Volume 1 13 Asset Recovery Or Asset Bubble

VOLUME   1.13 1.9  VOLUME  DECEMBER 4, 2009   

Asset Recovery or Asset Bubble?

Talk of burgeoning asset price bubbles has taken centre stage in the financial media. Caught between modestly improving economic

policy. Inflation is non-existent and long bond yields are flat. The Fed has a green light. Asset prices particularly in emerging

data and fears of a liquidity-driven mania,

markets will get increasingly frothy as central

prices of stocks and commodities have been

banks are forced to accommodate U.S.

increasingly volatile in recent weeks. Markets

monetary policy in order to limit currency

from time to time have become skeptical that a

appreciation against the dollar. Protecting

sustained period of growth will occur and

themselves from the inevitable bubbles in

concerned that debt troubles will resurface.

stocks and real estate will prove extremely

The next phase of the recovery will continue to see the Federal Reserve flooding the system with liquidity in a marathon battle

difficult without significant currency appreciation. Capital restrictions (such as Brazil’s

against rising unemployment which, together

portfolio tax), raising reserve requirements and

with elections, has always been the key to U.S.

other attempts to sterilize capital inflows have

economic policy. To date, there have been no

rarely been successful when applied in the

signals that would push the Fed to tighten

past. Chart 1 shows the close correlation between the change in U.S. dollar reserves held

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CHART 1

by the Chinese central bank, money supply and

mother of all carry trades,” and forecast

the Shanghai stock index. It is the same story

disaster. In our opinion, we are certainly in the

in Brazil, Indonesia, India and most other

early stages of a bubble. Liquidity and capital

emerging markets and commodity producing

flows have had a large impact on prices and

nations. Given that it is unlikely they will be

most markets have gotten well ahead of the

willing to accept the steep currency

fundamentals, although valuations are not

appreciation necessary to cool capital inflows,

obviously yet in bubble territory.

emerging market asset prices will continue to be driven by U.S. monetary policy for the foreseeable future.

The principal risk in the current environment is that international capital flows could be extremely volatile. In the 1997 Asian

Does this mean that we are in a general

Crisis, a correction turned into a full scale rout.

asset bubble? Opinions vary widely. Some

A similar panic could easily develop in the

say 2009 has been just “a very good year.”

current environment, causing the U.S. dollar

Others say that we have been experiencing “the

carry trade to unwind with alacrity.

 

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Although this may not be a bubble yet,

U.S. and foreign financial institutions. How

we are certainly on track for one. Liquidity

severe the damage would be is anyone’s guess

expansion will continue to drive the cycle for

at this point.

the foreseeable future, creating risk of a violent correction particularly in emerging markets,

A MURKY PICTURE OF A TENTATIVE gold and other commodities.

RECOVERY The Federal Reserve recognizes signs of froth in foreign markets, but has made it clear that it will not alter course well into 2010. The Fed will err on the side of excess liquidity in order to deal with the more sensitive problem of high unemployment. Furthermore, letting banks and consumers rebuild their tattered balance sheets through a broad reflation of financial assets is in everyone’s

The challenge with interpreting indicators for the U.S. economy is that fiscal stimulus, bailouts and monetary policy have created a totally artificial picture. While it is true that we can expect these interventions to continue through 2010, their impact has likely peaked. Policy makers are becoming increasingly hemmed in politically and will need to start demonstrating that they have a

short-term best interest.

credible plan to rein in deficits in order to keep It is difficult to gauge how widespread a handle on interest rates. With that proviso, participation by the U.S. financial sector is in we provide a look at some of the indicators we this nascent speculative mania. However, it is are following. clear from the Dubai default that emerging markets are becoming increasingly vulnerable. If this turned into a panic sell-off, shockwaves would trigger another round of losses at certain

 

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The U.S. economy officially returned to growth in the last quarter largely thanks to resilient retail sales. “Cash for clunkers” and

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first time homebuyer subsidies had a large

CHARTS 2-5

impact on these markets (charts 2 &3). Longer term, the key problem facing the American consumer is debt. Chart 4 shows the rise in household debt, which began to increase much faster than income in the late 1980’s. The trend peaked in mid 2008 at close to 120% debt to income ratio. If we assume that household debt has been stretched to the maximum, household deleveraging will be prolonged as debt levels need to be brought down to a manageable level. What is unclear is how successful policy makers will be in coaxing consumers out to the malls while this process plays out. Unemployment is now at 10%, but if we include discouraged and under-employed persons, the figure is 17.2%. Most discouraging, structural unemployment is at its highest level since the 1930’s: 35.6% of the total unemployed have been out of work for at least 6 months (Chart 5).

