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Asset price bubbles are a fact of life

By Paul Murphy

Is this not incredible? The world has only just and so returned to the path of economic growth after the biggest financial bust in living memory, and already economists and strategists across the financial spectrum are warning of bubbles in asset prices.

The reasoning is simple. During a downturn like the one we have just experienced, asset markets tend to overshoot on the downside. Then, with all the stimulus that has been pumped into the system, there is a natural tendency to overshoot on the upside. We've got the authorities actively creating boom and bust conditions, if you like, rather than trying to pretend (as Gordon Brown did in the UK) that economic cycles somehow no longer exist.

Which brings us to what must be a rather brave piece of research published last week by Matt King, a credit strategist at Citibank. His investment thesis, to summarise, is that asset price bubble are just a fact of life in the current post-crisis environment – and we should just learn to live with them and profit accordingly.

Here's his introduction to a slide presentation delivered to Citi clients last week: "Investors seem to be coming round to the idea that markets are increasingly prone to bubbles. For many, this is the easiest way to reconcile surging asset price performance on the one hand with a lingering feeling of having not really dealt with the true causes of the latest crisis on the other. This presentation explains not only why we agree, but why we think this process has much further to run. We argue that in the current cycle, while high grade and high yield credit have scope to rally further, the biggest bubbles are eventually likely to form in both emerging markets and in government bonds.

"But despite current market chatter, we suspect their bursting is much further away than most investors think. With valuations not yet stretched, and with the authorities not having the stomach for a new crisis, our recommendation is to buy in – despite the fact that we fear a bath later."

Is this reckless – simply telling clients to enjoy the bubbles rather than help pop them? No matter. As King points out, it is very easy to see why people are resorting to the language of bubbles when market movements themselves are so difficult to understand.

"On the one hand, during 2009 pretty much everything was going up. The rally was not only in high grade and high yield, but also in equities, in commodities and in emerging markets. Govies failed to sell off very much, despite a deluge of supply. Even house prices in the US and UK have been rising for the past five to six months.

"And yet on the other hand, despite growing evidence of economic recovery and of the efficacy of the various stimulus measures, a sensible argument can be made that we haven't really fixed anything. If the true cause of the crisis was the unsustainable build-up of private sector debt in countries like the US, all we have really done is move from private sector borrowing to public sector borrowing.

Household debt levels may no longer be growing, but government debt has gone through the roof. As such, the total level of debt in most developed countries [excluding the financial sector, where grossification effects tend to make trends hard to interpret] has not only continued to rise during 2009, but has done so at an accelerating rate.

"In extricating ourselves from this crisis, we fear we are sowing the seeds of the next – conceivably even bigger – crisis a few years down the line."

So King is being upfront about the dangers here. So extreme has been the response of the authorities to the threat of deflation, the dangers now of an even bigger bust somewhere down the line are very real indeed. The Citi man uses the analogy of childrens' bathtime to ram home his point: "In the 1950s, 1960s and 1970s, mummy was in charge of bathtime. Mummy uses a hard-bristled scrubbing brush. The children cry, but the dirt [debt] does actually go away.

"Sometime in the 1980s or 1990s, though, daddy took over. Daddy [at least in the King household] prefers to use soap. The children make bubbles, they play and have fun for way longer than you would have thought possible, but the downside is that they don't actually get clean. Now daddy can probably get away with this on Monday, Tuesday, Wednesday and Thursday, but by the time mummy comes home on Friday and looks behind their ears at the dirt which has accumulated during the week, there is the most almighty explosion."

He expects bathtime – complete with bubbles – to continue for a few years yet, if only because the memory of the last crisis is so fresh that neither politicians nor central bankers have any desire to pull the plug.

But what happens when Friday arrives? "Sooner or later, Mummy will come home, and the more the dirt that is still sitting around when she does, the greater will be the likely explosion, and the more painful the necessary scrubbing will be."

One day, mummy will arrive in the form of bond investors or central bankers, who start to push up interest rates sharply. Governments will be forced to cut back drastically on their expenditure, with painful consequences for their populations.

But when will that be? King quotes a recent statement from Fed chairman Ben Bernanke: "The Federal Reserve remains committed to its mission to help restore prosperity and to stimulate job creation, while preserving price stability… We do not see at this point any extreme misvaluations of assets in the United States".

Correctly or not, King observes, mummy hasn't even called yet to say that she's leaving the office.

The writer is an Associate Editor with the Financial Times. The views expressed are his own


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