The phase that launched a thousand bubbles

The Dysfunction Trilogy Part C

Bubbles last just as long as it takes for technical to become fundamentals. 

By Chan Akya

Helen of Troy had the face that launched a thousand ships while Federal Reserve chairman Ben Bernanke and his compatriots have presided since 2007 over the economic phase that launched a thousand bubbles. 

In the previous two parts of this trilogy, the focus was on real-world businesses and pension planning that have been adversely affected by monetary policies over the past few years and particularly since 2009. 

Have these efforts at quantitative easing produced any tangible (positive) economic results at all - not that anyone would notice really. Key figures such as retail sales and capital investments still vastly lag levels seen before the crisis; and even the figures that look like improvements don't quite stack up when you look closer. 

For example, US non-farm payrolls for April showed an increase of 165,000 jobs against market expectations of 150,000 jobs for the period. However, once the average work hours were taken into account, payrolls were actually down - the quantum has been estimated from 300,000 to 500,000 based on the measure. 

What about the other major focus of Keynesian measures namely to propel inflation in Group of Seven economies with a view to increasing consumption and investment while cutting real debt burdens? Well, that hasn't panned out yet either. 

There is no inflation - at least in the way that it is popularly measured, nor have yields on Treasury Inflation-Protected Securities (TIPS) moved in any fashion that would suggest sticky, higher prices. This is because the fear of lower real returns and increased government debt (as suggested in the previous two articles) have pushed people to cut consumption even further and instead attempt to save money even if that means going for speculative investments. This is covered in the next section. 

Bubbles galore

So if the intended consequences of the Keynesian stimuli haven't panned out as per plan, what about the unintended consequences? Typically, when central banks fail in their policies, one would expect to see the following:

a. Asset bubbles

b. Rising systemic risk

Random correlations 

On the subject of asset bubbles, we don't have much to complain about with, at a minimum, stocks and real estate around the world moving sharply higher without any basic support from fundamentals. In the rest of the article, some details about the asset bubbles will follow. 

The issue of systemic risk is germane to any consideration of how central bank policies have panned out. With organic growth proving elusive even as intervention helped to obviate the need for taking significant balance sheet hits, banks as well as the shadow banking sector have plunged headlong into funding of highly risky transactions, be it US sub-prime mortgages (remember those? Apparently caused some crisis in our history) or highly leveraged investment mechanisms such as collateralized debt obligations and collateralized loan obligations (remember those?). 

Banks are once again at the forefront of risky investment strategies. Capital levels haven't risen to the extent required for the scale of assets in the pipeline, while falling margins have disallowed banks from recuperating their reserves. 

A key highlight of financial crises tends to be the emergence of random correlations - random in this case referring not so much to financial history but overall investment logic; but this also goes into the heart of rising systemic risk being mentioned above.

For example, all the investment talk now is of the Japanese yen levels against those of dollar-denominated assets such as US stocks and real estate. Granted that as the low-yielding currency of choice, increased positions in the yen are normal, but this time around, the explicit weakening strategies of the Bank of Japan have meant that more investors have piled into this trade, usually by borrowing in yen from their local banks and then purchasing US dollars and other hard-currency assets. 

In effect, while banks today show the risks to be low thanks to this random correlation, the fact of the matter remains that this correlation can go the other way too - a quick reversal in the yen back towards 90 for example will create massive investment losses and in turn create hedging losses for banks, while the yen movements may not match the credit quality characteristics of their borrowers (seeing as we know hedge funds go bust all the time). 

To consider an example closer to home of how asset bubbles end up creating massive problems for banks, let's go back to the point about ships as previously discussed in the article "Keynes stole your ship". Rising ship prices since 2008 were seen as “fundamental” by the sector and therefore soon enough by the banks; typically a number of new ship purchases were funded to the extent of 70% or above by the banks. 

