What is an investment bubble?

The PortfolioConstruction Forum outlines what is, and what is not, a bubble, and what that means for constructing investor portfolios.

As he opened Markets Summit 2011, PortfolioConstruction Forum Publisher Graham Rich noted that the definition of insanity was to repeat the same actions over and over again and expect a different result each time.

And yet, with the global economy not out of the woods yet, here we are again, dealing with potential investment bubbles. So the big question for the panel of local and international presenters at this year’s Markets Summit was: ‘Any sign of a bubble, anyone?

’Open a newspaper, turn on the TV or surf the internet these days and you’ll find a flood of debate about investment bubbles: a gold bubble, an equities bubble, a bond bubble, a commodities bubble, an emerging markets bubble, a China bubble, another tech bubble, a social marketing bubble... the list goes on.

Hence, the aim of the PortfolioConstruction Forum Markets Summit 2011 was to decide what is (and what is not) a bubble, and what that means for constructing investor portfolios.

Offering some scene-setting perspectives of the global scene was a video presentation from economic historian, Professor Niall Ferguson.

He warned that stimulus didn’t always stimulate the right thing and was prone to leakage, which could lead to bubbles.

And when the biggest fiscal stimulus in world has just taken place, that leakage is likely to be vast.

In his view, the huge unprecedented monetary stimulus of the past two years has not stimulated the right things, such as employment.

Rather, it has leaked off and instead stimulated commodities and the emerging markets.

As a consequence, Ferguson flagged both areas as susceptible to bubbles.

The Honourable Dr Philippa Malmgren, president of the Canonbury Group, also sounded a warning note on emerging markets.

But, the single most important issue globally right now is inflation risk, she warned. Inflation figures are lifting all over the developing world and beginning to cause civil unrest where rising food and energy prices — which form half the expenditure of an emerging market worker — are compressing standards of living dramatically.

She urged delegates not to be deceived by top line growth in cases where the rate of bottom line inflation is going up even faster.

The big picture

Dr Bob Baur, chief economist with Principal Global Investors offered delegates a more positive outlook on the global economy.

The US and world economies have embarked on an economic expansion that has the potential to be better and last longer than the consensus expects, he said.

But, he too pointed to inflation as the biggest risk: now, in emerging markets and, within a couple of years, in developed countries.

He pointed to various fundamentals in support of his positive view.

US companies have had spectacular profit growth, with Standard & Poor’s reported earnings at all time record highs, as is cash on balance sheets, along with dividends increasing, continued mergers and acquisitions activity and continued capital spending.

On the consumer side, positive indicators include deleveraging and savings rates moving from zero to almost 6 per cent, with spending cut on appliances, cars and other consumer durables likely to lead to pent up demand.

Meanwhile, US exports are excellent, the trade deficit shrinking and the job market on the improve, he noted.

And while other indicators and activities such residential and commercial construction continue to drag, in Baur’s view, these are at least stabilising.

In Europe, Baur noted, Germany was booming with growth at 3.6 per cent its highest since reunification, along with similar highs in employment and consumer confidence.

As France and Germany are the region’s strongest trading partners, this means France too is poised for improved growth.

The numerous austerity programs in place throughout Europe were a positive, he said, with shrinking governments leaving more room for private sector growth, providing people with a better outlook and the belief that taxes would be down.

Meanwhile, the growth story continues in the emerging markets, which now account for some 37 per cent of global gross domestic product, Baur pointed out.

And that’s not all, with China and its 9 per cent per annum growth. India is growing at 7 per cent.

Both economies continue to build new infrastructure, demand commodities and show increases in consumer spending. Although wages might be up, with inflation and interest rates on the rise, at this stage there’s still a lot of room to grow, he argued.

Having looked at the overall momentum of the post recovery expansion, Baur then turned his attention to some of the risks that could derail it. And, despite his broadly positive view, he did acknowledge there are a few.

