Jeremy Grantham of GMO LLC has stated that all assets are in speculative bubbles. We agree. Indeed, globally equity markets and the prices of commodities and property have boomed. Prices for art and rare artifacts have been going through the roof. Real yields on government bonds have been abysmally low and credit spreads for junk and emerging market debt have tightened precipitously (they are now widening off of record low levels). The coordinated loosening of monetary policy by central banks (from 2000-2004) may be partially responsible for these asset bubbles.
Research by Deutsche Bank has found that monetary growth in developed economies since 1996 has far exceeded growth in nominal GDP and that “monetary tightening has not yet been able to prevent growth in broad money supply from reaccelerating since mid-2004.” However, the main central banks are continuing their efforts to contain monetary growth.
But now, central bank interest rate increases in the leading economies (except Japan) are slowly choking off liquidity, the oxygen of financial markets. The relationship between money supply growth and asset prices isn't precise, but the broad pattern is clear. Asset prices took off in March 2003 (with a lag) after monetary policy was loosened in the first years of this millennium.
In the US, the Fed Funds rate was cut from 6.5% in 2000 to just 1% by mid-2003- a negative real interest rate low enough to encourage almost unlimited borrowing. Other rate cuts were less dramatic, but for a year or two borrowers in most countries enjoyed interest rates not much above the rate of inflation. They responded in a rational way, by borrowing. That led to a rapid expansion in the money supply, the funds available in banks for lending, spending and investment. This helped support a wave of global GDP growth and was to a large extent responsible for the upsurge in world wide housing prices. Consumer price inflation has mostly remained moderate, except for headline CPI in the US, which has started to accelerate. We think this is mainly due to imported manufactured goods from low wage countries like China.
But interest rates have been slowly rising since mid-2004, from ultra-low levels. Only now is global money supply growth starting to slow. The US has been the first to feel a contraction in liquidity, with annual growth rate of "broad money", cash in banks as well as in pockets, now down to 6% (still much greater then GDP growth).
In the Eurozone and especially the UK, the broad money
supply is still growing rapidly.
Central bank induced liquidity is the source of bull markets in all asset classes. Since it ended a few years ago, why haven’t markets fallen back to earth? Two reasons:
First, there is a lag between monetary ease and the growth of the money supply and then use of that new money for investments. Deutsche Bank found that it took two years of high money growth to drive up stock markets. It may take even longer for slow monetary growth to have the reverse effect.
Second, there have been various other forms of liquidity that have exploded in the last two or three years. All of these new forms of liquidity are based on leverage (i.e. use of borrowed money for investment or speculation). In our previous article about the incipient demise of the buyout boom, we touched on another source of fuel for the bull market in global equities – loose loans and junk bonds to finance the acquisitions. We think that tactic will soon be a relic of the past. But we also think that an explosion of complex and misunderstood derivatives has created leverage for speculating in stocks, bonds, currencies, and futures. Japanese carry-trade borrowing has also played a role in the vertical ascent of many financial markets and gold.
We highly recommend reading the intriguing April 30th front page WSJ article entitled, OUTER LIMITS: As Funds Leverage Up, Fears of Reckoning Rise (Fed and SEC Question Wall Street on Policies; 'A Mockery' of Margin”). In that article the WSJ reporters state, “Thanks to advances in financial engineering, investors have never had so many different ways to make commitments that exceed their bankrolls. And never before has leverage wormed its way into so many nooks of the financial world. We're living on planet leverage, and regulators and market gurus are growing nervous.”
From experience, we have learned that when markets start to fall sharply, the leveraged players have to cut or exit their positions to avoid big losses (which are magnified by use of borrowed money). This causes asset prices to fall, which triggers more long liquidation. The cycle repeats itself and ultimately results in a sharp correction or bear market (for the asset class that had the leveraged induced run up in price). Are we there now? Only time will tell.
Curmudgeon is a retired investment professional.
He has been involved in financial markets since 1968 (yes, he cut his teeth
on the 1968-1974 bear market), became an SEC Registered Investment Advisor
in 1995, and received the Chartrered Financial Analyst designation from
AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative
(non-correlated) investment accounts for clients from 1992-2005.