Today's New Paradigm
Friday, May 15, 2015
I didn’t think it would come to this. When I began chronicling the “global government finance Bubble” more than six years ago, I saw a backdrop conducive for the biggest Bubble yet: desperate central bankers mindlessly determined to print Trillions, buy Trillions of securities and inflate market values tens of Trillions, while at the same time using zero rates to force savers into risky securities. Yet I never imagined we’d get to mid-2015, with a 5.4% unemployment rate, record stock prices, record M&A, booming corporate debt markets and abundant signs of froth (i.e. Palo Alto, upper-end real estate, Manhattan condos, art, etc.) – and rates would remain stuck at zero. I didn’t expect global bond and currency markets to prove so accommodating.
But here we are - at the precarious stage. I’ve posited that the more deeply systemic a Bubble the less conspicuous its effects. Yet this global Bubble has reached such extremes that obvious signs of excess have sprouted out everywhere – most conspicuously with European debt, M&A, Chinese equities, global sovereign bonds, biotech, etc. And with things turning more overt, there’s now some Wall Street research addressing the topic.
Citi Equities Research (Robert Buckland, Mert Genc, Beata Manthey, Cosimo Recchia, Jonathan Stubbs and Ayush Tambi) published an interesting report late this week, “It’s Bubble Time.” This insightful research is worthy of discussion. I excerpted from the Citi report and then followed with my own thoughts.
From “It’s Bubble Time”: “Bubble Breeders - Previous ageing bull markets have been associated with asset price bubbles. They are often based around a convincing idea (Secular Stagnation?), and fuelled by excess liquidity. They are big enough and last long enough to destroy many contrarian investors.”
From the experience of the past two decades, so-called “bull markets” were not so much “associated with asset prices bubbles” as they were outright manifestations of historic financial Bubbles. “Tech Bubble” market distortions were prevalent in Credit and equities markets by the mid-nineties. Even greater “mortgage finance Bubble” market distortions took root soon after the post-“tech Bubble” reflation was commenced.
A “convincing idea” – or good story – is essential. I’ll add that if sufficient “money” and Credit are thrown at a system a pretty “good story” is bound to pop out. Periods of new technologies clearly provide fertile ground for Bubbles – and are arguably essential to epic Bubbles. As we’ve witnessed now for better than 20 years – and certainly was the case in the two decades prior to the 1929 Crash – a flurry of technological advancement can wield powerful price impacts – along with economic upheaval and instability. Policy confusion is assured.
By their nature, the final phase of an epic Bubble will indeed “destroy many contrarian investors.” There’s a confluence of important dynamics at play. First, during final Bubble phases, officials are by then responding to serious fundamental deterioration with heightened policy desperation. So-called “bears” - positioned based on negative fundamental factors – are squashed by the policy whirlwind. Meanwhile, flows gravitate to the most bullish and aggressive (tending to be those content to overlook weak fundamentals and fragilities).
Such a backdrop foments dangerous Bubble Dynamics. “Money” chases inflating risk markets, while a depleted few retain the resources or willingness to take the other side of this “bull” trade. The upshot is a self-reinforcing market supply/demand imbalance. Over time, as bull market psychology and speculative impulses build, unhinged markets succumb to upside dislocation and “melt-up” dynamics: Too many anxious buyers facing a dearth of sellers.
Benjamin Strong’s “coup de whiskey to the stock market” and the fateful 1927-1929 speculative blow-off illustrate this dynamic. And I point to the summer of 2012 – “do whatever it takes” central banking and the unleashing of global open-ended QE – as the original catalyst for global securities markets upside dislocation.
From Citi: “Bubble Bursters – Rate hikes eventually burst bubbles, but it usually takes a least three to stop the juggernaut. We do not expect the third Fed hike until 3Q16. In the meantime, expensive stocks may keep getting more expensive.”
