China, US Treasuries and the dollar seen as most likely candidates for the next bubble
From Hedge Funds Review
China and the US economy are the most likely candidates for the next bubble. China exhibits many of the tell-tale signs. The US economy represents a bubble, supported by government stimulus measures.
Vikram Mansharamani, author of Boombustology: Spotting Financial Bubbles Before They Burst and lecturer at Yale University
China today exhibits many of the tell-tale signs that telegraph the existence of a bubble. The investment boom that has been driving this bubble appears likely to slow and when it does the commodity markets are likely to be seriously affected. Pardon the pun, but I see five red flags typical of bubbles rising in China.
First, rising prices are generating increasing demand from property investors, creating bubbly price dynamics. Second, there appears to be many signs of malinvestment and overcapacity (South China Mall, Kangbashi) as a result of cheap money and credit levels rising rapidly. Third, Chinese national (over) confidence – bordering on hubris – has been running high, as evidenced by world record art and wine prices. Fourth, political incentives to drive GDP have led to uneconomic decision-making. Finally, moral hazard and amateur investor participation are widespread. One of the most disturbing developments is the fact that state-owned banks are financing state-owned enterprises to purchase land from the state.
In an ironic twist of fate, a material slowdown in Chinese investment spending may not be as bad for China as it will be for those feeding China’s voracious appetite for raw materials. Spot prices of certain commodities could fall by 75% (or more).
While the pain will be most acute within industrial and base materials, it seems likely the entire commodity complex will be dragged down by a China slowdown. This has the potential to snowball into a global de-risking event with emerging markets and global growth also slowing significantly.
Olivier Garret, Casey Research
Everyone seems to be calling bubbles left and right. And for good reason. Following three years of quantitative easing, bailouts and money printing, several markets show indicative signs of a bubble from tech to China and commodities. Each has seen extraordinary gains and it is naturally time to question the remaining upside potential from here.
But what truly certifies a bubble is a widely held irrational belief in an endless upward trajectory. This was true for ’90s dotcoms and most recently US housing prices. The very fact that so many bubbles are now being discussed in some ways disproves their existence. There may be serious corrections in some of these bubbles but the damage will not resemble the 2008 crisis.
The next completely off the radar major bubble is long-term US Treasuries. With investors accustomed to a zero-rate environment, no one is talking about Treasuries other than guessing the Fed’s first quarter-point hike.
Despite the complacency with rates, over the next decade they will reach double digits in turn hitting long-term bondholders hard. First of all the Fed will be forced to raise rates, especially with the rest of the world pushing them upward. Second, inflation will pick up and launch them even higher. In the past few years, Ben Bernanke has tremendously expanded the money supply. Expecting this not to translate into inflation would violate a basic principle of economics: the lack of a free lunch. Monetary stimulus always comes with a price and we still clearly have not paid our bill.
Third, US Treasuries added trillions in debt. Sure we are still standing but this is merely the eye of the storm. Another crash is just around the corner and it will result in yet more fiscal stimulus and bailouts. After that, only fools will view US Treasuries as risk-free.
Steve Shafer, Covenant Investors
We believe the US economy itself represents a bubble, one that is largely supported by government stimulus measures and its excessively loose monetary policy and unsustainably high deficit spending. When the crutch of monetary policy is gradually withdrawn, the US economy must be able to progress on its own via organic demand-led growth. But to do so, employment must recover, incomes must rise, housing must stabilise, bank lending must expand, inflation must remain muted and consumer confidence must improve. We think the odds of this cyclical scenario evolving are small.
Why? First, the problems that led to the credit and housing crisis of 2007/08 have not been fixed but merely been kicked down the road. Second, massive injections of global fiscal and monetary stimulus have stabilised world economies and led to an interim recovery and expansion while simultaneously sowing the seeds of new asset bubbles. Third, this approach has created a ‘veneer’ over the real, unsolved secular problems, leading investors into a season of complacency and renewed risk-taking.
Today, the financial crisis has subsided, the recession it created has ended, corporate profits have returned to historic highs and the stock market is nearly 100% above its crisis low, yet the US government remains fully engaged in supporting the US economy through $1 trillion-plus annual budget deficits and artificially low interest rates near 0%. These excessive monetary and fiscal policies are artificially supporting the economy and distorting prices as well as contributing to the formation of new asset bubbles that are accumulating on the back of previous bubbles that were not allowed to fully deflate.
Bob Haber, Haber Trilix Advisors
The next asset bubble to burst is one many people do not want to talk about – the hegemony of the US dollar as a sole reserve currency and by extension US debt. Right now it is exhibiting all the classic traits you see in any bubble. There is an unlimited supply because the Fed continues to print money. The value of the dollar is low relative to other currencies due to what is essentially a zero interest rate policy endorsed by the Fed through QE1 and QE2.
As the reserve currency to most of the world, the US dollar is also over-owned compared to every other currency including gold. The result has been a weakening of the US dollar with the occasional intermittent rally.
But like every other bubble top before it, there will be a point where there is no value in the underlying asset. Unlimited dollar printing and a significant negative real yield on dollar cash are clear evidence of no value. This will inevitably affect the desire of global investors to continue to be holders of our debt. We are already seeing central banks diversifying into alternative currencies and accumulating more gold and silver.
Protection, as always, means looking for uncorrelated assets and the best in our view are strategic resources such as oil, agriculture and precious metals. The underlying fundamentals will be strong for years to come. The world needs them to grow and supplies are either shrinking or becoming harder to get to. In addition to these hard assets, the currencies of the countries that produce these assets will do well relative to the US. This would include Canadian and Australian dollars.
Fabrice Seiman, Lutetia Patrimoine Fund
The markets’ recent enthusiasm for high-yield bonds, technology stocks and commodities is largely irrational. Recovery may be on track in both developed and emerging economies but investors should remain extremely cautious: sovereign debt levels in almost all Western countries continue to rise and the major currencies are especially volatile. Of particular concern are difficulties in the US job market where unemployment by some measures still stands at 16%, despite the International Monetary Fund’s projections of 2.3% GDP growth in 2011.
The apparent contradiction between an IT or commodities bubble and a still-uncertain recovery is largely explained by unconventional monetary policies among Western nations. By issuing currency to acquire assets from banks, quantitative easing programmes have artificially fuelled some segments of the financial markets.
Policymakers have effectively bet they can sustain growth through monetary policy while putting public finances and financial institutions’ balance sheets back in order. They actually might be proven right in the medium term, in part thanks to growth coming from the emerging markets. However, this could come at a cost, namely the burst of some of the bubbles encouraged by the unconventional central banks interventions.
High uncertainty over the near future must lead investors to favour absolute-return strategies with very low market beta such as merger and acquisition arbitrage. M&A activity is expected to boom in coming months. Record high corporate cash reserves, historically low interest rates and sector-based drivers are likely to encourage big corporations to choose external growth. Combining moderate leverage with significant returns, M&A arbitrage is probably the best option for investors wishing to minimise their exposure to a volatile macro environment.
