2014: year of the surge
“In China, the ratio of credit to GDP rose from 100 per cent before the financial crisis to 230 per cent in 2013... We know how this story will end”
© Bloomberg via Getty Images
Equity markets in developed economies had a second consecutive banner year in 2013 with markets up around 10-15 per cent in Europe, 25 per cent in the US, and about 50 per cent in Japan. Most strategists think that markets, which have been rising for five years, have further to go in 2014, with expectations of around 10-15 per cent for equity market returns. They may be right—or even too cautious—but if so it’s important to understand why, because stock markets are much less about robust economic fundamentals—the health of the economy according to particular indicators—than about how much cash is available. Central banks in the US, Japan, Europe and China are the largest providers of liquidity, and are therefore implicated in criticism that they are underwriting asset bubbles, including in equities. As we know, including from recent experience, asset bubbles always end badly. It’s only the timing that’s opaque.
You may well ask, therefore, how and why we are back here just about five years since the collapse of Lehman Brothers, after which there was a brief “never again” public debate demanding that in future central banks pay attention to asset, as well as consumer, price inflation. It was not to be. To understand why, we have to consider why loose money (expanding the money supply) has become part of the global financial furniture, and why, because of the legacy of the crisis, it is hard to jettison. Asset bubbles may be the new normal.
The problem of credit and debt
The basic problem in global finance, ever since the collapse of Bretton Woods, is that we don’t have a rules-based system to align the interests and responsibilities of creditor countries running external surpluses with debtor countries running external deficits. You can see the consequences of unbalanced and fractious creditor-debtor relations in the economic carnage in the eurozone. Clearly European institutions were not up to the task. In the global economy, the principal tensions over the last 30 years have been between the US and first Japan, and then more recently, China. Spats over trade and currencies have spilled over into competitive monetary easing and credit creation, in which equity markets have prospered for a while, but then shown that optimism was an illusion.
The Japanese asset bubble in the 1980s was in many ways the outcome of the tension over Japan’s trade and financial policies. When the US sought to regain competitive advantage by devaluing the US dollar in 1985 and easing monetary policy, Japan resisted by easing its own monetary policies and intervening to hold down the value of the yen, boosting domestic liquidity in the process. The Nikkei shot up from 12,000 in 1985 to almost 40,000 in 1989. At the time, the grounds on which the Emperor’s Palace stands in Tokyo were said to be worth more than all the real estate in California. But then came the collapse. More recently, Japan’s quantitative easing programme that started a year ago has helped to roughly double the level of the Nikkei compared with the all-time low of 8,000 in 2011.
China syndrome
The asset bubble in the 2000s had its roots in the aftermath of the Asian and Russian financial crises in 1997-8. Following Japan’s example, other countries in Asia with developing economies decided to focus on export-led growth and the accumulation of foreign exchange reserves. China, which escaped the Asian crisis, also prioritised export surpluses, high currency reserves—now totalling $3.6 trillion—and high levels of investment financed by cheap credit.
What emerged was, in effect, a vendor-based finance system, in which China sold increasing volumes of goods to the US, for example, and helped the US finance those purchases by providing credit through the purchase of US Treasury bonds. This is simple balance of payments accounting: China’s trade surplus has to be matched by capital exports, while America’s trade deficit has to be matched by capital imports. It is perverse, of course, that China, as a relatively poor country, lends its excess savings to a richer one, but that’s because of the structure of China’s economic model.
Under this mutually acceptable arrangement in the 2000s, and despite occasional arguments over trade practices and allegations of Chinese currency manipulation, everything that seemed to matter at the time went up: Chinese investment, exports and currency reserves, and US consumption. The Chinese stock market was a dull place in which to invest, but because interest rates and monetary conditions in the US and other western countries were easier than they would have been otherwise, US stock prices, for example, doubled between 1997 and 2007, albeit with a steep plunge in between related to the bursting of the technology bubble.
The 2008 financial crisis and economic aftermath ruptured this arrangement and pitted the US and China against one another in a sort of grab for growth. China’s response was to boost investment, especially in real estate and infrastructure, and credit creation. It also encouraged extensive financial innovation and growth in so-called shadow banking—non-bank financial intermediaries who provide services to banks—which facilitated a vigorous expansion of debt-financed investment. The US and other western countries, by contrast, embraced modest fiscal stimulus briefly in 2009, but relied heavily on unorthodox monetary measures, such as quantitative easing. Initially deployed to unblock the economy’s credit arteries, QE was then used for different reasons, namely to boost economic growth. With policy rates at or close to zero, the idea was to get longer-term interest rates to fall, so as to encourage risk-taking, boost asset prices, and lower capital costs for companies and investors.
