January 2018 – Has the Irrational Exuberance Phase Arrived?
Storm Eleanor is hammering at the window, announcing her arrival at the South West Atlantic coast, as I write an opening blog for 2018. North Atlantic depressions are picked up and explained by meteorologists in advance of arriving, thank Heaven. The Irish Met uses using traffic light colours so we can grasp the strength of what’s approaching. Just as well that human behaviour doesn’t influence the North Atlantic because, add the irrationality of certain aspects of human behaviour to weather systems and, what you’d get is the cacophony of stock market forecasts for 2018 against the backdrop of continued surges in risk asset prices.
Has the Irrational Phase Arrived?
As we enter the new year with global economies operating in synch, tax back schemes in the USA, ultra-cheap money all over the world and $20 trillion in extreme Central Bank money policies, economic weather points to near perfect conditions, accommodative to rising equity and property markets as consumer, business and Government sentiment look rosier. So long as Central Banks don’t take away the fruit bowl and there are no surprises, this surge will continue – until it doesn’t. The end of bull markets is characterised by one final huge wave of buying, an ‘everybody in’ surge that pushes fundamental data to the sidelines. This does look like it.
Regular readers of these blogs will know that underneath this remarkable run up in asset values lies an unresolved structural problem of too much debt and not enough economic growth to sustain it. You cannot print your way to sustainable long term growth if there is an unaddressed structural problem and the accumulation of another 50% in global debt to $215 trillion, much of it serviced at near zero interest rates, is a structural problem.
What’s most notable isn’t the further run up in equity and property markets last year but the extreme calm in which these have occurred. It’s a real challenge in these conditions to remain cautious and see the illusion for what it is, especially when the neighbours change their cars to 2018 registrations, the boom time swagger returns and dissenters are dismissed as cranks.
With cryptocurrencies and risk asset markets surging and a spate of feel good economic reports now spilling from financial media to popular news, its all set up for an ‘all-in’ phase again, where price and valuations don’t matter, where fear of losing out dominates behaviour and where it looks like there’s easy money to be made.
It is also an illusion to think that Irish economic growth and property price bounce is purely organic because everything depends on the action elsewhere, most especially in the pump room of world economic growth, the USA, still the most dominant economy in the privileged position of issuing the reserve currency.
Now look at Chart 1. The run up in US stock prices, when compared to GDP, normally ought to be enough to unnerve stock market bulls, but these are not normal conditions.
Meteorologists might flag extreme calm in weather as a red alert before a cyclone but in markets where the volatility index which measures choppiness is at all time lows, this can represent that hoary old moment when fear of losing out has taken a grip, relegating asset valuations to matters of less importance
Money is rushing into markets much of it from passive index-tracking funds (ETFs) as uncommitted bears are capitulating, selling out of safe assets and joining in the party.
Volatility practically flatlined by the end of 2017 as sidelines money, tired of getting paltry returns and fearful of losing out on easy gains to be made in risk assets, jumped into the market cheered on by a US President who it appears believes that he now commands the rising tide in markets. So it’s a great time to buy risk assets because everyone’s jumping in? Well, no it isn’t
Chart 1 US GDP Vs Total Market Capitalisation
Sven Henrich’s chart shows, the relative value of the total US stock market compared to USA GDP, in other words the valuation of its Plcs compared to the total value of its economic output. Look at the spikes, these have last been at this level just before the dot.com collapse which was followed by a rout of nearly 80% in the NASDAQ. You may recall that the fiscal and monetary response to that crisis, which caused a loss of $5 trillion in asset values, was President George Bush’s tax back scheme and a massive cut in US interest rates from the Fed.
This morphed into a huge housing bubble that collapsed in 2008 causing losses in the USA alone greater than what the country spent prosecuting World War Two, that’s after adjusting for six decades of inflation. Since US stock market valuations are close to the high water mark of the millennium year, this means that bulls are taking a gamble that the US economy can grow at a far faster pace than today to support these prices. They’re also assuming that it can be done without margins shrinking from rising wage demands as employment tightens, spooking the Fed to raise interest rates to head off inflation.
But bulls, who let’s remember are incentivised to stay in until the last second, are making two final interlinked assumptions; Firstly that they will get out of the market at the perfect moment securing maximum profits for clients and fees for themselves, and secondly that any large fall will be met by the next round of Central Bank bailouts, restarting a fresh cycle.
You can expect to hear much about why the US economy in particular is in an early expansion stage, why a super cycle of growth lies ahead, why Europe is beating forecasts, why emerging markets and Japan are hip again and why valuations at these levels can be supported and expanded from here.
But remember, when the S&P 500 opened 2008 close to a price of 1400 most of Wall Street’s finest predicted high single digit to low double digit growth for the year despite the mounting problems of 2007. Then came the Lehmann supernova and when the tide raced out the scale of unpayable debt revealed itself and the Global Financial Crisis began in earnest. The S&P 500 lost a third of its value ending that infamous year at 865.
This time around in January 2018 the main investment houses expect the Trump tax cuts to push the US economy higher, justifying further jumps in stock market prices as corporate earnings expand. With interest rates still at ultra-low levels it doesn’t take much reasoning to see how this will spill over into further rises in property prices as the wealth effect leads to a boost in consumer sentiment and fresh waves of buyers enter the market for risk assets, including for property. If that sounds familiar, it should
The big problem with forecasts is that they rely on mathematical models that inadequately describe a global economy that continues to produce outcomes that are deemed to be extremely improbable, or in the parlance of graphs, the bell curve of probabilities has big fat tails not thin ones.
