Asset bubbles are created when euphoria, cash and credit are present and rational thought is nowhere to be found. These bubbles eventually burst when reality sets in.
This is nothing new. In the early seventeenth century Europe became enamored with a single flower that became the ultimate symbol of wealth and prestige. As most investors know the flower was the tulip and this period of time is known as the “tulip mania” period of Europe.
At the peak of the mania in 1637 a single tulip bulb cost up to 4000 guilders or around $200,000 in today’s terms. Of course this did not last once reality set in.
Years later this was followed by the South Seas trading bubble, which sucked in someone as rational as Sir Isaac Newton who suffered massive losses after the bubble burst.
A more recent and obvious example would be our own housing bubble. Whereas there are multiple factors that were involved in the creation of this bubble - including poor lending requirements, easy credit terms, mortgage-backed securitization, lax regulation, etc. - the underlying issue was the unfaltering belief that housing prices would always go up and could never go down.
This prompted many euphoric homebuyers to buy more house than they could afford. We all know what happened next.
To provide a backdrop to the past as well as the present, let’s borrow some quotes this author made in prior editions of the Market Overview:
September 30, 2005; Oil Obsession - Market Overview
“Housing booms and speculation are created when sufficient fuel (liquidity) is provided. This fuel is typically provided by banks and other lending institutions through low interest rates, creative financing and lenient lending terms.”
September 30, 2006; Real Reality - Market Overview
“…marginal homeowners, especially those holding exotic mortgages, are facing a day of reckoning”
March 31, 2008; Extremes - Market Overview
“Markets can only go up when cash is present and flowing toward them. Conversely, markets fall when cash flows away.”
“Emotion is an investor’s worst enemy.”
Many of these conditions exist today.
The bottom line is that asset bubbles have existed throughout modern time and are always trying to either form or subside somewhere in the world at any given time. The reason is because we are dealing with human beings that let emotions, politics, ideologies or greed guide their investment or policy decisions.
So what potential bubbles exist in the world today? Here are a few examples:
China’s Debt Bubble
Half of all private-sector debt accumulated throughout the world since 2007 has come from China. Much of this debt is due to investor euphoria surrounding China’s housing market.
While households around the world were trying to de-leverage their balance sheets between 2007 and 2013, rising middle-class Chinese households went on a debt binge, buying three, five or even ten apartment units that stood empty. Naturally most of this accumulation was prior to the two-unit restriction put in place in September 2012.
Their reasoning was simple. Even though the apartment units were unoccupied, the appraised value of those units doubled or even tripled in price during the boom years that stretched into 2013. There was no other investment alternative that came close to that kind of return.
Fueling the fire were highly leveraged developers that continued to build aggressively even though the units stood empty and there was an eight year supply either available or under construction.
These actions created mountains of debt for households and developers alike.
The ability to repay that debt has deteriorated dramatically since the bubble began to burst in 2013. For example by the end of 2013, the average ratio of debt to operating cash flow for developers had already risen to a whopping 12 times on loans with interest rates as high as 40%. It has gotten worse since then as the Chinese economy continues to slow.
The underlying problem was that Chinese households and developers sincerely believed that housing prices would only go up and could never go down. They are now facing their day of reckoning as housing prices continue to fall and large developers face bankruptcy.
However, China’s debt situation is not limited to the private sector. Local governments also amassed enormous debts and spent recklessly on useless infrastructure projects ranging from multi-lane highways with no traffic to swank government buildings.
As noted in the June 22, 2014 Market Overview, Shadows, shadow banks provided much of the fuel that sustained the debt binge.
Shadow banks, which are commonly known as trusts in China, are simply non-bank institutions that make loans that come under less regulatory scrutiny than traditional banks. Because of this, qualifying lending requirements on trust loans are usually very lax with above market interest rates as high as 40%.
China’s trust companies take money from investors and make loans or invest and speculate in just about anything from junk bonds to wine. Their method of obtaining investor capital is through opaque bundled trust products that are typically sold though traditional banks.
Sort of sounds like the Collateralized Debt Obligations and exotic investment vehicles that were embraced by investors prior to the 2008 meltdown, doesn’t it?