Today, with that bubble bursting spectacularly, both banks and the sector are left praying for time. Large tankers - VLCCs - that commanded prices of over US$150-175 million barely four years back, can now be purchased for under $50 million. 

So even if you were the smart banker who lent "only" $100 million against this ship back then, there is still a potential loss of $50 million staring you in the face now. No wonder the European banks that focus on shipping have all been under pressure - at sea, so to speak - despite the broader recovery in other asset prices over the past few quarters. 

Even worse than these European shipping banks are the Asian banks - Chinese, South Korean and Japanese - who are being asked by their governments to support the shipping sector at current levels, both in terms of rolling over existing maturities of loans and funding new loans for buying ships. 

Already a number of Japanese and Korean shipping companies are bankrupt; add to the list a host of unknown Chinese companies that are suffering the same fate; and in all cases the banks are being told to continue lending money to the sector to avoid a "bigger" blow up that could imperil trade terms for these exporting countries. 

The anatomy of asset bubbles

Bubbles last just as long as it takes for technical to become fundamentals.

A key element of asset bubbles is that the primary impetus of irrational money chasing too few assets is always recognized; what follows is that thanks to the index-weighting focus of various investors - mutual funds and pension asset allocators to name a few - pretty soon real measures of value are assigned as reasons for increased asset prices - say for example in the Internet bubble era: folk started going for top-line revenues as the key measure on the logic that while these companies were losing money initially they would eventually turn around as long as the top line grew.

Then any improvement in the top line whether by organic means or acquisition was hailed as evidence of the investment thesis and so on. 

Similarly for the US sub-prime lending bubble, there was the commonly held fundamental that house prices in the US “never” fell; this meant that all the testing mechanisms for CDOs and other investments tied to mortgages were never tested for falling asset prices. Thus, when the inevitable happened, investors ended up being exposed to more losses than would otherwise be the case. 

The reason for delving into that drab history lesson is that today we are back in the same paradigm. Almost all of the world's asset bubbles are underpinned by a single variable, namely interest rates, and particularly that of the US dollar. Take that up a few notches for whatever reason and suddenly the complex of not just bonds but also equities, real estate and consumer spending all fall off a cliff rather quickly. 

From US indices that are at record levels to real estate markets in places as varied as Monte Carlo and Hong Kong, the existence of asset bubbles is obvious. Stocks are trading at price earnings ratios that are simply unsustainable - ask anyone who held Apple stocks this time last year and they'll tell you a lot of stories about the number of opportunities that were given to them to exit the position before the collapse. 

One reason why most folk haven't sold these under-growing stocks is that, compared to interest rates, dividend yields are still superior whilst allowing capital appreciation from time to time. When people want to reduce risks, they go for real estate, as seen in the cases of Hong Kong, Singapore, Monte Carlo and of course, Australia for the past few years. 

It is easy to see the fundamental drivers of such moves, whether it's from Chinese mainlanders cutting risks of asset seizures by purchasing apartments in Hong Kong or Australians unemployed due to the high currency rate turning around and punting on their domestic housing asset to make a living from speculation. 

Ironically such rising asset prices also make it more difficult for engendering a real economic recovery. This has been the case in Australia, where even the strategies that could offset high currency values have been pushed away by the rising cost of real estate in the country. 

Another example is in Britain, where nascent reinvestment in the financial sector has been cut short by the strength in London home prices that has in turn fed into commercial rents, acting as a serious disincentive for firms looking to increase their operations from the city. 

Perhaps the worst of all the bubbles though is in the former tier 2 and tier 3 cities in the US where house flipping is back on - the practice before the crisis where people bought then sold houses on high leverage and high frequency. The treatment of housing stock as a trading good has potentially serious consequences for longer-term investments, as well as the systemic risk of US banks. 

This then is the worst of all the unintended effects of central bank involvement in the markets; instead of ushering in investors who could help turn around economies across the Group of Seven countries, the central banks have created a class of traders who roil asset prices, maximize leverage, but produce no lasting benefits for the underlying economies.