The Silver Bullet | Interplanetary Bubbles
giovedì, 21 settembre 2017
A Martian economist lands on Earth. The most famous economists from Earth gather to greet their new visitor. They speak about Earth’s flourishing economy and global growth rates: the US is above 2%. Europe is catching up towards that, and Emerging Markets are in good shape with China still resilient despite approaching 6%. Earth seems to have recovered well from the global financial crisis.
The Martian, however, appears skeptical. “Last time I visited in 1946, Earth was just recovering from a great civil war, where over 36m people died. Now you are telling me you have solved all your problems and created this system called fiat money. But how come debt levels have grown even bigger than in war time, and so has inequality? And why do you think the solution is to buy even more assets?”
Our alien friend continues. “You see – back in Mars we have very limited resources. Water and food are really hard to produce, so we have to make the most of it. Investing in productivity and maintaining equality of resources and opportunities are a priority to survive. On Earth, he continues, humans may be chasing a dream of limitless growth, which they try to achieve not by improving productivity but with shortcuts – like boosting debt and asset prices – and assuming limitless resources.”
“And so, Earth’s growth engine appears very unbalanced. You just had a financial crisis in 2007, and debt levels are higher now than before. By allowing even more borrowing and boosting financial asset prices, inequality has grown even higher. There is more employment, but wages are not picking up. Is this a sustainable situation?”
“We are still suffering from hysteresis”, say the earthling economists. “Structural scars from the recession. These include a mismatch between skills acquired by our workforce during the past decades, for example in real estate and finance, against today’s new sectors, like technology. It’s a cyclical problem, with low interest rates and some time we will solve it. But we still haven’t figured out why inflation is still low. In fact, it is a mystery…”
The Martian shakes his head. “This doesn’t seem the best course of action, in my view. On the first hand, you have structural underinvestment in productivity, like education and infrastructure. On the second hand, you still have low interest rates generating collateral effects like asset bubbles, or misallocating resources to firms that survive only because of zero borrowing costs. On the third hand, politics are becoming more polarised, reflecting rising inequality and trending dangerously towards populism. On the fourth hand, you also risk hurting your planet; climate change means weather events are becoming more extreme and natural disasters more frequent”.
Earthling economists are baffled, used to thinking in two-hand juxtapositions. The Martian’s four-dimensional trade-off spans from productivity, monetary policy, politics and environmental issues. What should they do?
The perfect policy combination would be a combination of fiscal stimulus, potentially also aimed at reducing inequality and improving productivity, together with normalisation in monetary policy. The difficulty, however, is that these efforts need to be harmonised across various countries. Is it possible to normalise monetary policy without coordination? The short answer is no. One example is price action following central bank’s hawkish message at Sintra. Long-term interest rates have moved lower, while the Dollar weakened with falling consensus on fiscal stimulus. In turn, currency appreciation can redistribute inflation from hawkish countries to others, defying the central banks’ intent. As we wrote in our latest Silver Bullet in August, the result can be a currency war.
This makes our Martian friend pessimistic. With rising political risk globally, achieving coordination on fiscal and monetary policy appears very difficult. There is some hope on monetary policy coordination. The ECB started with hawkish words in June, followed by the Bank of England and most recently, the Federal Reserve. It will be more difficult, however, for fiscal policy to come to the rescue in an orderly manner, as monetary stimulus is withdrawn. In the US, the Trump administration is tentatively passing corporate tax cuts over the coming months. The UK is still evaluating its Brexit strategy, let alone focusing on a long-term industrial plan for the country. The situation is slightly better in Europe, Canada and China.
As an investor, a potential failure in normalising monetary policy would be bad news. First, it would reduce returns in “risk-free” assets. Second, it would encourage asset bubbles to grow even further, diminishing expected returns. Third, it would leave the economy and our society in worse shape and with less policy dry powder to use in case of a future slowdown.
Investors need to be prepared for three scenarios:
1. Perfect coordination: a normalisation in monetary policy accompanied by fiscal stimulus, with coordination across regions
2. Tentative coordination: a tentative normalisation in some regions, with imperfect coordination across regions and currency appreciation resulting from that
3. Currency war and return to QE infinity: a failed normalisation, with imperfect coordination and lack of fiscal policy stimulus
The last scenario means policy rates could remain low for longer. It also means bubbles would grow larger in financial markets, as interest rates stay low for too long. We discussed the link between QE and asset bubbles in The Silver Bullet | The Low Volatility Trap.
