Where Are The Bubbles
Tuesday, December 10, 2013

The simple fact is that QE, primarily by the Fed, the BOJ and some other central banks have depressed interest rates low. You can go on a convoluted discourse on how that is depressing global interest rates low as well - thus for other countries which did not have the "financial subprime crisis", you have an era of low interest rates pegged to US financial policies.

Largely this will reveal itself in current account deficits and asset price booms. Left unchecked, the era of low interest rates will also fuel personal debt accumulation that is "unsynced and untied" to the real productivity and real wealth of the borrowers - its just leveraged "gains and exposure" owing to the era of low interest rates.


The dangerous part of all this is that you do not see the bubbles that are created at one end as we are too focused on the starting crisis (subprime, QE, tapering) - many still do not see the correlation.

So where are the bubbles, we need to know where the bubbles are because once interest rates rise, they will prick the bubbles ... of course interest rates will rise based on two things: no more QE and more robust economic recovery/activity/lending in developed countries.

The following are my ratings on potential bubbles. 5 being fair value, 7 being speculative, 9 being over speculation, 10 being so dangerous its a matter of months before the bubble is pricked.

3 Months Ago Now
Developed markets equities 6.5 7.5
Emerging markets equity 8 8
Developed markets REITs 7 7
Emerging markets REITs 8 8
Developed markets bonds 6 5
Emerging markets bonds 7.5 7.5
Commodities 4.5 5
Developed markets housing 5.5 5.5
Emerging markets housing 8.5 9

The biggest culprit would be large scale government linked borrowings. Large scale infra projects that are started too early, that does not tie in with demand, ego-linked projects ... when interest rates rise, and the vision and execution do not pan out, you will find governments and banks with these exposure taking huge hits.

If you look at the picture above, some countries are already grappling with the high level of personal debt and struggling. NPLs are rising steadily every month, no kidding, in Brazil, China, Turkey and India (just to cite a few). It will get a lot worse ... Other better performing countries (rest of Asia) are buying time only.



The Worst Defences For Property Market

a) Its QE's Fault - Well, yes ... but all you have to really care are low/high interest rates, affordability, real occupancy vs real yield



b) Material prices keeps going up - That is a most naive defence ... WHAT THINGS in life do not have an upward price expectation??? If that is your defence then the world WOULD NEVER EVER FOREVER have any property correction .... but they still do!!! Why? Because cost of land and material are never the guiding light for speculative behaviour and their correction. Its (a), jobs and confidence.

c) Malaysia still cheap compared to the regional neighbours - Another ass-whacked job defence. You take that line, you would stayed very invest in MYR assets compared to say SGD assets for the last 10, 20, 30 years ... and you would have lost a lot of money (opportunity cost) taking that line of defence. Regional prices do not balance each other out. Asset prices are a reflection of the ability of its people to make money, the kind of businesses, margins that their goods and services can command, affordability ratios, whether an economy is moving up the value chain ...



By Eduardo Olaberría, Economist, OECD Economics Department
Read more at http://www.nakedcapitalism.com/2013/12/cap...vrVQfgwoU2Ei.99

For decades, policymakers’ perception has been that large capital inflows can fuel booms in asset prices. If this were true, bonanzas in capital inflows would imply an important risk to financial stability, since booms in asset prices are leading indicators of financial crises. However, as noted by Reinhart and Reinhart (2008: 50), despite being widespread among policymakers, until recently this perception was based mainly on anecdotal evidence.

Recently, a number of empirical studies (e.g. Aizenman and Jinjarak 2009 and Ferrero 2011, 2012) have studied the association between large capital inflows and asset prices – in particular housing prices. Focusing on the current account as a proxy for capital inflows, they found that the association is, indeed, positive and significant. These findings are clearly a step forward. However, focusing only on the current account can be misleading. In recent research (Olaberría 2012 and Jara and Olaberría 2013), we present strong evidence emphasising that to understand the association between large capital inflows and booms in asset prices, we need to go beyond the current account and look at the disaggregated flows. We argue that these facts are consistent with theory, and highlight why they matter for economic policy.

