Blowing bubbles in international asset markets

Wall Street has always had a way with words. The latest phrase making the rounds in those hallowed halls is typically disorientating: “priced for perfection”. Now, to everyone else in the working world, this would mean that assets are attractively priced and a worthy investment. On Wall Street, however, an asset which is priced for perfection is one that will see a return if and only if subsequent market conditions are, quite simply, perfect. This means that investment, corporate margins and profits, interest rates, inflation and growth all have to achieve a Panglossian alignment for current asset prices to be justifiable.

There is some evidence for reason to worry that current asset prices are approaching this state. Equity prices are the most notable example of high valuation. Currently, every dollar invested in the Standard & Poor’s 500 Index (S&P 500) buys around 5.5 cents of earnings, which is down from 7.7 cents two years ago and lower than pre-crash 2007. Analysts put the current value of the S&P 500 higher than the bubbles in 1929, 1972, 1987, 2007 and only 15 per cent below the all-time high in 2000. This is not pleasant company to be in. Sovereign bond yields, which move inversely to price, have collapsed across developed and emerging markets. This ranges from bond-buyers having to pay the German government to take their money when yields fell into negative territory over the summer, to countries still ridden with crisis, such as Greece and Spain, being able to issue debt at favourable rates. Real estate and derivatives markets follow this pattern.

These valuations have not happened overnight. They are widely viewed as a direct result of the low interest rate policies and quantitative easing schemes pursued by central banks. This has had three main effects on asset prices; two demand driven, one supply constrained. First, low interests rates mean that investors, pressured to deliver real returns – a pressure that gets more intense as inflation rises – are forced to enter a “search for yield”. So, as more and more investors pile in to riskier assets, the prices of those assets increase and so subsequent returns decreases. Second, cheap credit has incentivised lending in high-risk sectors. For example, the European Central Bank’s last round of long-term funding, a source of money for banks designed to revitalise business in the Eurozone through lending, was predominantly accessed by hard-hit peripheral banks as all appetites for lending in more stable economies had already been satisfied. This pushes up the prices of emerging market and junk assets. Third, purchase of sovereign bonds by central banks has limited the supply of bonds in the market, preventing investors in some markets from purchasing the traditionally safer assets that can strengthen portfolios in times of crisis.

Financial conditions such as these bring to mind the spectre of a bubble, and the possibility of that bubble bursting. However, it is notoriously difficult to predict whether current prices are inflated above their true value. Even market valuations which exist at the top of their historical averages are not automatically bubbles, as the prices could reflect new structural features, such as the expectation that central banks are going to be permanently more dovish in their policies. Moreover, even if current valuations require optimal market outcomes to deliver return, there is nothing – theoretically – to stop them from occurring.

Central banks and regulators have, historically, been just as unable as everyone else to identify bubbles before they burst. Further controls, such as macroprudential tools and regulatory enforcement, designed to prevent exactly this sort of over-exuberance, are inadequate to solve the problem of bubbles because of the foresight problem. Priced for perfection is a pretty phrase, but it hides the true message: beware the bubble.

 

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