There’s a few typical characteristics behind a bubble, which is typically a trade where an asset vastly exceeds its intrinsic value, associated with a number of irrational behaviors. These include:
1. This time is different: asset bubbles can be linked to a new type of good or technology. Investors conclude that “this time is different”, and therefore normal rules don’t apply.
2. Fear of missing out: the bubble attracts more types of investors, from fast money, to asset managers to retail and increasingly less experts in the field.
3. Sky is the limit: upside for gains is considered limitless.
4. Flipping: the hope of a quick profit and the loss of a long-term investment view shows up in high transaction volumes, like for flipping condos – buying and selling houses you have not even seen.
5. No credit, no problem: bubbles tend to appear more frequently when credit is cheap and freely available, and the opportunity cost of taking risk is low.
6. Buy the dip: policymakers suppress volatility by providing guidance that they will be there for investors, should a crisis happen. This can prompt additional risk-taking or buy-the-dip behaviour, e.g. with the famous Greenspan put.
7. Borrow while you can: as asset valuations increase, companies are tempted to stretch their capital structures for even larger mergers or to pay dividends to shareholders, ignoring their long-term cost of capital.
8. Bidding wars: buyers fight to buy an asset, as happened with London properties.
9. The trend is your friend: investors assume that tomorrow will be like today, and do not see any catalysts that could derail the current trend.
10. Financial engineering: derivative products are created to extract more returns from the existing asset, often taking a multiple of the risk.
There have been examples of asset bubbles in history, including the Dutch’s craze for tulips in the 17th century, the Baburu Keiki years in Japan and the chase after technology during the dot-com boom.
Where are the bubbles today? The potential suspects are:
Equities: Equity prices have risen in tandem with the size of central bank balance sheets since the crisis. Taking SPX as an example, valuations appear rich: purely historical, forward or cycle-adjusted valuation multiples are all well above historical averages.
However, we cannot say the broader equity markets are today in a bubble, given economic data both in the US and Europe remains stable or strong, unemployment is low or heading lower and central bank policy remains accommodative – which has made other assets relatively expensive as well – relative to historical levels.
We are more concerned however, that relative changes in monetary or fiscal
policy may lead to an overall correction. Equity markets may see a repricing in our view, if there is a meaningful broad shock to growth and confidence, such as protectionist headwinds in the form of aggressive trade barriers or geopolitical/political paradigm shifts such as a Korean War or a U.S. President Impeachment. A broader risk would be the repricing of long-term interest rates, which so far have remained stable, thanks to central banks’ stable guidance on inflation and terminal rates, as from the latest Federal Reserve press conference.
FAANGs: Facebook, Apple, Amazon, Netflix and Google appear a possible candidate. Current consensus and sentiment seems to price almost unlimited earnings potential, but we think there are three possible scenarios that could cap this potential in the medium term, highlighting today’s valuations might be irrational.
- Regulatory & political risk could erode their monopolistic position, whether through forced business model or fiscal changes
- Competition from other FAANGs, Asian FAANGs or unforeseen competitors
- Central Bank normalisation triggering more attractive risk/reward opportunities in other assets
Rates: G-10 bond markets have had a multi-decade bull run. The reasons are many: populations are ageing, inflation is structurally lower due to new technologies, central banks were already lowering rates before the crisis to keep debt sustainable, and the room to use more credit to boost growth and asset prices has become limited.
There are signs of a bubble: investors have piled into long duration carry trades on expectations of QE infinity, valuations appear stretched with interest payments barely protecting bondholders from yield moves or inflation (long-end Gilts in particular), and governments are issuing more long-dated debt – recent examples include Austria’s 100-year bond and Italy’s 50-year bond, issued at 2.1% and 2.8% yield. A normalisation in monetary policy should lead to a repricing in interest rates, as the long duration trade unwinds and term premia normalise. However, a lack of real deleveraging and structurally lower inflation may mean a slower hiking cycle and lower terminal rates in developed markets. In other words, rates should be wider, but may not return to historical-wides.
Credit: QE also provides a strong anchor to credit, as central banks purchase investment grade debt and pushed investors to go down into high yield bonds. In our view, the risk of a bubble is higher in US than in European credit, even though spreads appear tighter in Europe vs long-term averages. This is because European corporates have not re-levered as much as their US peers or engaged in shareholder-friendly activities. In addition, default rates are likely to remain lower for European high yield, given better average ratings, less issuance of covenant-lite debt and lower exposure to the energy sector. In the US market, instead, we have seen more evidence of shareholder-friendly behavior from borrowers.
