Asset bubbles forming again

Too early to tell, valuations are not anywhere near previous bubble territory, but the US has replaced Japan as the center of the world-carry trade, and all that liquidity has to go somewhere…

Bubble trouble: have prices already risen too much, too soon?

Central banks are relaxed about booming asset markets. But with repossessions rising and jobs still scarce, some fear we’re heading straight for another bust.
* Larry Elliott and Heather Stewart
*, Saturday 14 November 2009 23.29 GMT

The din from the commodity pits on the Chicago exchanges is growing louder. Estate agents in Kensington and Chelsea say they can’t meet demand for £1m-£1.5m homes. Wall Street’s hi-tech Nasdaq exchange has wheeled out its confetti machine for the first time since the credit crunch.

Everywhere the story is the same. Gold: at a record high, above $1,100 an ounce. Shares: 50% up since March. Oil: back to almost $80 a barrel. Bonds: yields on two-year gilts at a record low. Average UK house prices: up £11,000 this year.

Around the world, asset prices are booming. Relief that the global economy has avoided the Armageddon feared in March, combined with large dollops of virtually free money, have helped put a smile back on the faces of the speculators. Too big a smile, according to some experts, since the buoyancy of asset markets is not reflected in the real economy.

Away from the frenzied financial world, among struggling firms and cash-strapped families, signs of recovery from the worst downturn since the 1930s have been much patchier. The US returned to growth in the third quarter, thanks to Washington’s cash-for-clunkers scheme and tax breaks for first-time homebuyers. But unemployment is at its highest level since 1983 and the number of Americans losing their homes is still rocketing, so Fed chairman Ben Bernanke still has plenty to worry about.

In Europe, the big economies of Germany and France returned to growth six months ago but consumer spending remains painfully weak. In the UK, the latest official figures show the economy still contracting in the autumn after six successive quarters of negative figures. Mervyn King, Bank of England governor, warned last week that the UK has “only just started on the road to recovery”.

As share prices roar ahead, the question is: are policymakers trying to solve the problems caused by one of the biggest bubbles in history by pumping up another speculative frenzy? This was what happened after dotcom shares collapsed, when Alan Greenspan slashed US interest rates to 1% and left them there for three years, setting off the biggest housing boom in US history. And this time, central banks and finance ministries have added tax cuts, spending increases and quantitative easing – the creation of electronic money – and so created an even headier brew.

Ravi Batra, US economist and author of Greenspan’s Fraud, says: “We are repeating the mistakes of Greenspan but on a much bigger scale. There is going to be another big pop in the new year.”

He is not the only Cassandra. Nouriel Roubini, one of the few economists to see the crisis coming, warned this month that the US had replaced Japan as the centre of the global “carry trade” (whereby investors borrow money cheaply in a currency with low interest rates and buy risky assets that offer a return higher than the interest due on the loan). With the US Federal Reserve pledging to keep interest rates only just above zero for “an extended period”, Roubini says dollars, instead of yen, are now being used in “the mother of all carry trades”, forcing up the price of all kinds of other assets.

Central bankers past and present sought last week to allay fears that, just like last time, it would all end in tears. Frederic Mishkin, a former governor of the Fed, said there were two sorts of bubbles: “credit boom” bubbles and “irrational exuberance” bubbles. Credit boom bubbles – like the one that burst in 2007 – were far more dangerous than irrational exuberance bubbles, such as the wild buying of technology shares, he argued, because they created a toxic feedback loop. A rise in the price of an asset such as housing allows consumers to borrow, but they then invest the money in buying a bigger home, driving prices up ever further – and so it goes on. When prices plummet, hapless homeowners not only have a property worth a fraction of what they thought, they’re also sitting on a mountain of debt. Mishkin sees the dotcom boom as less catastrophic because it didn’t involve this vicious circle, and he regards the current rise in asset prices as being of this harmless, irrational kind.

Mervyn King agrees with this analysis. During a sepulchral press conference to launch the Bank of England’s quarterly inflation report, the governor made it clear that he was losing no sleep over the rise in asset prices. Threadneedle Street believes some increase in such prices – bonds and shares, in particular – is good for the economy because it lowers the cost of financing for companies and makes them more recession-proof. It is one of the channels by which the Bank believes the £200bn it is injecting through quantitative easing will feed through to the rest of the UK.

King’s message was clear: after a near-6% drop in output since early 2008 it is premature to be drawing comparisons with the Dutch tulip mania of the 1630s, Isaac Newton losing his shirt in the South Sea Bubble of 1720, the boom-busts in US railway shares in the 19th century, or any of the periodic speculative stock market frenzies of the 20th century.

