The title is deliberately provocative to relay the extent of my concerns with recent market action. Regular readers will know of my bearish long-term outlook for stocks based on the view that we remain in a secular bear market which began in 2000 and extraordinary central bank policies have only delayed an eventual bottom. But the recent activity in stocks and other asset markets is sending a clear signal that dangerous bubbles are building everywhere thanks to printed money and low interest rates. And central banks are unwilling to intervene as economic recovery remains as elusive as ever. The likely endgames are obvious enough: either recovery happens and central banks move too late to quell inflation or recovery doesn't happen at all. Those forecasting a happier outcome either don't know of the long history of consistent central banking failure or, more likely, are beneficiaries of the current policies.
Many commentators have rightly pointed out the froth building in the U.S. stock market with Twitter jumping 73% on debut, margin debt at record highs and extreme bullishness among institutional and retail investors. But the bubbles developing in Asia, arguably much larger in size not just in stocks but across all asset markets, have been largely ignored. Today's post will focus on three red flags:
- The Indian stock market reached record highs over the past week despite all of the country's problems and a currency recently in free fall.
- Australians have been increasingly using their superannuation funds as collateral to buy residential property, helping reflate one of the world's biggest housing bubbles.
- The Japanese bond market has effectively died with the government becoming the dominant player in the market due to its massive bond buying program. This isn't just a Japanese phenomenon with central banks now owning a third of the world's bond markets. Free markets, these ain't.
I'll also explore why the excesses are developing. And a key underlying reason, little acknowledged, is that the fiat money system - paper money without an anchor to something of solid value - is becoming stretched and perhaps reaching breaking point as central bankers print endless money without constraints. Some may see this as an extreme point of view but that ignores the relatively short history of the system and subsequent sharp increase in asset price volatility.
Asia Confidential isn't so arrogant as to predict an imminent downturn in asset prices. No-one knows exactly how this will play out. But increasing asset price volatility would seem relatively assured. Given this, it would make sense to keep your assets diversified, resist taking on too much debt (asset price risk outweighs attractive rates) and, most importantly, avoid areas that investors are salivating over (such as hyped IPOs).
Red flags everywhere
If alarm bells aren't going off for investors, they should be. And it's not just the IPO of a certain social messaging company which is valued at close to US$24 billion despite never earning a dime. I saw one portfolio manager describe the IPO as a great thing and the best of capitalism in action. I'm not sure who's more stupid: this investor, the Twitter founders who under-estimated public demand and left money on the table, the investment bankers who under-priced it or the retail investors who are holding onto the shares, which will probably go the way of RIM in a few years time.
The largest signs of excess instead lay in Asia. I've mentioned the Indian stock market reaching record highs. It was only in July that the country was in turmoil with a currency in free fall. Since then, stocks have surged, out-performing all other major markets in Asia.
Below is India's Sensex index.
For the record, I advocated accumulating Indian stocks during the turmoil, but the market has run extraordinarily hard since then, making it prudent to take some money off the table.
The country's problems haven't gone away. The economy is still growing at decade-lows. The current account deficit remains one of the largest in emerging markets. And politics remain uncertain ahead of a general election next year.
Now some will argue that the stock market is just forecasting a better economy ahead. Maybe. But your starting point is a market at record highs, on a not-so-cheap 16x trailing earnings, arguably distorted by low interest expenses given low rates.
More prominent warnings signs are outside of stock markets though. Everyone knows that residential property prices remain elevated in the likes of China, Hong Kong, Singapore and Australia. The latter has taken it to a whole new level, however.
The latest trend is Australians using their superannuation as collateral to buy residential property, as well as other forms of property. Residential real estate now accounts for 14% of so-called self managed super funds. That's helped drive an 8% year-on-year increase in house prices in September.
Now I'm not sure if the practice of using superannuation or pensions as collateral to purchase property is used in any other country but the dangers are pretty obvious. Particularly when many developed countries, including Spain, are raiding pension funds to finance their QE programs.
