'Another week, another high for equities' is the resigned way JPMorgan's Jan Loeys begins his discussion of "bubbles" this week - the massive gains in equity markets, in a month and a year of lower economic growth and earnings expectations, are raising a warning flag for many investors that easy money and liquidity are creating serious asset bubbles that threaten future growth and investment returns. Simply put, "a bubble view is a view that the Fed will stay easy for too long" and will then have to stamp on the brakes when growth and inflation suddenly react to easy money; and "a sudden spurt in growth is the biggest risk to asset reflation."
Via JPMorgan's The View,
What is a bubble? Bubbles are extreme asset price inflation and overvaluations; typically as easy money leads to exaggerated price gains on initially positive fundamentals that leverage then brings to a boil, before a reversal of conditions induces a crash as everyone tries to sell at the same time. The easy money is surely here this time, and so are the big price gains. The question is now whether markets are truly overvalued to fundamentals and whether conditions could reverse soon. We would like to say No to both. And we do not see that much evidence of leverage, either, at least not in DM, while recognizing that it is the unseen or underappreciated leverage that has done the most damage in past bubbles.
Starting with basic finance, a high asset price means high expected future cash flows and/or a low discount rate (low internal rate of return). An overvaluation must thus mean that cash flow expectations are too optimistic, or that they are discounted at too low a discount rate. Over the past two years, global growth and earnings expectations have been falling, and look realistic to us. Higher asset prices can thus only come from a lower discount rate. The most important market participants in setting this discount rate are the central banks, as they set the return on cash, which is the benchmark for everything else. The US Fed is most important here, as USD assets make up half the global security universe and a number of other central banks keep their currency close to the USD and thus follow the Fed’s policy.
Other asset discount rates, or IRRs, on equities and bonds are greatly affected by the Fed, but do not seem too low to us. The charts above show the risk-return trade off line of USD assets, and the slope of this line over the past 60 years. The average risk premium of bonds and equities over cash remains one standard deviation above its historic mean, and seems high relative to our judgment of future uncertainty. But the all-in IRRs on bonds and equities can only stay low, and prices high, if the Fed holds the return on cash near zero. A view that assets are in a bubble is thus a view that the Fed is keeping interest rates too low, relative to the outlook for growth and inflation.
By our measures, global growth is set to cruise at a trend pace of near 3% over the next year. A trend-like growth rate pace does not imply that policy rates should also be at neutral, though, as the world economy continues to operate well below capacity. Our economists judge that the DM economies are operating 3% below capacity, while EM is only 0.5% below capacity. A bubble view is a view that the Fed will stay easy for too long and will then have to stamp on the brakes when growth and inflation suddenly react to easy money.
There is little in US data that suggests a serious risk of a sudden spurt in private sector growth beyond the fading in fiscal drag from the public sector. But we cannot dismiss such risk as funding is extremely easy. The best we and the Fed can do is to monitor economic conditions and to adjust strategy and policy if growth were to accelerate suddenly. Investors should continue to overweight assets whose IRRs are least dependent on easy money. That supports our strategy since mid 2009 of overweighting equities versus bonds.
Paradoxically, low growth does not contradict higher asset prices, but is at its roots, as a weak recovery induced policy easing, which boosted asset prices. This summer's taper-talk crisis highlights that a sudden spurt in growth is the biggest risk to asset reflation. A gentle grind up is our preferred scenario.
ZH: So there you have it - the biggest risks are "unseen and under-appreciated leverage" (margin debt at all-time highs, rehypothecation at extremes, ETFs enabling it) and the catalyst for a popping bubble "growth" - once again good news truly is bad news...