on the way into work.

It’s a debate which is far from academic and its outcome will influence much more than the actions of central bankers and regulators.

While financial market volatility has been a feature during the past decades, the idea, or at least the feeling, of the Great Moderation has seeped into the culture, influencing the behaviour of actors across the economy.

A corporate manager is going to be more likely to leverage up and go for the big hit if he feels as if most recessions are mild and short, in the same way that a consumer will buy a boat on credit or an investment property for the same reasons. If the weather never gets that cold why waste money on insulation?

What if these people now decide that the universe is a less friendly place and that they ought to, heaven help us all, save a considerable amount against the day?

This is really about volatility, which, because it can tend to ruin you, is expensive. Most investment or economic management strategies have at their heart attempts to limit or cushion volatility. And so, if we really can expect more volatility in the economy we can expect it to find expression in a lower ceiling for economic growth, leverage and asset prices.

IT AIN’T NECESSARILY SO
Of course, the current debacle may be just one data point rather than a trend, a view financial markets seem to have adopted. That is more or less the argument of Larry Summers and the U.S. administration, who are betting that this is the kind of thing that happens only very rarely.

This is a version of the 100-year storm argument beloved of company managers trying to explain why their results are so poor; the implication is you could not have been expected to plan for a freak storm and once it is past it is back to the good times.

This thinking lies behind the strategy of making financial conditions so easy that people are tempted to borrow and invest. It just might work, and we just might have a sharp and long recovery which generates enough revenue to pay off the public debts we are now racking up.

But two other possibilities, both speculative, spring to mind.

One is that deleveraging proves to be not just an event but a state of mind. As in Japan, people may simply decide that they’ve had enough risk, thank you very much, leading to a weak recovery, a relapse and then a quandary about how best to pay off the bills we’ve recently run up.

The other is that the current mix of policy, deep cuts in interest rates, deficit spending and quantitative easing, the effects of which are little understood, ends up breeding volatility of its own, probably in inflation.

The cost of that volatility will be an unpleasant surprise to the investors now bidding up the prices of shares and managers now preparing to invest for expansion, and one that might lead them to at last act more conservatively.

Add to arguments for a new “Great Immoderation”  that emerging markets will almost certainly be more of a driver of global economic growth under most of the reasonable scenarios in the coming decade. Emerging markets historically are more volatile and if as they grow to be a bigger piece of the pie are likely to make overall growth more volatile.

None of this takes away from the essentially good news that the recession looks to be ending soon, but higher economic volatility will hang heavy over the recovery and the cycle to come.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.–

– James Saft is a Reuters columnist. The opinions expressed are his own –

The good news that the United States cannot keep contracting the way it has been is not to be confused with a return to robust expansion, a point financial markets eventually will grasp.

Consumers, the mainspring of the U.S. economy, will see the cash from government stimulus slip through their fingers but will still face very ugly personal balance sheets and a brutal job market. Their party is not going to get started again for some time.

And falling interest rates will have a hard time sparking investment by businesses until they become convinced that a recovery in manufacturing will do more than just take inventories from nearly empty to barely stocked.

The basic hope for the U.S. economy, that inventories are being run down so swiftly that a turn in the cycle must come, has been more or less confirmed by recent data.

The ISM manufacturing index advanced to 40.1 in April from 36.3, and especially encouraging is a sustained rebound in new orders, a leading indicator of forward demand, which having been more or less moribund in the early months of the year, now is in a sustained uptrend.

Inventories are still being cut, but this, optimists argue, is setting the stage for a recovery when managers see that their depleted stocks represent the threat of losing out on business.

There was also a surprising 2.2 percent increase in real consumer spending in the first quarter, as opposed to the shocking fall of four percent in the second half of last year.

We simply can’t fall at the same rate we have been if that keeps going. It probably will and we will probably see a sort of a recovery kicking off in the second half. Even now, billions in stimulus are sloshing through the U.S. economy. In May social security recipients will get an extra $250 and withholding rates for federal tax have been cut.

But the effect of government money will recede, and while stock markets have rallied, the balance sheets of many Americans are still very fragile. Remember too that the U.S. is aging, and many savers approaching retirement have seen zero investment gains in their portfolios over periods as long as a decade.

Their garages are full of junk they probably feel they don’t now really need, their employment prospects are as bad as in living memory and they face a very long retirement due to expanding life expectancy. Wages and salaries have fallen by 1.2 percent over the past year, an all-time record, and hardly an incentive for the average American to start splurging again.

Savings is here to stay and consumption will have to take a back seat.

TOO MUCH PESSIMISM

So, can business spending in the U.S. take the baton from exhausted consumers?
It probably cannot. First off, businesses are less interest rate sensitive than consumers, and so the effects of the official policy of driving market rates down will have less impact among them.

And while inventories are still low, so is final demand and most corporate managers, having just lived through the most gut-churning time of their entire careers, will not be likely to stick their heads above the parapet and make a lot of speculative investments in new capacity simply because things have stopped looking worse.

This may get to the heart of the problem that the economy will have in making a robust recovery: psychology. Just as people were too optimistic before the crisis, they are likely to remain too pessimistic for a time afterwards.

There is also the matter of sheer scale. Consumption is about 70 percent of the U.S. economy  while capital expenditure at about 8 percent will have a hard time being the engine of a robust recovery. That 70 percent must fall and will outweigh everything else.

Perhaps the proof of a turnaround in business activity will be corporate profits, which across the economy are still falling. Corporate profits allow businesses to expand and give them the cash to do it and the evidence needed to secure credit.

And finally we have a banking and financial system that, while improving, is still not able to intermediate credit properly. That the Federal Reserve is taking matters into its own hands is on balance good, but they are likely to make some ghastly mistakes, not to mention putting their very independence in jeopardy.

Balance sheet recessions, when cutting debt is a priority, take a long time and are characterised by disappointments.

We are past the worst of the crisis, but now moving on to something not as dangerous but just as hard: building a more balanced economy.