Short volatility strategies: Prolonged QE and the resulting search-for-yield activity have compressed market-priced volatility and led to a surge in short volatility strategies, as we discussed in The Silver Bullet | The Low Volatility Trap. Open contracts held in inverse VIX ETFs have grown by over 700% since 2012, but more importantly investors have also been selling volatility in FX, rates and credit, driving risk premia lower across assets. So far such strategies have produced attractive risk-adjusted returns, as global central banks take turns to add to the QE punch bowl. Meanwhile, political and geopolitical risks are rising, creating a divergence between real world uncertainty and market-priced volatility. This appears to be a potential bubble, as the risk of a sharp repricing in volatility following central banks’ QE exits remains high: investors who have grown so used to the central bank put may need to adjust from their buy-the-dip, low volatility environment.
Cryptocurrencies: Advocates of cryptocurrencies may argue that they represent a form of disruptive technology, similar to how fiat money replaced the gold standard. However, the fundamental difference between cryptocurrencies and fiat money is that they may not yet qualify as “money”. As per the IMF, money can be anything that can serve as 1) a store of value, 2) a unit of account to provide a common base for prices or 3) a medium of exchange. Taking BitCoin, the most well-known cyptocurrency, as an example, currently its acceptance at merchants is low and getting lower, putting its potential as a medium of exchange or a unit of account in doubt. Its high price volatility and susceptibility to regulatory risks also make it a poor store of value: a warning by the Chinese central bank in 2013 against treating BitCoin as legal tender triggered a 60% decline in its value. Since the crash, BitCoin has resumed its upward trend and appreciated by more than 15 times since 2015, largely due to investor speculation rather than more visibility on its intrinsic value or wider acceptance at merchants. The fast price appreciation and lack of rational analysis by investors chasing the trend mean that BitCoin and other cryptocurrencies are likely a growing bubble.
Real estate: Cheap credit, relatively scarce supply and strong domestic and foreign investor interest have driven rapid price increases in several real estate markets, most obviously Australia and Canada. With real disposable incomes having been fast outpaced by prices, and a rapid build-up of leverage we are ready to call a bubble, though we are not the first nor we suspect the last. Other niches of overvaluation include large international cities like London or Hong Kong, where limited supply, low interest rates and loose regulation have favoured cash inflows which use property assets as a cash-park.
The Martian economist beams back a memo to the Interplanetary Economic Council: “Earth has improved, but the humans are still prone to the same fallacies. Short-sighted use of resources, search for utopian never-ending wealth, irrational behaviour and euphoria and lack of long-term balance. There is no need to invade yet. Without a change in policy and incentives, they will probably self-destruct over the coming century.”
Conclusions: Navigating the Bubble Galaxy
A multi-decade credit expansion in developed markets, followed by prolonged central bank easing to fight the crisis has created asset bubbles in financial and real assets. Today, investors need to navigate this environment and position for a potential normalisation in monetary policy.
The Bank for International Settlements has long called for monetary policy normalisation, on the basis that inflation may be structurally lower – as we argued in previous Silver Bullets. Central banks seem to be finally following this advice, as recently shown by the Bank of Canada, Bank of England, the European Central Bank and the Federal Reserve.
That said, normalising policy will not be easy and may take longer than expected. This means that asset overvaluation may persist, and that countries in a better position to normalise will see their currencies appreciate.
The bubble galaxy may end up deflating slowly, rather than in a big bust. We remain cautious and position for the few remaining areas of value. In fixed income markets these are areas to which markets still apply unreasonable tail risk, in our view, like the Eurozone periphery including Greece as well as bank debt. We continue to think that Sweden and Norway, as well as the Eurozone, will have an easier time normalising policy than the UK, despite the recent hawkish rhetoric by the Bank of England, as we discussed recently in the Financial Times.
“If everything is a bubble, then the definition of bubble needs to change”
J.G., Macro Portfolio Manager
The Silver Bullet is Algebris Investments’ macro letter.
Alberto Gallo is Head of Macro Strategies at Algebris (UK) Limited, and is Portfolio Manager for the Algebris Macro Credit Fund (UCITS), joined by macro analysts Tao Pan, Aditya Aney and Pablo Morenes.
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