I would argue that Bubbles are burst by an inevitable reversal of speculative flows and attendant shift in market perceptions. Responding to increasingly conspicuous excess, central bankers will tend to raise rates (too little and too) late in the Bubble cycle. Still, it’s late-cycle “Terminal” excess that dooms Bubbles. Much belated rate increases had little to do with either “tech” or mortgage finance Bubble collapses.
“Tech” collapsed after a reversal of a spectacular market “melt-up” dislocation. Derivatives markets were instrumental – providing speculative leverage - for the upside dislocation and then during the downside collapse. Markets abruptly turned illiquid. “Hot money” rushed for the exits, while too many desperately attempted to buy market insurance and/or place bearish bets. The mortgage finance Bubble burst when “hot money” sought to exit subprime mortgage securitizations and derivatives. Excess associated with over $1 Trillion of subprime CDOs issued in 2006 ensured subprime’s demise. Fed rate policy had little to do with the timing of the collapse.
From Citi: “We suspect that asset price bubbles are formed by four key forces: 1) A new paradigm story supported by convincing fundamentals, 2) Surplus liquidity, 3) A demand/supply imbalance, 4) Business/benchmark risk amongst asset managers… New Paradigms: Every bubble is based on a good story. Tulips are beautiful flowers. 17th Century Far East trading opportunities were vast. Japan’s economic performance post WW2 was spectacular. The internet represented a transformational technology advance. Many of these stories were based on convincing fundamental evidence – they really were new paradigms which would go on to change the world. However, when combined with abundant capital, these great ideas were often accompanied by unsustainable asset price bubbles. What might be the current new paradigm? At a macro level, the most obvious candidate is ‘secular stagnation’ – a world where growth, inflation and interest rates are likely to stay low for the foreseeable future. Fixed income assets are the obvious beneficiaries.”
This is insightful analysis. Yet one cannot discuss Bubbles without a central focus on Credit. As such, I would add that “surplus liquidity” is a fundamental characteristic of inflating asset markets. Speculative markets create their own self-reinforcing liquidity. Liquidity is created in the process adding leveraging in search of bull market returns, while borrowing throughout the economy increasingly finds its way into bubbling markets. Moreover, the expectation for ongoing abundant liquidity becomes integral to bull market psychology. The underlying source of Credit and its progressive vulnerability goes unappreciated.
From Citi: “Demand/Supply Imbalance: The next key ingredient of a bubble is a demand/supply imbalance. High demand for a new investment idea usually overwhelms the supply and leads to sharp price increases. Limited supply of land and growing populations often drive house/land price bubbles.”
This critical issue is quite complex. Similar to “surplus liquidity,” “demand/supply imbalance” is inherent to inflating “bull markets”. In the Real Economy Sphere, rising prices tends to self-adjust by dampening demand and boosting supply. In the Financial Sphere, rising securities prices lead instead to heightened demand. Unfettered finance tends to be powerfully self-reinforcing. Importantly, heightened demand for Credit can be accommodated without higher borrowing costs. Rising securities prices spur progressively intense demand.
This already problematic securities market supply/demand dynamic has been radically exacerbated by central bank policies. First, their purchases have removed Trillions of securities from the marketplace. Second, zero rates and collapsing sovereign yields have spurred Trillions into global risk markets. Third, “do whatever it takes” central banking and open-ended QE have emboldened the view that policymakers are determined to backstop global securities markets. This has had a profound impact on risk-taking. Emboldened market participants perceive that policymakers will protect against illiquidity and guard against big downside moves. Moreover, the policy backdrop ensures the availability of cheap market derivative “insurance.”