Black Monday October 1987 which led to a -22% single day fall in the Dow Jones, the 1998 colossal losses by the LTCM fund led by two Noble Prize winning economists and similar losses in a Goldman Sachs fund in 2007, were each assigned a mathematical likelihood of happening so remote as to be unworthy of consideration. The 30% loss in one week in 2007 in Goldman Sachs, Global Equity Opportunity fund was described by its CFO as being a sigma 25 event, in other words it ought not to have happened since the time of the Big Bang, which means its probability of occurring was like winning the Lotto 20 days in a row. These remain the models used to issue forecasts in January 2018.
It may well be the case that prices run up further from here in the expectation of US and global economic expansion on a sea of cheap money but if the underlying problem is structural, these run ups will be a mirage
Throughout the global economy years of accommodative Central Bank policies and cheap money has swapped the old bubble for new bubbles. Regular readers will be familiar with our focus on Australia as an example, where three of the four largest quoted companies are banks which have 40% to 50% of their housing loan books on interest only, where starter homes in Sydney are 13.5 times average wages. The Australian Property market isn’t unique, there is overheating concern about key parts of Canada, Sweden, New Zealand even for Berlin and the list goes on.
Cheap money is flooding everywhere looking for yield and pushing up prices but look beyond the potential impact of bubble bursts in these sectors or in areas like US Student and Auto loans and Emerging market corporate debt and inevitably your gaze will come to rest on the world’s second largest economy run on a centralised, command and control basis. This economy, at its current rate of expansion is set to eclipse USA GDP in 12 years time to become the world’s largest, so China matters.
China has featured every year as a leading concern and each time the world’s second largest economy has defied expectations. But until 1991 so too did Japan whose economic miracle, which bound its Government, large industry and SME’s into a rigid internal market, became unstuck, going bust after four decades of spectacular growth and leading to zombie companies and banks being kept afloat by socialising their debts. Japan’s debt to GDP today is 230% and despite near zero servicing costs a fifth of the national budget goes to finance it and 40% to healthcare and pensions for its aging population.
Today China is funding its growth, estimated at 6.5%, by accumulating more debt to approach three times its GDP shortly. It has risen four times its opening position at the foot of the Global Financial Crisis. Look at it this way, last year the Chinese added fresh debt exceeding the combined new debt of the USA, the EU and Japan. Nothing too wrong with adding debt as a country is structurally transformed, especially when that debt fuels enough extra growth to sustain it, but this is not happening anywhere near as efficiently as before and not helped by the fact that China’s excess capacity cannot be exported at premium prices to a global economy that itself has spare capacity.
China faces a huge task if it is to deleverage its economy without damaging social cohesion from job losses and will first attempt to export its way out of its problems through aggressive global price competition with knock on implications for free trade in an era of growing protectionism led by Trump.
Last year post-Brexit political concerns before general elections in France and Germany proved to be overstated but, globally, geopolitical risk is quite obviously rising given the standoff between belligerent leaders in USA and North Korea both engaged in a public name calling. Trump’s Presidency ironically may become the leading geopolitical risk of 2018 if allegations surrounding money laundering stand up and expectations about the momentum of the investigation prove accurate. This week’s release of Fire & Fury and the alienation of Trump by Bannon appear to mark a significant elevation in the ongoing affair.
Trump’s America First Policy has retrenched international relations making the world more and not less risky, prone to protectionism as defensive responses to Trump. The list of risks is long, climate change, cyber-security, terrorism, an oil shock, a destabilised Iran, the risk of a hard Brexit, Catalonian self-determination, US multi-nationals redistributing growth back to the home market and the Trump Presidency itself.
Economically the biggest risk however is to the fragility of global debt-fuelled bubbles when interest rates, currently at levels never recorded before, rise to head off inflation and how this might play out across banks, bonds and currencies.
Heaven help risk asset prices when Central Banks inevitably reverse extreme monetary polices and raise interest rates which they are duty bound to do when inflation announces its arrival.
Last week Greek Government 10 year bonds were cheaper than China’s because of ECB bond buying as part of ongoing market support. This is just an example. The global edifice is propped up by Central Banks experimenting with extreme monetary supports and where a policy mistake could trigger a rout. These extreme monetary policies are now pushing a great glut of retail investors into risk assets at any price because of negative or tepid returns on ‘safe’ assets and the fear of losing out. The response to the GFC has been forgotten, experimental Central Bank supports have been normalised as if no more than a technical matter. It isn’t, it’s the key.
How to Position
There is a pivot coming, that is pretty much certain but when it arrives and its character is uncertain. This level of debt can only be sustained by making extreme Central Bank policies open-ended and reversing only at a snail’s pace and that cannot be done when inflation arrives. It is a trap.
At best there will be a shallow cyclical recession blowing the froth off prices and, at worst, a structural recession which will take quite some time to resolve.
There are two options, one is to take the long view and ride it out which is not unreasonable if you’ve decades left before you hang up your boots. This means reviewing your overall balance sheet to de-risk it by shedding laggards, reducing debt but keeping with good long term risk assets irrespective of potential falls in value in the near term.
The second option is to play very cautiously, a must if you don’t have enough time left in your career to recover losses. This means reviewing your balance sheet differently, shifting cash to strongest banks, owning some gold, reducing equity exposure now, owning some inflation-linked bonds, resisting jumping into property at these prices, not borrowing and bunkering down until the next deep trough in asset prices, when everything is for sale once again.
That’s when it will be time to act and mindset will be the most important asset when it does. If you’d like to explore how you might reposition your balance sheet and its financial investments including pensions, just drop an email to firstname.lastname@example.org and we will take it from there.
Eddie Hobbs, Jan 5th 2018
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