Rising for a fall?

This is a good summary of the current state of play, with opinions from both sides:

Rising for a fall?

Saturday Nov 21, 2009
By Heather Stewart and Larry Elliott, Observer

The din from the commodity pits on the Chicago exchanges is growing louder. Real estate agents in London's Kensington and Chelsea say they can't meet demand for 1 million-1.5 million ($2.2 million-$3.4 million) homes. Wall Street's high-tech Nasdaq exchange has wheeled out its confetti machine for the first time since the credit crunch.

Everywhere the story is the same. Gold: at a record high, above US$1100 ($1476) an ounce. Shares: 50 per cent up since March. Oil: back to almost US$80 a barrel. Bonds: yields on two-year gilts (British government bonds) at a record low. Average British house prices: up 11,000 this year.

Around the world, asset prices are booming. Relief that the global economy has avoided the Armageddon feared in March, combined with large dollops of virtually free money, have helped put a smile back on the faces of the speculators. Too big a smile, according to some experts, since the buoyancy of asset markets is not reflected in the real economy.

Away from the frenzied financial world, among struggling firms and cash-strapped families, signs of recovery from the worst downturn since the 1930s have been much patchier. The US returned to growth in the third quarter, thanks to Washington's cash-for-clunkers scheme to encourage car sales, and tax breaks for first-time homebuyers. But unemployment is at its highest level since 1983 and the number of Americans losing their homes is still rocketing.

In Europe, the big economies of Germany and France returned to growth six months ago but consumer spending remains painfully weak. In Britain, the latest official figures show the economy still contracting in the autumn after six successive quarters of negative figures. Mervyn King, Bank of England Governor, warned last week that Britain has "only just started on the road to recovery".

As share prices rocket, the question is: are policymakers trying to solve the problems caused by one of the biggest bubbles in history by pumping up another speculative frenzy?

This was what happened after dotcom shares collapsed in 2000, when former Federal Reserve Chairman Alan Greenspan slashed US interest rates to 1 per cent and left them there for three years, setting off the biggest housing boom in US history. And this time, central banks and finance ministries have added tax cuts, spending increases and "quantitative easing" - the creation of electronic money - and so created an even headier brew.

Ravi Batra, US economist and author of Greenspan's Fraud, says: "We are repeating the mistakes of Greenspan but on a much bigger scale. There is going to be another big pop in the new year."

He is not the only Cassandra. Nouriel Roubini, one of the few economists to see the crisis coming, warned this month that the US had replaced Japan as the centre of the global "carry trade" (whereby investors borrow money cheaply in a currency with low interest rates and buy risky assets that offer a return higher than the interest due on the loan).

With the US Federal Reserve pledging to keep interest rates only just above zero for "an extended period", Roubini says dollars, instead of yen, are now being used in "the mother of all carry trades", forcing up the price of all kinds of other assets.

Central bankers past and present sought last week to allay fears that, just like last time, it would all end in tears. Frederic Mishkin, a former Federal Reserve board member, said there were two sorts of bubbles: "credit boom" bubbles and "irrational exuberance" bubbles. Credit boom bubbles - like the one that burst in 2007 - were far more dangerous than irrational exuberance bubbles, such as the wild buying of technology shares, he argued, because they created a toxic feedback loop. A rise in the price of an asset such as housing allows consumers to borrow, but they then invest the money in buying a bigger home, driving prices up ever further - and so it goes on.

When prices plummet, hapless homeowners not only have a property worth a fraction of what they thought, they're also sitting on a mountain of debt. Mishkin sees the dotcom boom as less catastrophic because it didn't involve this vicious circle, and he regards the current rise in asset prices as being of this harmless, irrational kind.

Mervyn King agrees with this analysis. During a sepulchral press conference to launch the Bank of England's quarterly inflation report, the governor made it clear that he was losing no sleep over the rise in asset prices. The bank believes some increase in such prices - bonds and shares, in particular - is good for the economy because it lowers the cost of financing for companies and makes them more recession-proof. It is one of the channels by which the Bank believes the 200 billion it is injecting through quantitative easing will feed through to the rest of Britain.

King's message was clear: after a near-6 per cent drop in output since early 2008, it is premature to be drawing comparisons with the Dutch tulip mania of the 1630s, Isaac Newton losing his shirt in the South Sea Bubble of 1720, the boom-busts in US railway shares in the 19th century, or any of the periodic speculative stock market frenzies of the 20th century.