From Citi: “Business/Career risk: A weary client once defined a bubble to us: ‘something I get fired for not owning’. It is career-threatening for an asset manager to fight a big bubble. For example, the late 1990s TMT bubble almost destroyed the value-based fund management community. Any bond manager hoping that valuations were mean-reverting would have been fired many years ago. Big bubbles are especially dangerous. TMT stocks already represented a large part of equity market benchmarks when they rerated aggressively in the late 1990s. By contrast, Biotech stocks might currently be expensive but their small market cap means they are still not a big benchmark risk. You don’t get fired for not owning Biotech stocks now, but you did get fired for not owning TMT stocks in the late 1990s. Bubbles are obvious in hindsight, but they are very hard to fight in real time. Indeed, proper bubbles are so overwhelming that they force sceptical fund managers to buy into them in order to reduce benchmark risk and avoid significant asset outflows. As these sceptics capitulate, of course they contribute to the bubble and so force other sceptics to capitulate and so on and on until there are no sceptics left to capitulate. It makes sense for an asset management company to manage its business risk but this can end up contributing to the madness. Through this, the modern fund management is almost hard-wired to produce bubbles.”
Again, insightful analysis. I would, however, suggest that it is not so much that “modern fund management is almost hard-wired to produce bubbles” as it is that the entire financial services complex has been transformed by central banks inflating serial Bubbles. Inflation psychology has become deeply, deeply ingrained: everything revolves around purchasing securities that will benefit from ongoing central bank market manipulations and interventions. To survive has meant to climb aboard the great bull. This ensures the entire industry is now on the same side of the “trade” – with functioning “two-way” markets relegated to history. And markets will remain seductively “abundantly liquid” only so long as bullish psychology is sustained.
From Citi: “What Bursts Bubbles?: The new paradigm of this cycle is probably the Secular Stagnation story, with fixed income assets looking the obvious bubble candidates. Nevertheless, our rates strategists think it is too early to call the end of the secular stagnation trades… We also asked our regional equity strategists to identify potential bubbles in their markets… Jonathan Stubbs suggests that Low Risk (low leverage, earnings stability and price beta) stocks look like bubble candidates. European Low Risk stocks (40% are from Consumer Staples and Health Care) are trading at 5x P/BV, well ahead of the 2.5x PBV reached in 2007.”
The issue of Today’s New Paradigm is fascinating. Many see “secular stagnation” as guaranteeing that central bankers won’t bring this party to an end anytime soon – “lower for longer, QE infinity.” True enough, though I don’t see “secular stagnation” as the prevailing market perception underpinning historic securities markets Bubbles.
From my analytical framework, there’s a New Paradigm in Credit and market perceptions that operate at the epicenter of Bubble distortions. The Nineties “New Paradigm” revolved around exciting new technologies; the collapse in communism and rise of global free-market capitalism; and globalization and productivity advancements that would have central banks providing economies and markets more leash to run. For the mortgage finance Bubble, the New Paradigm perception was perpetual “loose money” ensured by the “great moderation” and the fact that policymakers would never allow a crisis in mortgage Credit and housing. Policymakers ensured that “Too Big To Fail” mortgage securities would remain liquid “stores of value” – “money-like.”
Today’s New Paradigm misperception from my perspective: Global central bankers control market liquidity and will not allow another financial crisis. Global securities markets have become too big to fail – with central bankers’ guarantees of liquid and continuous markets elevating global risk markets to the stature of “money-like”. And it is this New Paradigm that has led to monumental financial flows. Trillions have flowed into various types of markets, funds and asset-classes based on the perception of low risk. In particular, the ETF and hedge fund industries have each grown to about $3.0 Trillion.
So where do I see Credit vulnerability and the potential for a destabilizing reversal in “hot money” flows? I believe that securities-based speculative leverage has grown to unprecedented dimensions – particularly within the ETF, hedge fund and derivatives complexes. Moreover, currency “carry trade” leverage has exploded, especially after policy-induced devaluations in the yen and euro. And as I’ve been emphasizing lately, an end-of-cycle dynamic has speculative opportunities now quickly transformed into Crowded Trades. Understandably, the bulls see timid central bankers ensuring that this game runs unabated. I suspect heightened market volatility is signaling that de-risking/de-leveraging could emerge at any moment. It was another rough week for the dollar. And what about that move in gold…