A brief history of bubbleomics

by , 10th September 2017

Sean Corrigan, principal of his own independent advisory firm, Cantillon Consulting, has been active in financial markets since the mid-1980s. Bond trader, investment strategist, author, public speaker, and sometime TV pundit; his career stretches from the Crash of ’87 via the ’92 sterling crisis, the 1997 Asian Contagion and ensuing 1998 LTCM panic, on via the first great tech bust of 2001 to the commodity boom, the sub-prime calamity, Brexit, and the ever-recurring problems of the EMU. In his first column for ETFstream he looks into the history of the past 10 years and ponders how to navigate a world beset by asset price bubbles.

Almost exactly 10 years ago, a hitherto obscure German institution called IKB – majority-owned by an arm of the German government –made headlines around the world.

On the last day of July 2007, a company which ironically had its origins in a foredoomed effort to ‘stimulate’ the German economy in the aftermath of a Weimar Republic real estate boom, revealed it had been seduced once again by the lure of a property bubble having managed to build up a $17.5bn exposure to some of the worst of American sub-prime lending.

Events soon escalated. On 9 August Banque Paribas announced it was freezing withdrawals from three in-house hedge funds which disposed of $2.2bn in similarly dubious assets – a move which forced a startled ECB to pour money into the now-shaky market in a vain attempt to calm its fears. A week later, across the Channel, Northern Rock began secret negotiations with the Bank of England in what would prove a futile attempt to stave off its own, property-related problems while – half a world away – the Japanese powerhouse Mizuho announced a supposedly deck-clearing loss of Y600m which would end up ballooning a thousandfold before its own US nightmare finally ended.

The tide waters of a monstrous era of global speculation were draining rapidly out only to feed the onrushing tsunami of losses which was already speeding towards a largely unsuspecting shoreline.

We start with this brief history lesson since everything investors face today has its roots in that crisis. A decade on and we still live with its supposedly ‘emergency’ policy settings in terms of interest rates and central bank securities purchases. As a consequence, we still have not fully liquidated the bad old debts, closed the bad old businesses left high and dry in the wreckage, or brought bad old government borrowers back to balance, even as the flood of loose money is building new bubbles among the debris of the old.

The search for yield

Everywhere we look, stock markets are moving upwards – many of them making new all-time highs while the business pages are littered with Cassandra-like warnings about the historically elevated ‘multiples’ many of them now carry.

Despite the recent uptick, bond yields also remain historically low and, tellingly, the extra premia or ‘spreads’ to be earned for buying the riskier among them have been greatly compressed – some again to record levels, this time of meagreness. Take the case of Iraq where, notwithstanding the daily upheavals in that chronically war-torn land, a 5-year bond flew off the shelves last week at a 6.5% interest rate which may well be considered ‘high-yield’ in today’s Wonderland, but which the UK government itself was all too happy to pay in the run-up to the last tech bubble at the closing of the old millennium.

Property prices, too, have risen sharply and not just where Chinese buyers – both home and abroad – are the dominant force. Sweden and the Netherlands have been wrestling with double-digit house prices rises for some time, while the fact that Italy can barely keep its smaller banks open has not stopped office space in Milan climbing 20% in a year. Residential building land in Munich has been another star performer, jumping 30% in the that same time. It’s best not to ask about Dublin.

Add in the fact that wine collectors paid a quarter more for cases of the best French claret last year; that classic cars are up 150% in the past five. Consider, too, that a painting by a since-deceased ex-graffiti artist, Jean-Michelle Basquiat, sold for an incredible $110m in May, nearly doubling the sum paid for a not dissimilar work of his just 12 months previously.

For a work by a man whose brief, troubled career ended less than 30 years ago to command a sum only ever previously attained by such luminaries as Picasso, Modigliani, Giacometti, Bacon, and Munch surely says as much about the feverish urge to spend some of that surplus moolah as it does about the man’s own artistic merits.