King said: “It’s very important that we don’t end up in a world in which everyone describes every increase in asset prices as a bubble, and every fall in asset prices as the bursting of a bubble.” He made it clear he was not worried because there had not been the “rapid extension of credit” seen in the early 2000s – indeed, we are gripped by a credit shortage.

Gerard Lyons, chief economist at Standard Chartered, says he sees no sign yet that prices in the US or the UK have risen out of control: “It should not be a surprise that in the early stages of a recovery, property prices and equity prices rise, particularly if they have taken a big hit.” He is concerned, however, about China, where a return to strong growth has been achieved with a massive government stimulus programme, which has led to a jump in bank lending – potentially making it a damaging credit boom. “Where asset prices have risen sharply alongside rampant lending and credit growth, there is more reason to think it’s a bubble, and China fits into that category,” he says, though he adds that Beijing is well aware of the risk, and is now clamping down on lending.

Even the severest critics of Mishkin’s and King’s laid-back approach to the current buying spree accept that some recovery in asset prices – of perhaps 20% – has been justified. After the collapse of Lehman Brothers in September 2008, financial markets continued to fall sharply throughout the winter as global output contracted and credit dried up. By March, investors had fully priced in the possibility that the world economy could be heading for a new Great Depression, so even the first tentative pieces of good economic news sparked a relief rally.

But markets tend to have only two moods: deep gloom and wild euphoria. Having prepared for the return of soup kitchens in the spring, they are now betting on a strong and rapid return to business as usual – a so-called “V-shaped recovery”. And that’s what worries analysts, who are not comforted by the age-old cry that “it’s different this time”.

“It sounds too good to be true and it is,” says Robert Barrie of Credit Suisse. “It’s time to take asset prices and credit more seriously. They can have long-run effects that are big and problematic. They took a long time to show themselves last time and could do so again.”

Concerns about a new speculative bubble fall into three categories. The first is that the recent track record of central banks does not engender much optimism that they will be able to distinguish between a credit bubble and an irrational exuberance bubble, or indeed spot either sort developing. The Fed, for example, denied that the US housing market was a bubble right up until the point the global financial system was paralysed by the sub-prime meltdown in 2007, and the Bank of England flatly rejected arguments that central banks ought to “lean against the wind” and prevent prices in markets such as housing getting out of kilter.

Moreover, as London market analyst Andrew Smithers noted last week, even the popping of the irrational exuberance dotcom bubble, dismissed by Mishkin as relatively harmless, had baleful long-term consequences, since it led to the cuts in interest rates and taxes in the US that fed the housing bubble.

A second concern is that the fundamentals of the global economy remain weak, and when investors catch up with that grim reality, there will be another brutal crash. “The speculative economy that caused the problems in the first place has again reared its head,” says Graham Turner of GFC Economics. “But the real economy continues to flounder. 2010 will be a very big year because the global economy is not fixed.”

Danny Gabay, of Fathom Consulting, says the reaction of markets last week to the statement of G20 finance ministers in St Andrews was indicative of the over-optimistic mood. “The communiqué said that conditions were far too weak to consider removing the economic stimulus, yet stock markets rallied by 2%. Ministers were saying things are so fragile they daren’t take their foot off the pedal.”

Finally, there is the worry that the underlying reason bubbles keep recurring is that the modern global economy can only run on cheap money and debt, which fuel regular and powerful speculative cycles. Batra says that in the US there has been a profound mismatch between the increased supply of goods from improved productivity and the squeeze on real wages dating back to Ronald Reagan’s presidency. “Greenspan resorted to debt creation and budget deficits to bring demand and supply into balance,” he says. Turner says bubbles reflect how global capitalism now works, with firms moving operations offshore to cut wage costs, leaving demand in the world’s major economies so weak that it can only be kept going by spoon-feeding consumers with cheap credit.

Even some who believe that we are back in a bubble say central bankers have little choice, such is the scale of the downturn. “My view is that we have to go on with quantitative easing for as long as we possibly can,” says Crispin Odey, a City hedge fund manager.

So what happens next? Policymakers hope the rise in asset prices is a catalyst for stronger growth next year, with consumers feeling richer as house and share prices rise and so spending more. Businesses will respond to stronger consumer demand and easier financing by boosting investment and creating new jobs.

But at some point, governments and central banks will have to withdraw their emergency support by pushing up interest rates, selling the bonds they bought through quantitative easing, and cutting public spending. Only then will it become clear whether central bankers are cleverly “smoothing” the most painful adjustment in the world economy since the second world war, as King argues – or unleashing yet another bout of irrational exuberance.