• Problems in the Middle East — In economic terms, at least, revolutions often end badly for the country concerned and their trading and geographical partners. Continued disruption across the region augurs ill for economic wellbeing;
• A double-dip in housing in the US — The big concerning measure is household formations, which are stuck at record lows of 500,000 a year, compared to a 15 year prior average of 1.3 million per year;
• The European debt crisis — While on everyone’s radar, in Baur’s view, the contagion will be limited and ultimately, the distressed debt will be purchased and restructured with lower interest rates and longer maturity dates;
• A Chinese real estate bubble — This is also, in Baur’s view, an unfounded concern. While certainly some pockets of Beijing and Shanghai may be overheating, most people pay cash for houses. So with no leverage, there is no bubble.
• China will tighten too much — Yes, rates have risen several times recently and inflation is at 6.5 per cent to 7 per cent. However, in practical terms, this level of inflation is offset by real interest rates;
• Uncertainty about taxation and regulation in the US — Back to the developed world, in Washington DC, there have been concerns about transparency of government intentions and, in particular, more taxation. However, the power shift brought about by November’s Congressional elections has provided economic clarity for business, which is now expanding; and
• US debt — In Baur’s view, the problem here is government spending, which is up 25 per cent in the last two years. However, he argued, if this is brought under control, the long-term problem can be fixed. So, will it be brought under control? Some States and authorities are now acting and if this kind of leadership spreads, the debt situation may yet be resolved.

 Inflation

Inflation is the key risk, according to Baur — and one risk that was flagged throughout the day by numerous presenters.

Inflationary risk comes about as a result of the global currency system, Baur explained, describing it as “an enormous engine of liquidity”.

To illustrate his point, he walked delegates through the inflation story, highlighting the forces that have kept it down over recent decades and why he believes that, with those forces now in abeyance, inflation risk is once again on the rise.

The reason inflation has remained low over the past decades is because these inflationary forces have been matched by deflationary ones, including the incredible dynamism in emerging markets which — due to various geopolitical events such as the opening up of the USSR, the fall of communism elsewhere and the opening up of China — have in the past decade or more effectively added some 3 billion more consumers to the world market.

This has had a net global disinflationary effect.

The Asian currency crisis also helped keep a lid on inflation, as did the seemingly limitless pool of Chinese labour, in an age group not yet hit by the impact of the one child policy.

However, as that key labour demographic ages and is not replaced with a pool of commensurate size, then the days of limitless labour and its deflationary impact on wages will be over, albeit not overnight.

Now, these deflationary global forces are waning and it is likely that inflation will once again become a major risk for world markets.

The practice of emerging nations linking their currency to the US dollar means that they have to buy currency, then print more, and so on, creating a cycle of inflation. In a sense, emerging market inflation is a natural part of the global rebalancing that has to take place.

However, there are two immediate problems with this. One is that buying such vast numbers of dollars in effect constitutes an investment in US Treasuries on a huge scale.

This has the effect of putting prices up, at the same time distorting yields on the low side.

Secondly, because Treasury yields are the reference point, other markets and asset classes also become distorted. And voila! A bubble in the making.

In Baur’s view, falling out of the current world economic picture are three key investment themes to factor into portfolio construction:

• First, reflation in the US, Europe and Japan — Taking advantage of this requires investing in stocks, which when in the early stages of inflation, tend to benefit investors. In particular, look at US and German shares and possibly even Japanese stocks. This is especially the case for large cap, growth and dividend paying stocks in sectors such as technology, basic materials and industrials;
• Second, the impact of inflation in emerging markets — With inflation high, price/earning ratios and valuations higher and rising interest rates likely to continue, it is going to be harder for valuations to expand. For that reason, Baur believes that the major emerging markets outperformance of the past two years or so is over; and
• Third, rising interest rates in developed countries — Against this rising rate backdrop, Baur’s view (and he was not alone amongst the presenters of the day) is that bonds are not so attractive. He is steering away from US, UK or German sovereign bonds. Some investment grade corporate bonds, however, may offer more appeal.

The big exit trigger Baur warned to be on the lookout for — among others that remain less certain at this stage — is a sudden move in US rates. This would require a significant rethink of allocations and a reassessment of likely risks and opportunities.