Australia has added risks given the extent of its housing bubble. Demographia says the Australian housing market is the most expensive in the developed world, with property prices at 5.6x annual income, with 3x or below considered affordable. Meanwhile, The Economist magazine suggests Australia is the world's fourth most expensive housing market, with prices 44% overvalued versus rents and 24% versus wages (which are undoubtedly grossly inflated).
The risks to Australia from the inflated housing market are systemic also. Housing assets of A$4.9 trillion are 3.3x larger than Australia's GDP. Moreover, residential property represents more than 60% of the big four Australian banks total loan books. Given these banks have an average leverage of 20x (assets/equity), it would take less than a 10% fall in residential property prices for equity in these banks to be wiped out.
One word comes to mind: bail-outs!
Lastly, there's been unsurprising news over the past week that the Japanese bond market has become dysfunctional. I've previously talked about how the massive bond buying program of the Japanese central bank, equivalent to 70% of new bond issuance, would crowd out private investors and thereby significantly increase volatility.
Now one of Japan's larger brokers, Mizuho, has come out to declare that the sovereign bond market is effectively dead. The firm's chief bond strategist Tetsuya Miura told Bloomberg:
"The JGB [Japanese government bond] market is dead with only the BoJ [Bank of Japan] driving bond prices.
These low yields are responsible for the lack of fiscal reform in the face of Japan's worsening finances. Policymakers think they can keep borrowing without problems."
Recall that Japan is attempting U.S.-style stimulus on steroids to lift the country out of 20 years of deflation. It hopes to increase inflation without a rise in bond yields and interest rates. Rising rates would kill Japan given that interest rates of just 2.8% would mean interest expenses on government debt equaling all of current government revenues. An unsustainable situation.
Japanese government bond yields have behaved so far, though there was a huge spike in volatility earlier this year. Given the central bank has now effectively swallowed the bond market, you can expect to see increased volatility hitting headlines again very soon.
Below is a chart of 10-year Japanese government bond yields.
By the way, this isn't just a Japanese issue. Central banks now own a third of the world's bond markets. That number could substantially rise given plans for further QE. And it makes an eventual bond market revolt more likely at some stage.
The system reaching breaking point?
It would be easy to blame the above excesses simply on money printing and low interest rates. But that would ignore some of the key underlying causes. A few weeks ago, I highlighted how the significant trade imbalances between the U.S. and China played a major role in the financial crisis and subsequent policy.
But reading through the former publisher of highly-regarded Bank Credit Analyst Tony Boeckh's book, The Great Reflation, has reminded me of a larger issue at play. Namely, the central role of the paper money system in increasing asset price volatility:
"The Great Reflation now underway should be seen as another chapter extending the long-running saga of inflation - excess money and credit expansion - that began in 1914. A hundred years of financial background may seem a little esoteric to some, but it is important to understand that we have been living for a very long time in a monetary world that is without an anchor. When there is no anchor, the monetary system has no discipline. And it is this lack of discipline that is fundamental to where we are now and where we may be going. The Age of Inflation is deep-rooted and enduring but it is not sustainable forever. Anything that is not sustainable has an end point. When that time comes, it will not be pretty."
Boeckh goes onto explain the traditional anchor to prevent excesses was gold, and to a less extent, silver. In other words, central banks couldn't print money without additional metallic reserves, prior to 1914.
The big change came in 1913 with the formation of the U.S. central bank, the Federal Reserve. The anchor with gold was gradually wound back until the seminal event in 1971 when the U.S. broke the link to gold and floated the dollar. This allowed central banks to print money without any constraints.
What that's meant is that at the sign of any downturn, central banks have opted for the easy, most painless, solution: inflation. Which has resulted in increasing asset price volatility:
"The Great Reflation experiment now underway, while critical in avoiding a 1930s debt deflation spiral, ensures that we are a long way from writing the last chapter on the post-1914 Age of Inflation. The managed paper money system has been a huge failure, and lies at the root of the persistent tendency to inflation, instability, and debt upheavals. There are obvious political advantages to inflation in the short run, and a paper system with no brakes is a great temptation to politicians with one eye always on the next election."