We shall resist the temptation to talk about how all this money-pumping has also enabled the world’s first $1/2tn package for a footballer to be priced.

Elevator multiples

As asset prices rise, the all-important yield – the bit that ultimately puts bread in the investor’s mouth – moves in the opposite direction; both the current dividend or rental payment due and, more importantly, the prospective future return. Slowly but surely, we are changing our ‘assets’ into trading cards or (dare we say) bitcoins – items which are mainly valued because we imagine others like us will soon come to value them more.

‘Greater fool’ investing is all very well and good while it lasts, of course, but people should ask themselves how it is that so much ‘wealth’ can be created without anyone, anywhere, seeming to do very much in the way of work, or to engage in useful innovation, to augment it and why, if we are all becoming so effortlessly rich, do the economic – rather than the market – prognostications seem still so decidedly mixed.

The message therefore is that those fortunate enough to have ridden this easy-money bull market for a good while already should not confuse their accumulated windfall with evidence of either superior investment ability or as proof that we have arrived in the land of milk and honey, title deeds in hand and our acreage all marked out.

By all means, run your profits, if you are one of lucky souls to have been at the table these past few years, but do think to take some protection on the downside (with market volatility at record lows, this is cheap enough to buy) and, above all, do not be tempted to add further to your exposures.

Conversely, if you are someone who has not yet been convinced of the sustainability of the rally, now is decidedly not the moment to overturn your long-held scepticism and to plunge into the fray. History shows that the single greatest determinant of future returns is the initial price you pay to secure them. A market characterised by elevated multiples (in other words, by abnormally low yields) is therefore not the most propitious of outlets for your belated enthusiasm, especially since such multiples tend to exhibit a good deal of long-term reversion to the mean.

Looking to Japan Inc.

Realising that no-one really wants to hear a counsel composed entirely of cautionary words and thus pressed to name a market in which such evils are perhaps the most restricted and into which a certain fraction of one’s existing investments could usefully be channelled, we would opt for the sleeping giant which is Japan.

Though the market there boasts returns to equity of perhaps only two-thirds of those on offer in the US, Japan dwindling corporate debt burden – net gearing is at its lowest since the mid-50s – means returns to capital are far more comparable between the two. This also means that, reversing the practice of its glory days, balance sheets are generally more sound – for example, net debt as a multiple of operating income for Japan’s manufacturers comes in under three times whereas that for their American peers’ stands in excess of five times.

Similarly, a country where revenues have been almost stagnant these past 25 years but where pre-tax profits have nonetheless climbed at a trend 4.3% per annum not only gives the lie to the mindlessly-repeated idea that price inflation is a prerequisite of economic advance, but also shows that a determined entrepreneurial effort can indeed squeeze more blood out of a seemingly unyielding stone. Indeed, pre-tax margins in Japan are at their best levels in more than half a century of data, with the stereotypically lagging non-manufacturers improving even more than their industrial counterparts these past few years.

With labour markets eye-wateringly tight, signs are emerging that some of that vast pile of cash is being more liberally invested in aids to productivity – things such as automation, robotics, and smart systems. Not only is a successful implementation of this likely to increase margins further in the coming years but, as a macro-economic identity, fully-reckoned revenues will only be partially offset by contemporaneous costs above the line, thus boosting overall accounting profits long before a switch has been thrown on the newly-improved assembly-line.

Add in the fact that the big institutional investors are selling their deadweight government debt to an avid Bank of Japan and using the proceeds increasingly to purchase stocks. Next, mix in the contemporary push to improve corporate governance and at long last to prioritize shareholder interests. Finally, note that, despite the past year’s double-digit gains, the Japanese stock market still languishes near modern-era lows when measured against its now-pricey equivalents in the West.

Overall then, if you must insist on staying in the equity party right up until you see the blue lights of the neighbourhood cops flashing through the parlour window, that shy little Japanese wallflower in the corner might just be the girl you should be dancing with.