Beginning in 2009, Beijing began encouraging shadow banks to lend aggressively to complement traditional banks that were becoming overextended. This was all part of Beijing’s plan to flood the country with credit in order to avoid the credit and debt crisis that was enveloping the rest of the world.
Shadow bank loan growth soared, growing by 75% in 2010 alone. Of course part of the deal was that Beijing regulators would look the other way in regard to lending activities.
Then last year central planners and regulators went into full reverse as they began to understand the monster they had created. This resulted in a crackdown on banks that sold trust products.
The market response was immediate. In July 2014 the issuance of new shadow bank products fell by 310 billion yuan verses the prior month. By comparison these products were still growing at the rate of 993 billion and 526 billion yuan per month in January and June, respectfully.
It remains to be seen how China’s bursting debt bubble will turn out. However, it appears the fallout will be less severe than our own since their bubble does not involve highly leveraged securitized products that are held globally and the central government has a huge surplus to address the problem.
Eurozone Debt and Stability
At the time of this writing, there are two upcoming events that could impact financial markets going forward.
One is the anticipated announcement on January 22 from the European Central Bank (ECB) concerning a quantitative easing program where the ECB would buy the sovereign debt of eurozone countries.
The second is the upcoming elections on January 25 in Greece where the far-left Syriza party is expected to win.
The Syriza party has run on a campaign of anti-austerity and non-compliance with the terms associated with all of the bailout funds Greece has received since May 2010. If Greece were to embark on non-compliance, the ECB has countered that they would withdraw the 30 billion euros of finance due in February even if it tips Greece into a crisis that ultimately causes a Greek exit from the eurozone.
Naturally a Greek exit from the euro would cause financial market disruption.
As every investor knows this situation and that of other eurozone countries, such as Ireland and Portugal, is the direct result of debt bubbles that burst in 2008. These matters will be discussed further in the next Market Overview once the outcome of events is known.
Fiscal and monetary policies always result in some type of unintended consequence.
For example, even though the current monetary policy of extremely low short-term interest rates is supposed to stimulate the economy, it also reduces the interest rates on fixed income investments such as CD’s and money market funds. This has a very negative impact on retirees and others who may be dependent on income from these types of investments.
However on a more global scale, monetary policies can create asset bubbles in other parts of the world that are not domiciled to the particular central bank that is setting policy. The monetary policies of the three largest central banks - including the Federal Reserve, the ECB and the Bank of Japan (BoJ) - have and will continue to produce this outcome.
When the Fed enacted their Quantitative Easing - or what some would call “printing money” - programs between December 2008 and October 2014, their balance sheet swelled from just under $1 trillion to over $4 trillion. This pumped an enormous amount of liquidity into the system.
With developed countries experiencing slow growth and low interest rates, this excess investment capital sought out the higher rates of return and growth that could be found in the emerging markets. This money flowed into many economic, financial or political systems that were either too fragile or incompetent to handle this extreme inflow of capital prudently.
This huge inflow of capital caused explosive growth in many emerging economies.
Then in May 2013 when the Fed first suggested tapering and the internal problems within several countries were becoming more apparent, the money flowed out just as fast as it flowed in. Needless to say, many of these economic bubbles burst.
Now with Japan aggressively pursuing their own quantitative easing program and the ECB about to do the same, the question arises as to whether history will repeat itself with money flowing into emerging markets due to the large volumes of liquidity being created from these QE programs.
Many emerging economies currently face the threat of high inflation, falling currencies and slow or negative growth. Not a good combination.
As a result, these countries have been forced to raise interest rates that are way above benchmark rates in the developed world in order to defend their currencies and fight inflation. The downside result of these actions is even slower growth.
For example, while short-term rates in the U.S. stand at 0 to 0.25% and one European rate is actually below zero, the benchmark rate in Brazil is 11.25%. These very high rates remain in place even though Brazil is in full recession.
So will the excess liquidity in the world chase after these higher rates of return? In most cases the answer is probably no due to the conditions that exist today. These conditions will restrain whatever money does flow into these countries and that money will be very selective depending on the status of the individual country.
In 2009 many emerging economies had fairly reasonable fiscal budgets and debt levels that had been bolstered by the demand out of China and its double-digit growth from the prior two decades.
