Up and Down Wall Street
The Greatest Investment Bubble
By Randall W. Forsyth
If 2017 was the year of the bubble, 2018 stands a good chance of being the year when one or more bursts.
“That we are having a major speculative splurge as this is written is obvious to anyone not captured by vacuous optimism,” wrote John Kenneth Galbraith, who was a far better historian and writer than economist. He penned this for the introduction to the 1997 edition of The Great Crash 1929, early on in the irrational exuberance that would build into the dot-com bubble. But his description is equally apt for manias past and present:
“There is here a basic and recurrent process. It comes with rising prices, whether of stocks, real estate, works of art, or anything else. This increase attracts attention and buyers, which produces the further effect of even higher prices. Expectations are thus justified by the very action that sends prices up. The process continues; optimism with its market effect is the order of the day. Prices go up even more.”
The description written two decades ago by Galbraith seems as fresh as ever, with the incomparable and incomprehensible price action of Bitcoin—which soared 40% in a matter of 40 hours last week, according to The Wall Street Journal. While Coinbase, which allows individuals to participate in the frenzy, has become the most downloaded app on Apple’s iTunes, according to Recode, Bitcoin also was giving erstwhile Wall Street types the kind of volatility squeezed out of the modern stock, bond, commodity, and currency markets, as Barron’s cover story last week reported (“Bitcoin Storms Wall Street,” Dec. 2). The real fun should begin when Bitcoin futures trading begins Sunday evening.
That it ends is inevitable, and inevitably violent. “The descent is always more sudden than the increase; a balloon that has been punctured does not deflate in an orderly way,” Galbraith further wrote. “The phenomenon has manifested itself many times since 1637, when Dutch speculators saw tulip bulbs as their magic road to wealth,” he noted, adding that he wasn’t making a prediction. Neither is one offered here.
Galbraith posited 20 years ago that a bad stock market slump would take its toll on Americans’ spending, especially on big-ticket durable items, and “put pressure on their very large credit-card debt.” There was a relatively mild recession after the bursting of the dot-com bubble, but nothing like what he feared. He did not, however, live to see the housing bubble and the devastating effects of its bust, which actually did bring down the net worth of U.S. households, given many more of them had their wealth in their homes than in the stock market.
The $255 billion market capitalization of Bitcoin (as of Friday—it surely will be different by the time you read this) tops that of all but the biggest stocks of the Standard & Poor’s 500 index. The comparison of the cryptocurrency with equities was taken to a new extreme by one true believer who wrote that the value of JPMorgan Chase (ticker: JPM) had declined 89% this year, in Bitcoin terms. It is all a scheme of wealth redistribution, he asserted, to the enlightened believers of the new order from the old wealth, exemplified by JPMorgan Chief Executive Jamie Dimon, who famously declared Bitcoin a “fraud.”
But the size of Bitcoin pales against what really is the biggest bubble in the world. That would be the trillions of dollars worth of bonds with negative yields, contends David Rolley, co-team leader of the global fixed-income and emerging-debt group at Loomis Sayles.
According to JPMorgan’s latest tally, there is some $10.1 trillion in global government bonds with yields below zero—or 40 times as much as Bitcoin. That is down from the peak of $12.7 trillion reached in July 2016 in the wake of the market panic following the Brexit vote.
Of course, this isn’t the product of wild-eyed speculators’ relentless chase of a market’s accelerating ascent, but the result of sober central bankers’ monetary policies. The European Central Bank has been buying 60 billion euros’ ($70.6 billion) of bonds per month. The Bank of Japan, meanwhile, is acquiring Japanese government bonds in sufficient quantity to keep its 10-year yield pegged near zero percent.
In addition, JPMorgan also notes, euro-denominated corporate bonds total €847 billion, equal to 40% of the sector, a reflection of ECB buying. Among the bonds the ECB has snapped up are securities of Steinhoff International Holdings (SNH.Germany), which last week delayed its financial results and was investigating “accounting irregularities,” resulting in a 60% one-day drop in its shares.
The real effect of the negative bond yields has been to exert a downward gravitational pull on interest rates everywhere, even in places where they never fell below zero, as in the U.S. dollar market. Clearly, however, a security that guarantees a loss (if held to maturity) can’t be rationally priced. Only if its yield falls further, and its price rises, does it make sense. That’s what makes it a bubble.
