Tuesday, August 30, 2005

Bubbles All Around Us

Summary and Investment Conclusion

The world may be in the middle of the biggest bubble in history. The bubble (e.g., property, stock, commodities) could exceed 50% of global GDP in value. The key cause of the bubble is that the major central banks failed to lower inflation targets to account for the combination of productivity acceleration due to IT and the new upward stickiness in wages due to the influx of three billion people into the global economy since the mid-1990s.

The major central banks mistakenly released too much money in the past decade, justifying it with the low inflation relative to the recent past. The monetary excesses have led to the rapid expansion of asset valuation relative to income. The global economy has become dependent on the demand spillover from asset inflation.

The global bubble economy has unusually been resilient despite the rising Fed funds rate because: 1) the increasing use of leverage in financial markets is temporarily offsetting the liquidity impact of the Fed raising interest rates, and 2) some bubbles could prop up each other. The persistence of these bubbles expands the excesses in the global economy and makes the eventual correction more painful.

The end of the global bubble economy may be near. Mr. Greenspan recently recognized the role of the Fed’s monetary policy in the US housing boom, its associated consumption boom and the US savings shortfall. The Fed may be in a campaign to pop the bubble. The global economy could experience a big downturn or many years of slow growth to correct the past excesses.

Production-driven Asia has benefited tremendously from the global demand boom. Recently, it has also seen over $700 billion in hot money inflow, which is part of the global liquidity bubble. When the global bubble bursts, Asia could fare worst, as a global demand slowdown and hot money leaving may happen together. Indeed, the seeds for another Asian Financial Crisis have been planted, in my view. It will take proactive policy measures, especially ones that stop sudden money outflow, to prevent such a crisis.

Many Bubbles

Something unusual happened in the mid 1990s: the ratio of the US stock market capitalization to its GDP began to surge above its normal range. Mr. Greenspan made his famous speech on the ‘irrational exuberance’ in the stock market in 1996. The market shivered briefly but resumed climbing. It culminated in early 2000 when the listed stocks in the US exceeded 160% of GDP in value – more than twice the historical normal level.

After the tech bubble burst, US housing value began a similar upward move in relation to the US GDP. The ratio of US housing value to GDP could exceed 160% this year, up from 120% in the 1990s. The average of this ratio was 105% between 1950 and 1999 and the highest level during this period was 130% in 1989, right before the S&L crisis.

Similar trends in stock and property markets were observed in Australia and Britain. Between 1985 and 1995, the capitalization of Australia’s stock market averaged 37% of GDP. It is now about 120%. The value of household dwellings in Australia has swelled from 176% of GDP in 1995 to 337% now. Australia has had an excellent economy in the past decade due to its asset bubbles, I believe. Its extraordinary household debt (160% of household disposable income) and current account deficit (6.7% of GDP) show that its bubble-induced excesses are even worse than those of the US.

The capitalization of London Stock Exchange-listed stocks climbed to 198% of GDP in 1999 from 125% in 1995 and is now at about 134%. Its property price appreciated twice as fast as its per capita income in the past decade. Its current account deficit was 2% of GDP last year. London seems to exemplify the excesses – unreal prices. However, the UK’s macro data look tame compared with other economies with bubble problems.

The Anglo-Saxon bubbles have underwritten the global trade boom. Asia, and China in particular, has been the main beneficiary. With high savings rates, Asia has turned the export income into new capacity to keep inflation low. The booming trade has triggered monetary excesses in the region also. It occurred first in Southeast Asia in the mid-1990s. When foreign investors became scared of the property bubble there, capital flight caused the burst and the Asian Financial Crisis.

After the bubble deflated in Southeast Asia, China began to experience a property bubble. As the trade boom shifted to China from Southeast Asia, the liquidity excess made the same switch. A property bubble in an emerging economy is usually about putting up new buildings. China has not been different. This has also caused excess investment in commodity industries. Overall, China may have invested 30% of GDP in excess.

We often hear two arguments to justify the trends described above: (1) interest rates are low, and (2) corporate earnings are good. Neither argument is good enough, I believe. Low interest rates signal low-income growth rates. Hence, the real cost of money has not changed much. Good corporate earnings are supported by consumption, fueled by borrowing against asset appreciation. The good earnings are a bubble phenomenon.

The Bubble Genesis

Two factors led to a bubble-prone environment. First, technology led to productivity acceleration. In particular, IT dramatically increased the optimal scale economies of retail distribution. As the big-box retailers took market shares away from traditional retailers, it served to slow down inflation, ceteris paribus.

Second, the influx of three billion people of the ex-planned economies into the global economy was a strong headwind for wages in the established industrial economies, cutting off the traditional linkage between money supply and inflation. This deflationary force became stronger over time as IT made the labor arbitrage easier.

The fundamental changes in the 1990s severed the short-term relationship between money supply and inflation. Indeed, the monetarist explanation for inflation championed by Milton Freidman was discarded in the 1990s as inflation rates failed to respond to surging money supplies.