Asset Price Booms and the Composition of Capital Inflows

Using a panel of quarterly data for 35 countries covering the period 1990–2010, in Jara and Olaberría (2013) we estimate the unconditional probability of observing a boom in housing prices, and the probability of observing a boom in housing prices conditional on having:

1. large current-account deficits;
2. a bonanza in net FDI inflows;
3. a bonanza in net portfolio equity inflows;
4. a bonanza in net portfolio debt inflows;
5. a bonanza in net banks and other inflows;
6. a bonanza in 4 and 5.

Bonanzas are defined as episodes of extreme net capital inflows – when domestic or foreign investors substantially increase capital inflows into a country relative to their historic levels (see Forbes and Warnock 2012). Asset-price booms are defined as periods of unusually large price expansions (a method used in Mendoza and Terrones 2008 to identify credit booms).



The main results, reported in Figure 1, show that having a large current-account deficit does indeed increase the probability of observing a boom in housing prices, but that the increase is not very significant (17.7% vs. 15.4%). In contrast, the figure shows that the probability of observing a boom in housing prices more than doubles (increases to almost 40%) during periods of bonanzas in debt-related inflows. (Olaberría 2012 found similar results for booms in stock prices.)


These findings are consistent with theory. Theoretical models linking booms in asset prices with large capital inflows start with the idea that, because of financial market imperfections – such as adverse selection and moral hazard – an economy’s borrowing capability is limited by the value of its assets. When large capital inflows enter an economy, the demand for assets that are in rather fixed supply increases, and asset prices rise, increasing the economy’s credit limit. Increases in the credit limit promote new rounds of capital inflows, potentially evolving into an asset price boom through a circular process in which higher asset prices make the financial conditions of the economy appear sounder than they actually are, promoting more borrowing and pushing asset prices even higher.

According to Aoki et al. (2009), this theory applies mainly to debt-related flows – which are more likely to suffer from problems of adverse selection and moral hazard, and can exacerbate cycles in asset prices by encouraging excessive risky lending during booms – and not necessarily to equity-related inflows. In fact, according to Krugman (2000), equity-related inflows – i.e. FDI – could help flatten cycles in asset prices.

In sum, the composition of capital inflows matters. While large current account deficits driven by FDI inflows are less likely to be linked with booms, large inflows of debt-related investment are likely to put pressure on asset prices – even when the current account is in surplus. (Although countries with current-account surpluses are better equipped to respond to the risk than countries with large current-account deficits.)

A Non-Economist View Of QE

We are now trapped into a vicious cycle of quantitative easing, mainly by the EMU and Federal Reserve. Even the hint of tapering seems to shock the markets into a tailspin. Then we have the rising share prices and property prices almost globally, and when each country tries to pull the handbrakes on property prices, the developers complain that its not their fault, its the QE stupid!



a) USD/Euro devalues - For every dollar/euro that is printed, the existing dollar or euro gets depreciated a little as these are technically not backed by anything, they just roll off the printing press. It is HIGHLY UNLIKELY that the Fed or EMU will be buying back all the notes they have printed, that's a given.

b) The Bastardisation of Currency - Gold went on a tear as that was said to be the best keeper of value in an era of drastic bastardisation of real currencies. When it is printed by a small country, you can be assured that the currency will be devalued almost immediately. However, the situation is a bit different with the top two currencies plus the yen getting into the picture albeit a bit late. Can you, will you technically devalue these currencies? These three currencies can get away with a lot of indiscretions. Most central banks keep large amounts of these three currencies as a way to build up reserves to shore up confidence for their local currency. In a big way, the smaller developing countries are subsidising these heinous acts by the 3 major central banks.

c) Inflation, What inflation? - All things being equal, the amount of QE should have, would have seen a much larger circulation of funds chasing after the same amount of goods, services and assets. But inflation has been benign for most countries. Much of the QE funds reside with the big banks which basically get cheap funds, but do not lend the same amount out. It is safer and more profitable to take advantage of the interest rates differentials. Thus big banks profits have been rejuvenated. It looks like inflation will still be muted as not much of the QE gets to flow to the end consumer in loans.