 

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Existing house prices looked set to rise

CHARTS 6-9

back from the lows of early 2009, but have resumed the downward trend since June (Chart 6). The volume of existing sales has bounced back to 2002-2003 levels, but new home sales remain depressed, less than ¼ of the peak (Chart 7). Few building permits are being issued, indicating that no quick turnaround in residential construction should be expected (Chart 8). Business activity appears to be expanding at a healthy pace. The ISM purchasing manager’s index1 is in positive territory, but the non-manufacturing (service sector) index turned negative (below 50) again last month (Chart 9). Capacity utilization has improved somewhat, but at 70.7% it remains at an extremely low level (Chart 10). Producer prices continue to show no sign of inflation even at the crude materials level, despite the rise in commodity spot prices (Chart 11).

 

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Quantitative easing has yet to translate

CHARTS 10 -12

into business credit expansion. It is impossible to say that a depression would have occurred without the unprecedented expansion of Fed assets over the past 18 months; however it is clear that the situation would have been much worse without. Despite the increase in money supply, business credit continues to shrink at a rapid 20% annual rate. Typical of a balance sheet recession, demand for credit is likely the limiting factor rather than supply. Businesses are unlikely to borrow heavily when excess capacity abounds and the outlook is so uncertain, and consumers are already mortgaged to the hilt. The only type of credit that is actually expanding is margin debt (Chart 14), raising questions about stock market risk. Meanwhile, the banks are content to borrow at zero rates and buy longer dated Treasuries at close to 3½%.

 

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To sum up, the few positive signals

CHARTS 13 &14

coming from the U.S. economy are likely due almost exclusively to stimulus. Fed policy has yet to gain much traction domestically, and low rates alone may not prove successful in establishing sustainable growth. Restructuring the U.S. economy is necessary and will take time.

 

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INVESTMENT CONCLUSIONS

translating into domestic consumer or business

The last nine months have been a remarkable period in that equities, gold and corporate bonds have all appreciated by double digits. This has only occurred on two other occasions in the last 50 years. Typically, equities perform best during periods of low and stable inflation, like the current environment. Gold (and other commodities) performs best during inflationary periods and when the dollar is weak, while government bonds tend to outperform during periods of deflation and risk aversion. The current, unusual dynamic where

credit expansion. It is true that U.S. monetary policy will likely spur asset price inflation in emerging markets, but the lack of traction in the domestic economy means that slack will persist. Further, China is maintaining high levels of investment in the manufacturing sector, despite excess capacity. Given their refusal to allow the Rmb to appreciate, China will continue to import inflation from the U.S. There is no case for general consumer price inflation in the U.S. at this time. Regardless, momentum will likely

almost everything has gone up together cannot

carry gold prices for a while longer. The gain

last forever.

is up 38% year to date, and recent purchases by some central banks have given retail investors

The link between the Fed’s accumulation of assets and inflation is tenuous in the current environment. In most business cycles, easy policy leads to credit expansion which eventually leads to pressure on prices when business activity approaches maximum capacity. The current environment diverges

a confidence boost. Since the beginning of the bull market in gold in 2001, price action has followed the 1968-1980 cycle closely (Chart 15). During that 12 year period gold was up by a factor of 20, indicating that gold could move higher if the mania continues to build.

from the typical cycle in that easy policy is not

 

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Commodity prices have also been

CHARTS 15 & 16

following a similar pattern to that of the 19711980 period (Chart 16). However, unlike gold, commodities have almost matched the price increases of the 1970’s. It is worth noting that in the 1970’s cycle, commodity price increases preceded the big run-up in gold. Gold moved in response to actual inflation and dollar declines in the 70’s. Currently, gold is appreciating purely on inflation expectations, and is well ahead of dollar declines. Surely, the large proportion of new purchases of gold bought by retail investors through ETFs, and the proliferation of shady companies advertising on late night TV, begging for any “unwanted” gold are both clear signs we are in a mania. In the absence of any evidence of inflationary pressure, current gold prices are vulnerable, particularly if the dollar were to rally.

 

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North American equities and corporate bond spreads are still far from their best levels before the crash. As always, they have

in 2010 when the “earnings phase” of the recovery gets going. The U.S. dollar will remain under

responded well to plentiful liquidity. With the

pressure, but for the reasons we have continued

House elections coming up next year, high

to state, the decline should remain orderly as

unemployment and no inflation, the tailwind

no one wants their currency to rise in a world

from monetary policy will remain in place.

of deflation nor does anyone relish the chaos a

However, valuations have become a bit

dollar collapse would trigger.

stretched and confirmation of improving earnings is necessary for another big upleg in equities. We expect financial results to be at best ambiguous over the next couple quarters. Until a pattern of improving earnings is clear,

Tony & Rob Boeckh December 4, 2009

expect equities to be range bound and volatile. If liquidity continues to drive equity prices higher without clearly improving

BoeckhInvestmentLetter.com [email protected] *All chart data from IHS/Global Insights, and may not be reproduced without written consent.

business conditions, be suspicious. As we discussed above, the possibility of significant 1

The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.

correction in emerging markets and commodities can’t be discounted. Continue to build liquidity on strength. There could be some nasty surprises in the next few months and there will likely be good opportunities later

 

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STOCKS

 

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COMMODITIES

 

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CURRENCIES

 

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INTEREST RATES

 

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