However, money did cause inflation in asset markets. Rising asset markets led to a demand boom in the Anglo-Saxon economies. That demand could have caused inflation. But, the ex-planning economies were eager to accumulate capital to replace the useless capital built up during the planning era. That force increased their supply faster than their consumption. Their supply kept inflation low despite the bubble-induced boom in the Anglo-Saxon economies, allowing their bubbles to expand further.

The Power of Momentum

The monetary environment in the past decade has been favorable for speculation in asset appreciation. While the appreciating assets may change, some assets are usually rising. The growth of the hedge fund industry reflects this reality; hedge funds are flexible enough to capture the upside from whatever assets are appreciating.

The increasing risk appetite is denting the effectiveness of monetary tightening by the Fed. In particular, the increasing use of leverage in financial markets is offsetting the liquidity reduction due to the rising Fed funds rate. This is why, I believe, the Fed rate hikes have had limited impact so far.

Mr. Greenspan has been expressing worries about asset prices. However, he is not addressing the issue with sufficient actions, in my view. If the Fed either raised interest rates more quickly or expressed the intention to target asset prices, the bubble would burst. Raising interest rates slowly is not effective when the risk appetite is rising in tandem. The momentum in risk appetite will eventually require the Fed to raise interest rates higher than otherwise to achieve the same effect.

Of course, the global bubble is more than just about the Fed. The Bank of Japan has increased money supply dramatically since the Asian Financial Crisis through quantitative easing. The monetary growth did not reflate the Japanese economy, as Japanese people were still too scarred by the bubble of the late 1980s. Instead, Japanese financial institutions kept buying treasuries, which pegged the treasury to JGB and the yen to the dollar. How Japan has behaved is an important factor in how dollar and treasury yield have behaved, i.e., the monetary policy of the BoJ has increased liquidity in the US.

Why Is the Oil Bubble Resilient?

Economists have been confounded by the limited impact of skyrocketing oil prices on the global economy. There are already some visible negative effects in Asia (see ‘Business Cycle Likely to Resume Downward Trend’, August 26, 2005). But, the effect is limited in relation to the tripling of the oil prices in the past few years. The strength of the global economy, the strong demand for oil, and the rampant speculation in the oil market are all related to the global liquidity boom and the rising risk appetite.

Commodity is the asset class with most bubbles in history, especially during the 19th century. From grain to silver, every commodity has seen bubbles. Oil now is probably the biggest commodity bubble in history. It seems that there is some excuse to push up the price everyday. The oil price chart resembles the NASDAQ chart from five years ago.

Oil is one of the most important inputs in the global economy. The tripling of its price should have had a major impact on the global economy. But it has not. The reason is that the liquidity behind the oil speculation has also been pushing up property and stock prices. The wealth increase from property and stock appreciation has vastly exceeded the increase in oil costs. The oil bubble is one aspect of the global liquidity bubble.

The Ending Scenarios

Bubbles burst when few expect them to. In 2000, the tech bubble burst when many long-term skeptics were converted into believers. This one is likely to burst at an unexpected time. Most investors I talk to accept that there is a bubble, but believe that it will not burst for several years. Investors tend to think like this in every bubble. Such thinking tends to prolong the bubble as nobody wants to leave the game while the going is still good.

The most important support for the global economy is the property market, in particular, the US property market. The global property bubble could exceed $15 trillion – the value appreciation above income growth. The US property market is not yet close to the extremes that we have observed in Australia or Asia. So it is possible that the US property market could last for a couple of more years. This scenario is essentially the status quo: there would be periodic growth scares, but speculators would always return.

An alternative scenario is that the US property market stops going up but does not decline either. In such a scenario, the world would experience slow growth but not burst. Oil prices would collapse to give the world a tax cut, which would stabilize growth. This would be a soft landing scenario.

Asia could be the trigger for a global adjustment. If the hot money in Asia (over US$700 billion) is scared of something like 1998, it could rush out of Asia and into the US. The dollar would strengthen and the US bond yield would decline. The combination could prop up the US property market and the US economy. The world would look like it did in 1998.

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India: Industrial Growth Pickup: How Sustainable Is It?

Chetan Ahya (Mumbai) and Mihir Sheth (Mumbai)


The latest monthly industrial production data show a strong acceleration of growth to a nine-year high of 10.8%. However, we believe this acceleration is increasingly at the cost of escalating the macro risks. We have been a strong propagator of the likely acceleration in India’s overall growth in the long term driven by structural factors such as demographics and the gradual but positive direction of reforms initiated by the government. However, we believe that over the last two years a significant part of the acceleration in growth has been premised on support of unsustainable drivers. A large of the IP growth has been driven by a low real interest rate-sponsored consumption boom. We maintain our view that industrial growth is heading for a slowdown and further continuation of the strong consumption driven growth only raises the risk of tougher times later.

IP Growth: Structural or Cyclical?

Although there is a general perception that India’s current strong IP growth is premised on structural factors, we believe a large part of the growth acceleration has been driven by a low real interest rate-sponsored consumption boom. Unlike the 1993-1996 growth cycle (which also coincided with the emerging markets cycle), the current growth recovery has been premised on an out-of-proportion share of consumption. The 1993-96 cycle was driven by major structural reforms and matching excitement amongst entrepreneurs resulting in investments being the anchor of growth. Whilst the share of consumer goods in IP growth at the peak of the 1993-1996 cycle averaged only 34%, it is currently at 58%. Indeed, the consumer goods sector grew at a 10-year high of 23.7% in June 2005 compared with 10.8% growth in capital goods.

