We live in an age of investment bubbles. Stock markets, property and bonds have all been blown to unnatural highs by years of monetary stimulus and rock-bottom interest rates.
Nobody knows how this will end but the signals from history are worrying: ultimately, bubbles always burst. And the bigger they are blown up beforehand, the messier the explosion. So how on earth do investors respond?
How bubbles form
Every time central bankers cut interest rates or announce yet another burst of virtual money printing, or quantitative easing (QE), asset prices surge as a result.
We live in a back-to-front world where bad economic news is greeted by yet another stock market surge, because it means the sugar rush of central banker stimulus will continue for that bit longer.
This means that despite – or because of – growing concerns over global economic growth, the US S&P500 and Nasdaq flew to all-time highs in August. Even more astonishingly, the UK’s benchmark FTSE 100 index of blue-chip stocks has blasted through 7,000 to near its all-time high, helped by a Bank of England stimulus after the shock Brexit result.
This is a remarkable turnaround after January’s traumatic start to the year, when global markets crashed on fears of a Chinese meltdown. Many markets are up by almost 30 per cent since those early-year lows.
Yet this is the bull market that nobody trusts or loves, because it appears to have been built on false monetary foundations.
Josh Mahoney, a market analyst at the global online trading company IG, which has offices in Dubai, says that most investors suspect the stock market has been driven far beyond its natural level by easy monetary policy. “Share prices have looked artificially high for a few years but they keep going up. We expect them to continue rising into 2017 as well,” he says.
The European Central Bank, Bank of England and Bank of Japan are all pursuing easy money policies, launching fresh rounds of QE and cutting interest rates even lower, with rates now negative in the euro zone, Switzerland and Japan. “There is no sign of a rate increase anywhere in the world aside from the US,” Mr Mahoney says.
The US Federal Reserve was supposed to hike rates at least four times this year but so far hasn’t moved once. Even if the Fed does increase rates by 0.25 per cent in November or December, they will remain astonishingly low by historic measurements.
Stocks and shares are not the only asset class that has been driven to new highs by easy money.
Global property markets continue to spiral, with urban house prices across 150 key cities rising at 5.5 per cent in the year to June, their fastest rate for more than two years, according to research from Knight Frank.
More than 30 cities posted double-digit growth, including Beijing, Shanghai, Budapest, Vancouver, Istanbul, Amsterdam, Auckland, Seattle, London and Ahmedabad.
Kate Everett-Allen, a partner for international residential research at Knight Frank, says China is growing fastest. “The average annual rate of growth for the top 10 performing Chinese cities was 22 per cent in the year to June, according to China’s National Bureau of Statistics. One year earlier the comparable figure was minus 1.1 per cent.”
China’s debt is growing faster than its economy and the Japanese bank Nomura recently said it now totals almost 212 trillion yuan (Dh115.54tn) or 309 per cent of GDP, up from 78 per cent in 2007.
Markus Rodlauer, the deputy director of the IMF’s Asia-Pacific department, has warned that the country is flirting with “financial calamity”.
“The level of financial and corporate debt and the complexity of the financial system and rapid growth in shadow banking is on an unsustainable path,” he says.
Globally, debt has hit a record high of $152tn, weighing down economic growth and risking stagnation or even recession, the IMF says.
Yet the banking system remains fragile, notably stricken Deutsche Bank, which has an unfathomable $47tn derivatives book.
Brexit, growing trade protectionism, Vladimir Putin’s mischief-making and the prospect of a Donald Trump presidency add a layer of political uncertainty as well.
The storm may eventually break, the problem is that nobody knows when.
The best strategy
Simply running for cover isn’t an option, as nobody knows when the bubble will burst.
In December 1996, for example, Alan Greenspan, then the chairman of the US Federal Reserve, made his famous “irrational exuberance speech”, warning that stock markets might be overvalued.
“The S&P500 dipped a little on that speech and then peaked nearly four years later after rising more than 140 per cent. Trying to predict short-term stock market movements is a mug’s game,” says Guy Stephens, the managing director at advisers Rowan Dartington Signature.
Ursula Marchioni, the chief strategist at the specialist exchange traded fund (ETF) manager iShares Emea, says that despite the recent spike in volatility, particularly for foreign exchange and commodities, investors are still happy to accept risk. “This is mostly attributable to the Federal Reserve holding rates and to marginal changes from the Bank of Japan’s purchase programme.”
Monetary stimulus has also helped to revive emerging markets, with investor inflows now at their highest since 2012. “The emerging markets asset rally could have more room to go,” Ms Marchioni says.
But she warns that volatility is likely to increase in the final run-up to the US election.
Trend isn’t your friend
Christopher Dembik, the head of macro analysis at Saxo Bank, says prolonged low interest rates have created speculative bubbles in the technology, internet and biotechnology sectors.
“It is best to avoid ‘trendy investments’ because sooner or later they will certainly result in major losses. One example is Twitter: it has changed the way people communicate and reinvented the media industry, but it is clearly not profitable enough.”
Another problem with cheap money is that it keeps many companies alive, whereas under normal credit conditions they would have gone bankrupt or been bought out a long time ago, Mr Dembik says.
Investing in the age of bubbles is tricky but there is no point in running away from financial markets, he says. “The only solution is to find a balance between growth and safety. There will be a new global crisis in the coming years but for now the situation is under control, thanks to the actions of central banks, who have become key market players in the US, Japan and Europe.”
This makes markets surprisingly safe because central banks are buying up a growing stock of the world’s bonds and shares and “will never commit hara-kiri” by allowing major losses. “They will be inclined to support financials markets well beyond 2020, by keeping interest rates low or buying further assets in the market.”
A balanced view
Eoin Murray, the head of investments at Hermes Investment Management, says today’s era of low natural interest rates is likely to continue for the next decade and beyond, squeezing the returns on assets such as equities and bonds.
“Long-term investors need to make a radical response: go for growth. This means substantially reducing exposures to low or negative-yielding bonds in favour of assets with strong prospects of generating positive real returns.”
This could mean investing in higher-risk, higher-growth sectors such as smaller companies or commodities and high-yielding stocks for income.
Others are more sanguine, including Tom Stevenson, the investment director for personal investing at global fund manager Fidelity International, who questions whether we are in a bubble at all. “The US may now look quite fully valued but this is not widespread. Japanese and European stock markets are not expensive and there are even opportunities in high-grade corporate bonds, although government bonds offer minimal returns.”
Even if the bubble does burst, solid, established, global companies should still emerge relatively unscathed. “Today, an investor can still find good investment opportunities in dividend paying equity income stocks, commercial property and in parts of the bond market. Selectivity and a disciplined approach are key to avoiding the overblown areas of the market,” Mr Stephens.
Vaqar Zuberi, the senior portfolio manager for alternative investments at Mirabaud Asset Management, expects further volatility in the years ahead.
“Central banks worldwide have injected unprecedented levels of liquidity in global markets. This abundance of liquidity has caused absolute and relative levels of mispricings across asset classes. As the Federal Reserve moves towards normalising monetary policy, volatility in asset price levels should materially increase.”
Mr Zuberi says these are attractive conditions for hedge fund managers, who can use price volatility to buy or short various assets and securities, including foreign exchange, interest rates and equities.
Hedge fund managers may be able to take advantage but ordinary investors will want to approach with greater caution. However, that doesn’t mean you should leave all your money under the mattress, or in a zero interest savings account. You have to take risks to get any kind of return these days.
pf@thenational.ae
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