The ripple effects of QE spread to emerging markets. US dollar capital flows boosted local asset prices directly and put upward pressure on emerging market currencies. Much as Japan and China had done before, emerging market central banks intervened to limit the rise in their currencies against a weak US dollar, boosting money and credit creation in the process. Since 2009, credit creation has surged in China, in the so-called “fragile five”—Brazil, India, Indonesia, Turkey and South Africa—and in the whole of developing Asia. Worryingly, this has occurred against a background of persistent downgrades in economic growth prospects in emerging countries. In China, the ratio of credit to gross domestic product (GDP) rose from 100 per cent of GDP before the financial crisis to 230 per cent in 2013, while underlying growth has fallen from 10 per cent to about 7 per cent, though it is likely to slide further.
We know how this story will end, though not when. Investors seem to sense that there is something not quite right with the emerging markets story nowadays. The immediate issue is that of bringing the credit genie back under control, especially in China. The People’s Bank of China and its peers will have to call time on the credit party eventually, but every time they get cold feet and back away, as happened in China in June and again in December, the green light for equity markets comes on.
More of the same in the West
Meanwhile, the Fed and other central banks will remain exceedingly cautious about “normalising” their monetary policy regimes. The Fed has begun to wind back its asset purchases but only gingerly. The Bank of England has suspended its own programme. The Bank of Japan is still in the process of doubling the size of its balance sheet. The ECB doesn’t do asset purchases in the same way, but all the central banks have made a public commitment to keep policy rates at zero for an extended period of time. Stock markets probably won’t have much to fear until or unless we get to the point where a rise in policy rates becomes a realistic prospect.
If and when that point arrives will be the subject of close scrutiny in 2014. Many people worry whether we can sustain growth when interest rates eventually rise, concluding that roughly zero policy rates will be with us for a long time. Leading US economist Larry Summers sparked a minor storm late in 2013 by suggesting that advanced countries might be succumbing to a period of “secular stagnation”. This notion holds that poor demand, combined with low interest rates, mean that price bubbles are the only way to stimulate economic growth and employment. He wasn’t recommending this, though, and warned that the policy agenda should be to pre-empt such an outcome.
So how bubbly are equities? Over the past year, about 75 per cent of the rise in global equity returns has come from a rise in the so-called price-earnings (PE) ratio, which is the multiple of a company’s share price relative to its earnings per share and is a measure of how expensive they are. The global PE ratio is now around 15, which is about average for the last 25 years, excluding the dot com bubble in 2001. Whether that’s bubbly depends on your perception. It’s at the top end of a range of 10-15 that has prevailed since 2008, and therefore looks quite rich. But it is only at the bottom of a range of 12-25 that spans most of the last quarter of a century.
If you think we have now left the financial and economic crisis, that banks are lending and the Eurozone is past the worst, and can look forward to a sustainable economic recovery, higher investment by cash-rich companies, and rising profit margins, then you’re in the latter camp. This view holds that stocks could go up simply because the economic fundamentals have changed in a material way, and investors might be prepared to pay a higher price for a claim on future profits.
But this view doesn’t stand up well to scrutiny if, like Dorothy arriving in Oz, you think “we’re not in Kansas anymore.” In other words, despite the improvement in the cyclical economic climate, many things still aren’t right. Many structural economic problems that have been accumulating for years persist. Foremost among these, are the cumulative effects of rising age structure, weak capital spending, stagnant real incomes, rising income inequality, lower labour force participation rates, and the significant substitution of low wage for middle wage jobs. The depths to which inflation has fallen means that many countries are perilously close to deflation, or falling average prices, and some like Greece and Spain are already there. This is an inauspicious environment for earnings and equity markets.
The surge case for equities rests on central bank policymakers in advanced countries sticking with their current stance, more or less, and on their peers in emerging markets avoiding a major clamp down on credit growth. For financial markets, bad economic news is good news if the outcome is more of the same monetary and liquidity policies. And conversely, good economic news is bad, if it really means that interest rates are going up. Those of us being tempted to join the equity fray would be well advised to remember that the case is based on money and momentum, not robust economic fundamentals. Caveat emptor.
George Magnus is an economist and author of “Uprising: Will Emerging Markets Shape or Shake the World Economy?”