The current cycle has also been marked by a sharp slowdown in the reform process. Some of the long pending widely expected reforms such as privatization, labour reform, increasing foreign investment limit for sectors such as banking, insurance and telecom, and structurally correcting the fiscal deficit by reducing subsidies or expenditure have all been deferred by the government. Indeed, public finances continue to remain poor as the government’s decision to subsidize oil prices has resulted in an off-budget burden of US$8.3 billion (1.1% of GDP) during F2006 (assuming average WTI crude oil price of US$ 60/barrel). In addition, the recent decision to implement the Employment Guarantee Act resulted in an annual burden of 0.7% of GDP on the government. We believe that government not performing the productive role of the public sector is one of the key reasons for the current skewed growth trend in India.

So What’s Wrong with Consumption Driven Growth?

Whilst initially this consumption growth supported by borrowings was good as it helped improve domestic capacity utilization, we believe that since the end of 2003, a rising proportion of this consumption is being met through imports. In other words, incrementally every rupee of consumption boosted by borrowing is not generating the same positive impact on domestic output and corporate operating earnings as it did when the capacity utilization was low. Not surprisingly, corporate revenue and operating profits have already witnessed deceleration in growth.

More importantly, a continued push in consumption driven growth could significantly increase the macro risks. Firstly, this consumption boom has already pushed the credit-deposit ratio to a 19-year high of 63%. Although India’s credit-deposit ratio and credit to GDP ratios appear to be low on an absolute basis, the aggregate leveraging in the system is now not low compared to other Asian countries as the government debt level in India is very high. Our broad measure for leveraging, which includes government debt plus bank loan advances to corporate and households indicates a huge spike up in borrowing in the past 6 years. The total of these two has shot up to 119% of GDP as of March 2005 (estimated to rise to 124% by March 2006) from 87% of GDP in March 1999. We believe that this total is still understating the overall debt in the system as it excludes external borrowings by corporates and loans funded by non-banking financial entities. We believe that this current high level of leverage in the system is clearly not a comfortable starting point if the country has to pursue aggressive manufacturing and infrastructure capex from now onwards. Pursuing an aggressive capex cycle at this stage will only increase the risk of a huge interest rate shock on the system.

Secondly, even as the private corporate investments as % of GDP is close to 12-year lows, the government and households have leveraged considerably (primarily for consumption) above the fair the levels of debt. Our banking sector research team believes that there is a rising credit risk building in the system as Indian households have leveraged significantly above the fair level that is supported by the current trend in per capital income. Even the Central Bank has conveyed its concern on sharp growth in consumer credit by increasing the risk weighting related to consumer credit lending, housing loans, commercial real estate and capital market related advances.

Thirdly, a further rise in external imbalances poses an additional macro risk. Due to global trade integration, a pick-up in domestic demand when capacity utilization is running high and import protection is low is resulting in a higher trade deficit rather than adding to inflationary pressure. In other words, with the investment cycle (i.e. new capacity creation) remaining weak, a higher consumption-oriented growth push supported by low real interest rates has been a key factor pushing the trade deficit to an all-time high of US$11.5 billion (5.6% of GDP, annualized) during the quarter ended June 2005. However, unlike China, which has used global liquidity for creating capacity that has allowed it to increase market share in global exports and sustain higher growth trend, India has used the external monetary stimulus for consumption. Our analysis shows that a large part of the sharp widening in the trade deficit over the last two years was driven by consumption. 12-month trailing imports to GDP have risen to 16.0% as of May 2005 from 12.2% in May 2003. Out of this only 9% of the increase is due to capital goods. Oil accounted for 27% of the increase and the balance 65% is due to non-oil non-capital goods imports (read consumption). This widening trade deficit has only increased the country dependence on less stable capital inflows like FII equity investments and external commercial borrowings.

Rising Risk of Significant IP Growth Deceleration

There are many signs of risks emerging out of current over-stretched consumption growth. The credit-to-deposit ratio is close to a 19-year high of 63%, household debt is significantly above fair levels supported by India’s per capital income, government debt to GDP is at all time high of 80%, the rupee is overvalued by about 9% and the trade deficit has risen to an all-time high of 5.4% while the balance of payments has been boosted by less stable foreign capital. The good news is that India’s foreign exchange reserves are high at US$143 billion and the balance sheet of the corporate sector is looking very healthy. Hence, while there is vulnerability in terms of a potential significant rise in real interest rates and a significant deceleration in consumption (i.e. GDP) growth, we believe a crisis is unlikely. However, we believe that rising interest rates, slowing exports and a sharp rise in global oil prices are likely to trigger a significant slowdown in industrial growth over the next few months. We maintain our view that industrial growth will decelerate to 5-6% from the current 10.8% over the next 4-6 months time, weighing on corporate revenue and operating profit growth.

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