Bubbles everywhere -- and about to burst?
How do you know when interest rates are too low? When bubbles start to appear in asset markets in the form of prices rising above historical norms. And there are signs that bubbles have indeed appeared, and in assets that are not always considered as part of financial markets. When bubbles are so widespread, investors would do well to watch out for their bursting.
The stock market is one area that low interest rates could have created a bubble. In a recent commentary entitled "Poor start to 2005 for US equities", I had highlighted a CBS MarketWatch article by Mark Hulbert that indicates that the US stock market could be as high as 50 percent above historical norms. Hulbert's conclusion: Stocks aren't cheap.
What sustains the high valuation? By all accounts, it is low interest rates. Low interest rates allow investors to discount corporate earnings at lower discount rates, which inflates stock values.
If interest rates rise in a persistent manner, though, the high valuation may fall. And that is a real danger, with the Federal Reserve currently on a campaign to raise interest rates. Even 10-year Treasuries, whose yields had stayed stubbornly around 4 percent for some time in the face of the Fed hikes, have started to rise over the past few weeks.
Global real estate is another area that many consider to be experiencing a bubble. I have discussed this before in an earlier commentary (see "No bubble in housing?"). And in December last year, The Economist warned in an article entitled "Flimsy foundations" that the "ratios of prices to incomes are now above levels that have proved unsustainable in the past. Taking the average ratio of house prices to incomes in 1975-2000 as a baseline, American house prices are now almost 30% overvalued".
And the bubble may be about to stop expanding. The Economist article had pointed out that house prices in Britain and Australia were already falling. The US may be about to follow suit.
Sales of existing homes and condominiums in the US dipped 0.1 percent in January, while sales of new homes fell 9.2 percent, and the median price of a new home fell 13.2 percent to the lowest level since December 2003. It is not certain, though, that these indicate softening demand for homes, since bad weather could have played a part.
Richard Berner of Morgan Stanley, nevertheless, thinks that demand will indeed soften soon. On 28 February, in a commentary in the Global Economic Forum entitled " Housing -- Bubbly?", he wrote:
The effect of cheap money is not necessarily restricted to housing. Andy Xie, also of Morgan Stanley thinks that even oil is a bubble. In a commentary on 1 March in the Global Economic Forum entitled "Oil Is a Bubble", he pointed out that although rising oil prices have been widely attributed to growing Chinese demand, China is actually still "a low-income economy and cannot sustain its rapid growth at current oil prices". According to Xie, in the short term, the pain of higher oil and material costs in general have been offset by expectations of "massive profits from property inventory in a rising market".
The real driver behind the rise in oil prices to current levels, Xie thinks, is liquidity.
However, Xie thinks that the property bubble in China is likely to deflate first, and pull down demand for oil in China as a result.
Cheap money sometimes makes its appearance in places not normally associated with the financial world. The latest issue of the New York Magazine features a story entitled "She Can't Be Bought" that, among other things, describes the huge demand for artworks:
If bubbles are spilling over into the art world, it is difficult to avoid the feeling that the era of cheap money has advanced to a rather mature stage.
The stock market is one area that low interest rates could have created a bubble. In a recent commentary entitled "Poor start to 2005 for US equities", I had highlighted a CBS MarketWatch article by Mark Hulbert that indicates that the US stock market could be as high as 50 percent above historical norms. Hulbert's conclusion: Stocks aren't cheap.
What sustains the high valuation? By all accounts, it is low interest rates. Low interest rates allow investors to discount corporate earnings at lower discount rates, which inflates stock values.
If interest rates rise in a persistent manner, though, the high valuation may fall. And that is a real danger, with the Federal Reserve currently on a campaign to raise interest rates. Even 10-year Treasuries, whose yields had stayed stubbornly around 4 percent for some time in the face of the Fed hikes, have started to rise over the past few weeks.
Global real estate is another area that many consider to be experiencing a bubble. I have discussed this before in an earlier commentary (see "No bubble in housing?"). And in December last year, The Economist warned in an article entitled "Flimsy foundations" that the "ratios of prices to incomes are now above levels that have proved unsustainable in the past. Taking the average ratio of house prices to incomes in 1975-2000 as a baseline, American house prices are now almost 30% overvalued".
And the bubble may be about to stop expanding. The Economist article had pointed out that house prices in Britain and Australia were already falling. The US may be about to follow suit.
Sales of existing homes and condominiums in the US dipped 0.1 percent in January, while sales of new homes fell 9.2 percent, and the median price of a new home fell 13.2 percent to the lowest level since December 2003. It is not certain, though, that these indicate softening demand for homes, since bad weather could have played a part.
Richard Berner of Morgan Stanley, nevertheless, thinks that demand will indeed soften soon. On 28 February, in a commentary in the Global Economic Forum entitled " Housing -- Bubbly?", he wrote:
Housing fundamentals, in my view, are as good as they get, and activity is likely to decline over 2005 and 2006. Among the reasons: Previously favorable demographics are turning less supportive, much pent-up demand seems to have been satisfied, soaring housing prices have made purchase less affordable, interest rates are gradually rising, and starts are slightly out of line with sales.
The effect of cheap money is not necessarily restricted to housing. Andy Xie, also of Morgan Stanley thinks that even oil is a bubble. In a commentary on 1 March in the Global Economic Forum entitled "Oil Is a Bubble", he pointed out that although rising oil prices have been widely attributed to growing Chinese demand, China is actually still "a low-income economy and cannot sustain its rapid growth at current oil prices". According to Xie, in the short term, the pain of higher oil and material costs in general have been offset by expectations of "massive profits from property inventory in a rising market".
The real driver behind the rise in oil prices to current levels, Xie thinks, is liquidity.
Oil is a bubble because the strong demand reflects the global liquidity bubble. At the same time, financial investors have poured into this commodity... Without the demand from financial investors, the current oil price could be US$15/barrel lower, in my view.
The oil and property bubbles are aspects of the global liquidity bubble that has arisen from the combination of a low US Federal funds rate and the willingness of Asian central banks to accumulate foreign exchange reserves. The property bubble is the primary manifestation of this liquidity. The oil bubble is a secondary aspect. Oil, however, could destabilize the equilibrium through its contractionary redistributing effects...
However, Xie thinks that the property bubble in China is likely to deflate first, and pull down demand for oil in China as a result.
China's property bubble could deflate under its own weight. The number of residential properties under construction exceeds 10 million, or about 8% of urban households. The current average price exceeds 10 times urban household income nationwide and is more than 20 times in many cities of the Yangtze Delta region. The probability that all these properties can be sold at current or even higher prices is quite low, in my view. As soon as property prices begin to fall, the pain from high oil prices will be felt by the economy, and the demand for oil will likely decline sharply.
Cheap money sometimes makes its appearance in places not normally associated with the financial world. The latest issue of the New York Magazine features a story entitled "She Can't Be Bought" that, among other things, describes the huge demand for artworks:
People on Wall Street are seeking contemporary-art trophies...everyone wonders when this bubble will burst. Right now "feels like the last days of the Roman Empire," says private-art curator Todd Levin. "Compared to the eighties, it's a much broader group with much more money"...
If bubbles are spilling over into the art world, it is difficult to avoid the feeling that the era of cheap money has advanced to a rather mature stage.
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