Don’t Worry About Asset Bubbles

One of the Federal Reserve’s (Fed) current dilemmas is how to square its battle against deflation with investors’ fears of inflating asset bubbles. The former is part of the Fed’s mandate, the latter is not.

Krishna Memani, CIO

Oppenheimer Funds, September 3, 2015

Fed Chair Janet Yellen is already on record saying that the goal of central banks is not to prevent asset bubbles from occurring but rather to make sure the financial system is resilient should bubbles occur. Are we now sowing the seeds of the next 2000 tech wreck or 2008 housing crisis? No, not from where I sit.

For all the hand wringing over asset bubbles and central banks erring on the side of being too accommodative for too long, there are few signs of excess:

Credit growth is not outsized: I don’t believe there’s an asset bubble, but even if one existed, it is accelerating credit growth that feeds the bubble that really matters. U.S. bank credit growth is now climbing more than 8% year over year, which is back in line with the long-term average yet still below the prolonged periods of 10%-15% credit growth that often presage the end of business cycles and notable increases in defaults. What’s more, in Europe, private-sector loan growth recently turned positive for the first time since 2012 (see Chart 1).

Chart 1

Sources: St. Louis Fed, European Central Bank, and Haver Analytics, 6/30/15.

Bond yields are reflective of a weak growth world: Select investors and certain bond market heavyweights have, at different times, identified fixed income assets such as U.S. Treasuries, German Bunds, and high-yield corporate bonds as being dangerously close to bubble territory. I vehemently disagree. In a country that posted second-quarter 2015 economic growth of 2.3% on a quarter by quarter annualized basis, and headline inflation of 0.1% over the last year, 10-year U.S. Treasury rates in a trading range of 2.0% to 2.5% are entirely appropriate. High-yield bonds trade at an even more reasonable spread to benchmark rates than they did at the start of 2015. Defaults are likely to stay low as debt coverage ratios remain sound and the market faces few bond maturities between now and 2017. Recent underperformance can be attributed almost entirely to the energy sector (see Chart 2).

Chart 2

Source: Bloomberg, 8/17/15. The Bloomberg USD High Yield Corporate Bond Index is a rules-based, market-value weighted index engineered to measure publicly issued non-investment grade USD fixed rate, taxable corporate bonds. The 10 sectors include energy, industrials, materials, financials, communications, utilities, technology, consumer discretionary, consumer staples, and healthcare. Past performance does not guarantee future results.

Furthermore, I believe that supposed liquidity concerns in the bond market are a myth created by Wall Street in hopes of repealing regulation. Spreads will of course widen in the event of a bond market sell-off, but there is enough appetite for yield that more than enough investors will be available in the marketplace to provide the other side of the trade.

Equity valuations are relatively attractive: Global equity valuations are generally in line with or slightly above long-term averages and attractive when low interest rates, low inflation and the benign monetary policy environment are factored into the calculation. Emerging market equities are now trading below long-term averages.

Get the Big Calls Right

For long-term investors, the most important things are to get the big calls right and ignore the noise. What are those big calls?

1. We are in a slow-growth world with little inflation in sight. In fact, deflation is the far bigger threat. The risks global central banks face from not tightening policy are small. The risks of tightening too soon are huge.

2. Global policymakers will remain accommodative well into the future. The Fed’s first rate hike since June 2006, whenever it comes, will likely be the last for a while. It may be one-and-done, just like in 1996.

3. The usual indicators of the end of a cycle are nowhere in sight. By my assessment, the credit cycle, which is a harbinger of future economic activity, is just getting started. Ultimately, this credit cycle will be the longest on record.

In the current environment, I continue to favor global equities over bonds and credit over Treasuries. Benchmark returns will be more muted than in the past six-and-a-half years and bouts of volatility will occur as they do in any bull market. However, in a world where growth is scarce, investors will continue to pay up for it, wherever they may find it. Fortunately, there is no shortage of growth trends, and some individual companies and sectors are growing far faster than the aggregate global economy.

This has been my call for six-plus years and will likely be so well into the future, assuming that policymakers don’t take away the punch bowl at the exact worst time.

Follow @krishnamemani for more news and commentary.