Central banks insist that there is no credit bubble. But like politicians, when a central banker denies something vigorously and repeatedly, it is usually true.
To resurrect the global economy from the Great Recession, central banks implemented a policy of ultra-low interest rates and quantitative easing to restore growth. The policy relies, in part, on the asset inflation and portfolio rebalancing channel. In effect, low rates and abundant liquidity drive up asset values and also encourage switching to riskier investments.
Given that the same policies were central to problems of 2008, the authorities seem to corroborate John Kenneth Galbraith's observation: "Nothing is so admirable in politics as a short memory".
The justification was that the policy would encourage additional consumption increasing economic activity. But the effect on the real economy has been limited.
Only around one to two per cent of the higher wealth of American households (up more than $25 trillion since early 2009 from increased house and equity prices) has flowed through into added consumption. This is well below the three to four per cent average between 1952 and 2009. One explanation might be that the increase in wealth has accrued to better-off sections of the population, with a lower propensity to increase spending incrementally. In the euro zone and the UK, the effect of higher asset prices on consumption has also been low.
Instead, monetary methamphetamine has driven a desperate dash for trash, which threatens financial stability.
Equity markets have risen strongly. Desperate for capital appreciation, investors are chasing "blue-sky" technology and bio-technology stocks, which promise earnings and/or revenue growth that is faster than the industry or overall market.
Established technology companies are using their highly priced stock as currency to acquire smaller start-ups, further inflating values. Facebook's acquisition of WhatsApp, a messaging service, for $19 billion is a case in point. Facebook paid around eight per cent of its market value for WhatsApp. The high price was justified as giving Facebook presence in mobile devices. The price assumes optimistic future growth rates and profitability, projecting a doubling of the application user base to one billion and a doubling or tripling in smartphone numbers, which would further broaden its clientele. In fact, the acquisition and the price paid underlined Facebook's strategic dilemmas, raising questions about the social media network's own high valuation.
Many companies have borrowed at low current rates to finance buybacks of their own shares. In the US, 2013 buyback authorisations totalled $755 billion, the second-largest year on record, further supporting share prices.
Property prices have risen, supported by low financing costs and the absence of yields from other assets. In markets such as the US and UK, property prices have recovered and in some cases have reached or now exceed 2008 levels. In other markets, such as Germany, Switzerland, Canada, Australia, New Zealand and a number of emerging markets, especially in Asia, property prices have reached record levels.
Sovereign bond interest rates are at historically lows, fuelled by central bank buying and an artificially created shortage of safe assets. The most striking change has been the fall in rates for government bonds of beleaguered euro zone countries, such as Greece, Ireland, Portugal and Spain, which, in some cases, have returned to pre-crisis levels.
In April 2014, Greece issued euro 3 billion of five-year bonds at a yield of 4.95 per cent, below market expectations. There was over euro 20 billion in investor demand. It was a return rivalling the biblical tale of Lazarus' rise from the dead. The successful issue belied that Greece had defaulted on its debt merely two years ago. Greece's debt levels remain unsustainably high, even before adjusting for unpaid government bills or potential recapitalisation needs of the banking sector. A further debt restructuring cannot be ruled out. The evidence supporting a "narrative" of Greece's recovery is weak, with the economy having shrunk by around 25 per cent and with around 25 per cent of the workforce unemployed. The issue itself will worsen Greece's position significantly adding to interest costs.
Investors bet that Greece is too big to fail and on Germany and France's continued support of both Greece and the euro. They believe that they will earn higher returns than those available on bonds by core euro zone nations, with minimal risk.
Demand for risky debt has increased, driving down the additional return available to historical lows. In 2013, the issuance of US non-investment grade bonds reached $378 billion, up from $154 billion in 2007. The strongest increase was in the speculative "B" and "CCC" rating categories. Leveraged loans (a riskier form of lending) reached $455 billion, up from $389 billion in 2007. Transactions with low underwriting standards and weaker credit conditions have recovered to 2007 levels.
Even volumes of notorious collateralised debt obligations have almost recovered to 2007 levels, with corporate and sub-prime auto loans taking the place of sub-prime mortgages.
Bonds investors desperate for yield have moved beyond emerging to frontier markets, embracing less well-known African and Asian borrowers. The reasoning is that these countries have better growth rates and prospects than the BRICS and other better-known emerging nations that face significant challenges.
In 2013, Rwanda, a country remembered mainly for a horrific genocidal civil war, issued 10-year bonds to raise $400 million, around five per cent of its gross domestic product. Attracted by the 6.875 per cent coupon, investor demand was nine to 10 times the issue size. Other African issuers have included Nigeria, Zambia, Tanzania, Kenya and Mozambique. Asian borrowers have also taken advantage of the "all you can eat" debt buffet. In January 2014, Sri Lanka, rated non-investment grade, raised $1 billion in US dollars, a yield of six per cent. Demand was three times the amount offered. Subsequently, in April 2014, Sri Lanka undertook a $500 million five-year bond issue at a yield of 5.125 per cent. In the secondary market, the bond is now trading at below five per cent. A Bangladeshi telecom operator (rated B+ or highly speculative) raised $300 million for five years at 8.625 per cent. Demand was over three times the issue size.
Investor enthusiasm is inconsistent with many issuers' reliance on foreign aid, volatile commodity export revenues, political instability and governance issues (a euphemism covering lack of institutional infrastructure, grandiose projects, corruption and misuse of funds).
The market's animal spirits are supported by a belief that authorities have no option but to maintain abundant liquidity conditions in the face of low growth and the risk of disinflation or deflation. In effect, there is a deep-rooted belief that central bankers cannot and will not risk a sharp fall in asset prices in the current fragile conditions. There is also belief that default on borrowings are unlikely, as the available liquidity will not be withdrawn allowing even weak borrowers to refinance or increase borrowings as required.
In the worst case, investors have faith in their ability to anticipate changes in the environment and exit positions. Purchasers of flirty technology and bio-tech stocks, Greek debt and CCC-rated bonds assume that they can flip them at will. But failures, industry consolidation and reduction in trading activities mean that the number of dealers and market-makers in financial securities is lower today. Higher capital and liquidity requirements as well as regulations such as the Volcker rule, mean that the ability of dealers to hold inventory of unsold securities has reduced sharply. The ability of investors to exit positions without creating sharp price falls and volatility is now heavily constrained, increasing risk.
Markets are now "priced for perfection", that is, investors are assuming that nothing can or will be allowed to go wrong and there will be no unexpected developments.
The writer is a former banker and author of Extreme Money and Traders, Guns & Money
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