It's important to understand that Boeckh doesn't necessarily predict inflation ahead. He views, as I do, inflation and deflation being two sides of the same coin as inflation always begets deflation and vice versa. Right now, you're seeming asset inflation, but disinflation (declining inflation) in the price of goods (reflected in CPI numbers). Whether we get asset deflation or inflation flowing through to CPI remains to be seen.
And it's imperative to realise that inflation doesn't aid economic growth. This is contrary to the views of just about every economist on the planet. But the fact is that the U.S., for instance, experienced superior economic growth in the 19th century when there was practically zero inflation. And during that time, there were fewer economic downturns than has occurred over the past century.
The warped belief that economies need inflation for growth was aptly on display in a recent New York Times article entitled "In Fed and Out, Many Now Think Inflation Helps". A more silly and misinformed article you won't find readily, but it certainly furthers the agenda of the new Fed chief to keep on printing money in the hope of reviving the economy.
Getting back to Beockh and what he does suggest, and I totally agree with, is that the current paper money system is being stretched to breaking point. Consequently, you should expect heightened volatility in future:
"The fragile state of the economy and financial system will continue to require inflation of money and credit, heavy government intrusion into the private sector, and frequent resorting to subsidies and support programs. This will continue to distort relative prices of labor, goods, services, and assets. It will sustain the economy in an artificial state and will compound instability and make it impossible to understand what is real and what is not."
If this is right, the question then becomes how best to protect your assets in what is likely to be a treacherous environment going forward. Let's turn to some specific recommendations.
How best to preserve your capital
Given no-one, including your author, knows exactly how events will unfold, diversification of your assets should be a key priority. A traditional stock and bond portfolio is fraught with danger given the significant distortions in these markets. Real estate, cash and precious metals should all be considered.
Under different scenarios, you want to protect your capital. If excessive inflation occurs, as happened in the 1970s, then stocks and bonds will get slaughtered. Real estate and gold are better inflation hedges. If there's mild inflation, stocks will do well, as might gold, while bonds and cash should under-perform. If there's mild or extreme deflation, bonds and cash should outperform. Gold could also do ok if faith is lost in the paper money system.
For stock exposure, the U.S. looks pricey, while parts of Asia and Europe offer opportunities. In my neighbourhood of Asia, banks in Singapore and Thailand offer reasonable value, beaten down energy and gold stocks are worth a look, and inepensive gaming stocks such as Genting Berhad (KLSE:GENT) and Crown Ltd (ASX:CWN) should prove resilient.
For bonds, try to avoid sovereign bonds, barring perhaps prudently run countries such as Singapore. Corporate bonds are worth considering, but remember that these bonds have quasi-equity type qualities. Which means if stocks tank, corporate bonds will suffer too.
For property exposure, residential property in many countries looks elevated. That's particularly the case in Asia. Office real estate offers better value but is at risk if economies don't recover. Meanwhile retail property is largely unattractive given the continuing loss of retail market share to the internet. Industrial real estate is probably the most defensive property exposure. Historically this sub-segment has proven less cyclical as significant oversupply is rare given the quick time that it takes to build industrial versus office and retail.
Cash is the world's most hated asset right now and that's part of the reason why you should have some in reserve. Central banks want you out of cash and into risk assets, so having some cash is akin to flipping the bird at the Fed. More seriously, you'll need cash in reserve to take advantage of any opportunities should there be a major shake-out in markets.
Which currencies to own? Ah, that's the difficult part. The Singapore dollar remains a stand-out. Other than that, there's not a lot else to like. A basket of Canadian loonie, Thai baht, Malaysian ringgit, U.S. dollar (at least in the short-term), New Zealand dollar and Norwegian krone should be considered.
Now to precious metals. You own gold if you believe there's even a small chance of a breakdown in the current financial system. It's disaster insurance. It's why China is buying as much gold as it can get its hands on. Not because it wants to become the world's leading currency, as many suggest, but because it doesn't trust the U.S. dollar or current paper money system (more on that topic at a later date). It foresees the possibility of a new monetary system with the partial or full backing of gold. You might be wise to follow the Chinese when it comes to gold.
This post was originally published at Asia Confidential: http://asiaconf.com/2013/11/09/3-signs-of-bloodbath-ahead/