“In China, the ratio of credit to GDP rose from 100 per cent before the financial crisis to 230 per cent in 2013... We know how this story will end”
© Bloomberg via Getty Images
Equity markets in developed economies had a second consecutive banner year in 2013 with markets up around 10-15 per cent in Europe, 25 per cent in the US, and about 50 per cent in Japan. Most strategists think that markets, which have been rising for five years, have further to go in 2014, with expectations of around 10-15 per cent for equity market returns. They may be right—or even too cautious—but if so it’s important to understand why, because stock markets are much less about robust economic fundamentals—the health of the economy according to particular indicators—than about how much cash is available. Central banks in the US, Japan, Europe and China are the largest providers of liquidity, and are therefore implicated in criticism that they are underwriting asset bubbles, including in equities. As we know, including from recent experience, asset bubbles always end badly. It’s only the timing that’s opaque.
You may well ask, therefore, how and why we are back here just about five years since the collapse of Lehman Brothers, after which there was a brief “never again” public debate demanding that in future central banks pay attention to asset, as well as consumer, price inflation. It was not to be. To understand why, we have to consider why loose money (expanding the money supply) has become part of the global financial furniture, and why, because of the legacy of the crisis, it is hard to jettison. Asset bubbles may be the new normal.
The problem of credit and debt
The basic problem in global finance, ever since the collapse of Bretton Woods, is that we don’t have a rules-based system to align the interests and responsibilities of creditor countries running external surpluses with debtor countries running external deficits. You can see the consequences of unbalanced and fractious creditor-debtor relations in the economic carnage in the eurozone. Clearly European institutions were not up to the task. In the global economy, the principal tensions over the last 30 years have been between the US and first Japan, and then more recently, China. Spats over trade and currencies have spilled over into competitive monetary easing and credit creation, in which equity markets have prospered for a while, but then shown that optimism was an illusion.
The Japanese asset bubble in the 1980s was in many ways the outcome of the tension over Japan’s trade and financial policies. When the US sought to regain competitive advantage by devaluing the US dollar in 1985 and easing monetary policy, Japan resisted by easing its own monetary policies and intervening to hold down the value of the yen, boosting domestic liquidity in the process. The Nikkei shot up from 12,000 in 1985 to almost 40,000 in 1989. At the time, the grounds on which the Emperor’s Palace stands in Tokyo were said to be worth more than all the real estate in California. But then came the collapse. More recently, Japan’s quantitative easing programme that started a year ago has helped to roughly double the level of the Nikkei compared with the all-time low of 8,000 in 2011.
China syndrome
The asset bubble in the 2000s had its roots in the aftermath of the Asian and Russian financial crises in 1997-8. Following Japan’s example, other countries in Asia with developing economies decided to focus on export-led growth and the accumulation of foreign exchange reserves. China, which escaped the Asian crisis, also prioritised export surpluses, high currency reserves—now totalling $3.6 trillion—and high levels of investment financed by cheap credit.
What emerged was, in effect, a vendor-based finance system, in which China sold increasing volumes of goods to the US, for example, and helped the US finance those purchases by providing credit through the purchase of US Treasury bonds. This is simple balance of payments accounting: China’s trade surplus has to be matched by capital exports, while America’s trade deficit has to be matched by capital imports. It is perverse, of course, that China, as a relatively poor country, lends its excess savings to a richer one, but that’s because of the structure of China’s economic model.
Under this mutually acceptable arrangement in the 2000s, and despite occasional arguments over trade practices and allegations of Chinese currency manipulation, everything that seemed to matter at the time went up: Chinese investment, exports and currency reserves, and US consumption. The Chinese stock market was a dull place in which to invest, but because interest rates and monetary conditions in the US and other western countries were easier than they would have been otherwise, US stock prices, for example, doubled between 1997 and 2007, albeit with a steep plunge in between related to the bursting of the technology bubble.
The 2008 financial crisis and economic aftermath ruptured this arrangement and pitted the US and China against one another in a sort of grab for growth. China’s response was to boost investment, especially in real estate and infrastructure, and credit creation. It also encouraged extensive financial innovation and growth in so-called shadow banking—non-bank financial intermediaries who provide services to banks—which facilitated a vigorous expansion of debt-financed investment. The US and other western countries, by contrast, embraced modest fiscal stimulus briefly in 2009, but relied heavily on unorthodox monetary measures, such as quantitative easing. Initially deployed to unblock the economy’s credit arteries, QE was then used for different reasons, namely to boost economic growth. With policy rates at or close to zero, the idea was to get longer-term interest rates to fall, so as to encourage risk-taking, boost asset prices, and lower capital costs for companies and investors.