When the meltdown hit in 2008-9, most of these countries turned to stimulus spending in order to revive growth, racking up high levels of debt fueled by foreign capital in the process. The plan worked for about four years until May 2013.
Today with China’s growth slowing to 7%, most commodity prices in the toilet and many countries saddled with heavy debts, it is doubtful these countries will be able to repeat their prior growth successes.
There is the added factor that much of emerging market debt is “dollar denominated” making it much harder to service the debt as the U.S. dollar appreciates and their currencies decline. The strong dollar will also continue to put downward pressure on dollar denominated commodities such as oil, which will impact resource-oriented exporters.
In a nutshell, the bubble has burst in many emerging economies as they face their day of reckoning. This will make foreign investors hesitant and will force investors into safer havens.
The divergent paths of the major central banks of the world are causing volatility in the currency markets.
While the BoJ and ECB enact loose, over-accommodative policies through quantitative easing and zero or less interest rates, the Fed has quit QE and has indicated tighter future policy with higher short-term interest rates.
This discrepancy - along with our slow economic growth verses their zero growth - has caused rapid currency disruption with the dollar rising 13% against the euro and 14% against the yen since the end of June. This puts the euro at a nine-year low and the yen at a six-year low verses the U.S. dollar.
Actually this is all happening according to plan since both Europe and Japan are facing deflation and want to devalue their currencies in order to make their exports more attractive to the rest of the world. It is their hope this action will help re-inflate their economies.
There is something of an irony here in regard to inflation, our past relationship with China and our current relationship with Europe and Japan.
For almost three decades we moved labor-intensive manufacturing overseas in order to take advantage of lower cost labor. This was done in response to the hyperinflation shocks of the 1970’s. The lion’s share of this manufacturing went to China.
As the U.S. consumer accelerated its consumption of lower cost Chinese goods, they returned the favor by buying up our ever-increasing levels of debt. This allowed us to buy more of their goods whereby they bought more of our debt and so on.
In essence, we were “exporting our inflation” through this process.
Today, Europe and Japan are trying to “export their potential deflation” to the U.S. through the devaluation of their currencies. This process - that will include a further strengthening in the U.S. dollar - should continue to put downward pressure on our inflation rate.
This in turn will hamper and slow down future Fed tightening and limit the magnitude of any future interest rate hikes.
So how is the year 2015 shaping up?
As noted the Fed will be muted and will raise rates later rather than sooner since they do not want to choke off what appears to be an economic footing in the U.S.
China will continue to try and keep their growth rate near 7%, which could exasperate their efforts to control their debt bubble. Europe and Japan will be stuck in the mud with growth just above zero. Most emerging markets, with some exceptions such as India and Indonesia, will not have a good year overall.
By now it should be apparent that 2015 is the result of bubbles that have burst or have the potential to burst. The most significant underlying problem leading to this situation is excessive debt, in that countries as well as households sold their futures in order to obtain short-term gratification brought about through the accumulation of excessive debt.
Looking to the stock market, as the month of January has already confirmed the U.S. stock market will experience increased volatility in 2015 as the uncertainties in the world continue to impact investor perceptions.
However, when looking at the uncertainties of the world, the U.S. is the safe haven. When this fact is coupled with the excess liquidity being pumped into the world system through quantitative easing, it appears investors will seek out the safe haven of U.S. financial and real assets.
Therefore, it looks like 2015 should be a good year for the U.S. stock market, but it could be a bumpy ride.
- David B. Prilliman
Author’s note to long time readers: I started writing the Market Overview in January 1995. After 18 years and after writing over 75 editions of the Overview, I decided to take a semi-sabbatical a couple of years ago and only wrote two editions in 2013 and one in 2014. I’ll pick up the pace this year. Thank you for your patience.
Professional Investment Counsel, Inc. Principals: Gary M. Borsch (firstname.lastname@example.org) and David B. Prilliman (email@example.com)
Copyright 2015, David B. Prilliman. All rights reserved. All opinions and estimates included in this report constitute our judgment as of this date and are subject to change without notice. Although the information in this report has been obtained from sources we believe reliable, they are not necessarily complete and cannot be guaranteed. This report is for information purposes only.