So far, the bubble remains inflated. But things are due to change in the new year. The Federal Reserve has just begun to reduce its balance sheet, which more than quadrupled to more than $4 trillion from its multiple rounds of quantitative easing following the financial crisis. And the ECB has announced that it will trim its bond purchases, starting next year.
Peter Boockvar, chief market analyst at the Lindsey Group, estimates the Fed’s shrinkage of its balance sheet and the ECB’s tapered buying will mean $1 trillion less flowing into capital markets next year.
“I am completely amazed at the nonchalance with monetary policy, and some do not even mention it as a risk factor,” he writes in a client note, after listening to sell-side prognosticators’ 2018 market predictions. “Let me know if you’ve seen one forecast that includes a lower P/E multiple due to $1 trillion of liquidity that is being removed by the Fed and the ECB alone in 2018 on top of more Fed rate hikes. I haven’t seen many.”
That also should include the impact of subzero bond yields climbing into positive territory, which would result in price declines. Maybe the impact will be gentle and confined to central banks’ portfolios. Or maybe the biggest bubble won’t deflate gently.
THE SPECTER OF REDUCED LIQUIDITY has failed to keep U.S. stocks from scaling ever-higher peaks. Part of the reason is that there has been an actual easing in financial conditions, despite two Fed rate hikes this year and the near certainty of a third being announced Wednesday at the conclusion of Janet Yellen’s final Federal Open Market Committee meeting.
The easier financial conditions—which reflect a softer dollar, tighter credit spreads, and higher securities prices—recall the period of 2004-06, writes Albert Edwards, head of the global strategy team at Société Générale. The “measured” pace of predictable, quarter-point rate increases at each FOMC meeting allowed the inflating of the mortgage and housing bubble, with its disastrous consequences. Now, in contrast, Edwards argues, “the Fed’s desire to soothe the nerves of the financial markets has made a mockery of their tightening cycle.”
Fed officials have stuck to their go-slow policy owing to inflation consistently falling short of their 2% target. And despite a relatively robust labor market, wage gains continue to be meager. The November numbers released Friday continued that trend. Nonfarm payrolls increased by 228,000, a bit better than the consensus forecast of 195,000, as the effects of the hurricanes in the September numbers continue to be reversed. Average hourly earnings were up only 2.5% from the level a year earlier, barely ahead of a 2% rise in the consumer price index in the 12 months to October.
In 2018, the Federal Reserve may have to face two less-benign aspects of its dual mandate for price stability and full employment. According to the New York Fed’s Underlying Inflation Gauge, which seeks to flag trends in the CPI, prices are rising at closer to a 3% annual rate. If those pressures start to show up in the Fed’s favored gauge—the personal-consumption deflator, which has climbed just 1.6%, year-on-year—the pace of rate hikes could speed up, something the financial markets don’t expect.
Meanwhile, the seeming paradox of meager wage gains with full employment may be explained, at least in part, by demographics. The San Francisco Fed notes that workers who re-enter the workforce typically do so at lower pay than existing employees, especially compared with retiring baby boomers. How much this “silver tsunami” is tilting wages is a question mark for the Fed, which will be led by Jerome Powell, a lawyer, rather than an economist, by training.
To be sure, any number of so-called black swans could rock markets out of their low-volatility serenity. BCA Research lists five such serious but unlikely events. No. 1, in their view, is that President Donald Trump’s low poll numbers could cause him to seek “relevance” abroad, perhaps with a trade war with China or a confrontation with Iran. North Korea is too visible to be a black swan, but a coup in Pyongyang would qualify.
Another outlier would be a regime change in the U.K., with Labour, led by Jeremy Corbyn, producing a lurch to the left. Italy, however, is a “black swan hiding in plain sight,” with elections next year potentially unsettling complacency in the markets, as evidenced by its low bond yields. Finally, BCA sees a chance for sharp setbacks in Latin American markets, owing to both politics and the potential for a credit contraction induced by China. SocGen’s Edwards points out that China’s monetary policy already is tightening.
In all, lots to worry about in 2018, which doesn’t get mentioned much in the upbeat forecasts that predominate at this time of year.
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