King said: "It's very important that we don't end up in a world in which everyone describes every increase in asset prices as a bubble, and every fall in asset prices as the bursting of a bubble." He made it clear he was not worried because there had not been the "rapid extension of credit" seen in the early 2000s - indeed, we are gripped by a credit shortage.

GERARD LYONS, chief economist at Standard Chartered, says he sees no sign yet that prices in the US or Britain have risen out of control: "It should not be a surprise that in the early stages of a recovery, property prices and equity prices rise, particularly if they have taken a big hit."

He is concerned, however, about China, where a return to strong growth has been achieved with a massive government stimulus programme, which has led to a jump in bank lending - potentially making it a damaging credit boom.

"Where asset prices have risen sharply alongside rampant lending and credit growth, there is more reason to think it's a bubble, and China fits into that category," he says, though he adds Beijing is well aware of the risk and is now clamping down on lending.

Even the severest critics of Mishkin's and King's laid-back approach to the current buying spree accept that some recovery in asset prices - of perhaps 20 per cent - has been justified. After the collapse of Lehman Brothers in September 2008, financial markets continued to fall sharply throughout the northern winter as global output contracted and credit dried up. By March, investors had fully priced in the possibility that the world economy could be heading for a new Great Depression, so even the first tentative pieces of good economic news sparked a relief rally.

But markets tend to have only two moods: deep gloom and wild euphoria.

Having prepared for the return of soup kitchens in the spring, they are now betting on a strong and rapid return to business as usual - a so-called "V-shaped recovery". And that's what worries analysts, who are not comforted by the age-old cry that "it's different this time".

"It sounds too good to be true and it is," says Robert Barrie of Credit Suisse. "It's time to take asset prices and credit more seriously. They can have long-run effects that are big and problematic. They took a long time to show themselves last time and could do so again."

Concerns about a new speculative bubble fall into three categories. The first is that the recent track record of central banks does not engender much optimism that they will be able to distinguish between a credit bubble and an irrational exuberance bubble, or indeed spot either sort developing.

The fed, for example, denied that the US housing market was a bubble right up until the global financial system was paralysed by the sub-prime meltdown in 2007, and the Bank of England flatly rejected arguments that central banks ought to "lean against the wind" and prevent prices in markets such as housing getting out of kilter.

Moreover, as London market analyst Andrew Smithers noted last week, even the popping of the irrational exuberance dotcom bubble, dismissed by Mishkin as relatively harmless, had baleful long-term consequences, since it led to the cuts in interest rates and taxes in the US that fed the housing bubble.

A second concern is that the fundamentals of the global economy remain weak, and when investors catch up with that grim reality, there will be another brutal crash. "The speculative economy that caused the problems in the first place has again reared its head," says Graham Turner of GFC Economics. "But the real economy continues to flounder; 2010 will be a very big year because the global economy is not fixed."

Danny Gabay, of Fathom Consulting, says the reaction of markets this month to the statement of G20 finance ministers in St Andrews, Scotland was indicative of the over-optimistic mood. "The communique said that conditions were far too weak to consider removing the economic stimulus, yet stock markets rallied by 2 per cent. Ministers were saying things are so fragile they daren't take their foot off the pedal."

Finally, there is the worry that the underlying reason bubbles keep recurring is that the modern global economy can only run on cheap money and debt, which fuel regular and powerful speculative cycles.

Batra says that in the US there has been a profound mismatch between the increased supply of goods from improved productivity and the squeeze on real wages dating back to Ronald Reagan's presidency. "Greenspan resorted to debt creation and budget deficits to bring demand and supply into balance," he says.

Turner says bubbles reflect how global capitalism now works, with firms moving operations offshore to cut wage costs, leaving demand in the world's major economies so weak that it can only be kept going by spoon-feeding consumers with cheap credit.

Even some who believe that we are back in a bubble say central bankers have little choice, such is the scale of the downturn. "My view is that we have to go on with quantitative easing for as long as we possibly can," says Crispin Odey, a London hedge fund manager.

So what happens next? Policymakers hope the rise in asset prices is a catalyst for stronger growth next year, with consumers feeling richer as house and share prices rise and so spending more. Businesses will respond to stronger consumer demand and easier financing by boosting investment and creating new jobs.

But at some point, governments and central banks will have to withdraw their emergency support by pushing up interest rates, selling the bonds they bought through quantitative easing and cutting public spending. Only then will it become clear whether central bankers are cleverly "smoothing" the most painful adjustment in the world economy since World War II, as King argues - or unleashing yet another bout of irrational exuberance.

