Lasting Bubbles
Source: Morgan Stanley
Even though the current business cycle is old, the policy environment is still stimulative. US interest rates have yet to reach the neutral zone. The euro zone’s real interest rate is still near zero. Japan has not begun to tighten. As a result, global money supply remains ahead of GDP growth.
Globalization of manufacturing has allowed the major central banks to maintain stimulus. The price elasticity of the global supply curve has increased sharply due to the entry of China and other emerging economies into the global supply chain. Hence, inflation reacts much more slowly in response to money supply than before.
Instead, the excessive money supply has flowed into asset markets, which has stimulated demand by inflating asset prices. In that regard, the globalization of capital flows has played a vital role. The rise of the hedge fund industry has fundamentally changed how risks are priced. As this industry is compensated on annual performance, the future is increasingly irrelevant to risk pricing. The low risk premium everywhere has made borrowing much easier than before.
The easier borrowing terms have led to a global property boom that is at the heart of demand creation. In the US, consumption demand depends on borrowing against rising property prices. In China, investment demand depends on property construction and hence high property prices.
We estimate that the global asset bubble, mainly in property, may amount to US$15 trillion, which would make it the biggest bubble in history. However, players in the global financial markets are not scared, as there is a belief that the central banks will not burst the bubble. Hence risk premiums are kept low, sustaining the bubble. There is a self-reinforcing relationship between the central banks and hedge funds, which is sustaining global GDP growth despite the existence of imbalances and structural fragilities.
Risks
Bubbles burst when they are least expected to. In 1990, the bookstores in the US were full of books on Japan’s different but more effective economic model. In 1996, the World Bank had just come out with a study on the ‘East Asian Miracle’. In 2000, several large funds threw away their long-held skepticism on the tech story and bought NASDAQ. History is full of examples of those who thought bubbles would last forever.
The current bubble, just as previous ones, will burst unexpectedly, in our view. As long as inflation remains low, the central banks are unlikely to burst it by tightening. Considering the extent of overcapacity in China, it is difficult to imagine that inflation will get out hand. Hence, we would expect the burst to be triggered by a shock, probably due to internal fragilities in emerging economies.
China and India, the two countries at the centre of the current bubble, look the most vulnerable. China has invested its export income unproductively, creating overcapacity and empty buildings. China’s investment demand is based on excessive optimism about the future. ‘Build first and they will come’ has been taken to the extreme. History tells us that such optimism often turns suddenly to pessimism. Should this happen, asset prices could fall precipitously, leading to a demand crash.
India depends on capital inflow to fund its consumption-led growth, like a poorer version of the US. However, the optimism felt towards an emerging economy can be fickle. As US interest rates rise and the optimism becomes more expensive to maintain, sentiment could turn quickly, leading to devaluation and rising real interest rates. We see India as a candidate to experience the kind of capital flight that hit Southeast Asia in 1996.
While we expect moderate deceleration in the coming year, it is important for investors to mind the risks. When sentiment towards China or India turns negative, we think investors should rapidly decrease the beta in their portfolios.
‘Believe’ is okay. ‘Be prepared to run’ is vital.
This article clearly provides a healthy dose of caution at a time when the Indian markets are almost peaking. In the coming week we will see fools rushing in, and next week the correction will begin.
Eclectic Investor
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Eclectic Investor |
9:12 AM