The ripple effects of QE spread to emerging markets. US dollar capital flows boosted local asset prices directly and put upward pressure on emerging market currencies. Much as Japan and China had done before, emerging market central banks intervened to limit the rise in their currencies against a weak US dollar, boosting money and credit creation in the process. Since 2009, credit creation has surged in China, in the so-called “fragile five”—Brazil, India, Indonesia, Turkey and South Africa—and in the whole of developing Asia. Worryingly, this has occurred against a background of persistent downgrades in economic growth prospects in emerging countries. In China, the ratio of credit to gross domestic product (GDP) rose from 100 per cent of GDP before the financial crisis to 230 per cent in 2013, while underlying growth has fallen from 10 per cent to about 7 per cent, though it is likely to slide further.
We know how this story will end, though not when. Investors seem to sense that there is something not quite right with the emerging markets story nowadays. The immediate issue is that of bringing the credit genie back under control, especially in China. The People’s Bank of China and its peers will have to call time on the credit party eventually, but every time they get cold feet and back away, as happened in China in June and again in December, the green light for equity markets comes on.
More of the same in the West
Meanwhile, the Fed and other central banks will remain exceedingly cautious about “normalising” their monetary policy regimes. The Fed has begun to wind back its asset purchases but only gingerly. The Bank of England has suspended its own programme. The Bank of Japan is still in the process of doubling the size of its balance sheet. The ECB doesn’t do asset purchases in the same way, but all the central banks have made a public commitment to keep policy rates at zero for an extended period of time. Stock markets probably won’t have much to fear until or unless we get to the point where a rise in policy rates becomes a realistic prospect.
If and when that point arrives will be the subject of close scrutiny in 2014. Many people worry whether we can sustain growth when interest rates eventually rise, concluding that roughly zero policy rates will be with us for a long time. Leading US economist Larry Summers sparked a minor storm late in 2013 by suggesting that advanced countries might be succumbing to a period of “secular stagnation”. This notion holds that poor demand, combined with low interest rates, mean that price bubbles are the only way to stimulate economic growth and employment. He wasn’t recommending this, though, and warned that the policy agenda should be to pre-empt such an outcome.
So how bubbly are equities? Over the past year, about 75 per cent of the rise in global equity returns has come from a rise in the so-called price-earnings (PE) ratio, which is the multiple of a company’s share price relative to its earnings per share and is a measure of how expensive they are. The global PE ratio is now around 15, which is about average for the last 25 years, excluding the dot com bubble in 2001. Whether that’s bubbly depends on your perception. It’s at the top end of a range of 10-15 that has prevailed since 2008, and therefore looks quite rich. But it is only at the bottom of a range of 12-25 that spans most of the last quarter of a century.
If you think we have now left the financial and economic crisis, that banks are lending and the Eurozone is past the worst, and can look forward to a sustainable economic recovery, higher investment by cash-rich companies, and rising profit margins, then you’re in the latter camp. This view holds that stocks could go up simply because the economic fundamentals have changed in a material way, and investors might be prepared to pay a higher price for a claim on future profits.
But this view doesn’t stand up well to scrutiny if, like Dorothy arriving in Oz, you think “we’re not in Kansas anymore.” In other words, despite the improvement in the cyclical economic climate, many things still aren’t right. Many structural economic problems that have been accumulating for years persist. Foremost among these, are the cumulative effects of rising age structure, weak capital spending, stagnant real incomes, rising income inequality, lower labour force participation rates, and the significant substitution of low wage for middle wage jobs. The depths to which inflation has fallen means that many countries are perilously close to deflation, or falling average prices, and some like Greece and Spain are already there. This is an inauspicious environment for earnings and equity markets.
The surge case for equities rests on central bank policymakers in advanced countries sticking with their current stance, more or less, and on their peers in emerging markets avoiding a major clamp down on credit growth. For financial markets, bad economic news is good news if the outcome is more of the same monetary and liquidity policies. And conversely, good economic news is bad, if it really means that interest rates are going up. Those of us being tempted to join the equity fray would be well advised to remember that the case is based on money and momentum, not robust economic fundamentals. Caveat emptor.
George Magnus is an economist and author of “Uprising: Will Emerging Markets Shape or Shake the World Economy?”