Exuberance breaking out all over:

Shares: Heading for a fall?
Gut-wrenching declines in world share prices became a relentless routine at the height of the financial crisis, with Wall Street's Dow Jones index dropping by almost 400 points in a single day in the weeks after Lehman Brothers collapsed.

The Dow peaked at more than 14,000 in October 2007. By early this year, when traders were seriously beginning to factor in the possibility that recession in all the world's major economies would give way to a 21st-century Great Depression, it had more than halved.

Yet most of the world's indices have roared back from their lows; and some countries, including France and Germany, bounced out of the downturn more quickly than many expected.

In New Zealand, the NZX50 index fell by 44 per cent from its peak in 2007. But from its low point in March, the market has climbed by 30 per cent.

The Dow is now back above 10,000; the FTSE100 index of stocks on the London exchange has gained 50 per cent since it bottomed out in March and is back above 5300; emerging economies' stock markets have roared ahead.

Analysts are divided about whether this is a sustainable resurgence - or a dangerous bubble.

Oil: Recovering lost ground
During the relatively innocent pre-Lehman days of mid-2008, central banks fretted about inflation as oil prices surged to their record of US$147 ($197) a barrel.

Prices had already been on the slide before the financial crisis reached a peak of intensity in September and October last year, but then crashed to a low of just US$38 a barrel between Christmas and the new year as the global economy went into reverse.

Since then, prices of crude have been steadily rising as China has stockpiled commodities and traders have anticipated renewed demand throughout the world.

News that every G7 country bar Britain is growing again has helped to underpin confidence in rising energy prices and oil briefly clambered back above the US$80 mark this month. Some broking firms believe that prices are now on course to surge back through US$100 a barrel, although this would have a dampening effect on the global recovery.

Bonds: Key indicators of success
Rising prices for government bonds should come as no surprise, because they are a key indicator of the success of the aggressive policy response to the crisis by central banks.

Under "quantitative easing" - the creation of electronic money - the central bank purchases bonds from the commercial banks. The reduced supply of bonds pushes up their price and reduces yields, which move in the opposite direction to the price.

Long-term interest rates - which affect both what companies pay for their borrowing and what households pay for fixed-rate mortgages - have been driven down as a result of this policy.

In the US, the government has not just bought government bonds but corporate debt as well, to help reopen frozen credit markets and enable firms to borrow more cheaply. In Britain, the policy has been more beneficial for large corporations than small- and medium-sized companies, which are dependent on bank loans.

Gold: Safe as houses
Gold is the ultimate "safe haven" commodity in times of trouble - the Bank of England has a gold ingot that was damaged, but not destroyed, by a World War II bomb. Gold has surged in price by almost 50 per cent since January, as investors fled riskier assets.

This week the cost of a troy ounce of the precious metal hit another record, above U$1140, and TV advertisements have appeared on both sides of the Atlantic urging consumers to dust-off long forgotten jewellery and sell it for cash.

Gold has partly benefited from the waning power of the US dollar, as the two tend to move in opposite directions. The most potent symbol of the glittering metal's rising appeal came this month, when the Indian central bank bought 200 tonnes of gold from the International Monetary Fund, replacing rapidly depreciating dollar assets.

However, analysts warn that there have been unsustainable bubbles in the gold market before: the price rocketed to a peak of US$850 an ounce in early 1980, before rapidly losing more than half its value.

Housing: Don't believe the hype
Gazumping is back in London's top postcodes, mortgage approvals are on the rise and the long-predicted housing crash turned out to be a short, sharp shock, instead of the early 90s' long slog.

House prices fell 20 per cent between 2007 and this year as confidence collapsed, and it became near-impossible to secure a mortgage. But in the northern spring prices began to bounce back, and have risen for the last six months.

They are now down 13.1 per cent from the peak - though the bounce has been concentrated in London. Rock-bottom interest rates helped prevent the rash of repossessions and forced sales of other crashes, helping to prevent prices from falling off a cliff. But with fewer homes changing hands than in the boom years, some believe the crash is far from over.

Even estate agents, usually the most optimistic observers, warn that a shortage of properties for sale could be distorting the market.

In New Zealand, Quotable Value's house price index fell 10 per cent from late 2007 to early this year, but climbed by about 2 per cent in the three months to June, and according to Real Estate Institute figures, prices have kept climbing since.