d) Main reason why excessive QE is bad - Do we have excessive QE, yes by a very huge sum. The WORST thing as a direct result of QE is "false confidence" in the economic system. Stock prices do not need to correct, investors do not get penalised for making bad decisions or taking on miscalculated risks. When stock prices do not correct, property prices also do not correct. In fact, it is the very "safety option" that a lot of liquidity or wealth (not from QE) were diverted into property investment and speculation as share prices did not correct and did not present "genuine value" to the broader spectrum of investors.

e) Did investors flee USD, Euro? - To a certain extent yes, but the pendulum has swung back already (too swiftly). The best performing country bonds for the past 18 months has been Greek bonds.

f) Commodities - as these are priced in USD, by right they would have devalued. In reality they already have, its just that they have not gone up. This tells you a lot about the uncertain recovery in the global economy. If demand had been the same now as it was before the 2008 crisis, commodities may have moved up by 30% by now. The fact that it did not tells you suppliers cannot move prices up as demand was not there over the last 4 years to take up the supply. Another side shot was that there had been over-investment in commodities (oilfields, mines, etc...) and these came onto the supply chain following the 2008 crisis, which would give you the current supply-demand imbalances.



g) Property - Property is still very much in negative equity territory for many Americans and Europeans, and that is probably the only segment that actually had a correction that they had to deal with. The flip side now is that other developing economies not so affected by the 2008 financial crisis are really seeing property as a great storage of equity and wealth, so much so that domestic demand and liquidity for those respective economies are very much tied to these perceived huge jumps in property equity/wealth and/or unmitigated mortgages/debt linked to ever rising property prices - can anyone not see what is very dangerous here!!!

h) Destabilisation? - So, when your government tries to rein in property prices, IT IS A GOOD and NECESSARY THING, its not that we do not understand why it happens. Just because it is cause indirectly by QE by some other central banks does not mean we should not rein in property prices. Developers must shut up more. When you are recipients of imbalances, you enjoy the ride and enjoy the profits ... when these very imbalances causes massive dislocation in "inflated wealth perception" and excessive speculation and drives away affordability equation for most - it is a recipe for disaster if left untreated. Property developers cannot suddenly pretend to be CHIEF ECONOMIST as well, and then tell the government not to pull the brakes or do something else to address the affordability issue.



i) Currency Wars - In a classroom of theoretical economics, there would have been currency wars and massive destabilisation already. These has been very little because of issues mentioned above and the lack of options by major holders of Euro-US debt papers. Plunging the USD and Euro by dumping half your debt papers onto the market may make your currency strengthen a lot but the end result is not one anyone wants - a weak, destabilised USA and/or EU will almost immediately plunge the rest of the world's economy into a tailspin.

So what is my conclusion - There are already pockets of bubbles being formed, in particular global property prices, and many stock indices are getting there as well. However, we do not yet have catalysts that would bring about any kind of correction in shares, property or currency. It will happen but probably not so soon. We need USA and EU to stage strong economic recoveries, thus supplanting the need for QE, thus making way for robust lending and investing again. But mind you, there WON'T BE much buying back of the QE which they released for the past 5 years - thus these would force the banks to start deploying back into the real economy .... thats when another bubble will burst, my feel is that we are 12-18 months away.

Asset Class Returns As At 30 November 2013
A significant shift in money flows saw smart money leaving REITs, in anticipation of higher rates sooner than later thus making these almost fixed rates REITs less attractive in the near future. Where did the funds flowed to? Surprisingly, equities. Which is to say, while smart capital sees higher interest in the near future, they also see good corporate profits outlook and/or a more robust economic recovery, esp in the USA.


The negative skew for November’s returns overall kept last month’s advance for the Global Market Index (GMI) to a tepid 0.8%. The numbers still look encouraging on a year-to-date basis, however. Indeed, GMI is higher through the first 11 months of 2013 by a strong 12.9%, thanks in no small part to soaring stock markets in the developed world. The MSCI EAFE’s total return so far this year is an impressive 21% while the Russell 3000 in the US is ahead by more than 30%. If you exclude those two pieces of the global asset pie, the performance numbers for global multi-asset class strategies are considerably weaker.
Genius is a bull market, as the saying goes. For 2013, we might add that brilliant investing is also about two seemingly innocuous decisions about asset allocation.