The Fed is Blowing Bubbles
The market rally that began last November continued in Q1 as global economic growth and earnings accelerated. Fears of recession have faded causing investors to pile back into risk assets, pushing up prices. This trend should continue until there are signs that inflation will remain sticky and therefore interest rate cuts are unlikely to materialize. We expect this will become clear in the second half of 2024, at which point valuations will once again come under pressure, as they did in 2022 when interest rates spiked.
HIGHER FOR LONGER
Last quarter we focused on why investors should expect inflation and interest rates to stay higher for longer. At the beginning of 2024, the expectation was for the Fed to cut interest rates by 1.5%. It appears the consensus has begun to shift towards our view, as they are now forecasting just 0.75% rate cuts, in-line with the Fed’s own estimates. Why the market continues to follow Fed forecasts is baffling, given their recent track record. Not only can they not forecast inflation, but they are also slow to react to data as it comes in. Back in March 2021, inflation already hit 4.2% but their projection was the first rate hike would take place in 2024! One year later (March 2022) as inflation hit 8.5%, they did their first rate hike.
We believe any Fed rate cuts at this point would be a policy mistake. That said, they seem determined to cut despite ongoing strong economic growth and record low unemployment. One possible deterrent is the upcoming US election, as the Fed could be wary of taking action for fear it would be politicised. Another is when they realize inflation will be sticky, which we believe will become apparent in the second half of 2024. This is because the recent decline in inflation was driven by falling goods prices, which surged during the pandemic but have now returned to historical averages. As seen in the chart below, to get inflation down further we would need service prices to fall. Unfortunately, they moved up recently and are unlikely to fall until we get a recession.
Regardless of what happens in the short-term, it is clear Central Banks are biased towards lower interest rates. This is a result of persistent deflation last decade and was outlined in more detail in our Q4 2022 Newsletter. This tendency will persist until the consensus fully capitulates to our view of higher for longer interested rates. Since that was already discussed at length, our focus for this newsletter is how keeping interest rates below what is economically necessary creates fertile ground for asset bubbles and how investors should respond.
INFLATING A BUBBLE
While every bubble is unique, there are three key elements you need to create a bubble:
- Story: The foundation of all bubbles is a strong narrative. A story that is rooted in truth and captures the imagination of investors. As prices begin to rise, it attracts attention from outside investors and acts as confirmation the story is true. At this point, rising prices are justified.
- Liquidity: To inflate the bubble, we need a large supply of cheap money. This is typically a result of artificially low interest rates. The lower they are and longer they stay there, the bigger the resulting bubble. This is common in the aftermath of a significant crisis or recession, where policymakers unleash massive stimulus to stem the fallout but end up creating fertile ground for new bubbles.
- FOMO: At this point investors throw caution to the wind, eschew traditional valuation metrics and convince themselves it’s rational because “this time is different”. Best epitomized by fear-of-missing-out (FOMO), investors are willing to pay any price to get in on the action. This leads to the final stage of a bubble, when prices go exponential and completely detach from reality.
BURSTING A BUBBLE
Unfortunately, what goes up must come down. Most investors who get caught-up in a bubble are blissfully unaware as it can be hard to identify a bubble when you’re in it. Those who are aware might try to ride the momentum and get out before the bubble bursts, but timing the peak is nearly impossible and extremely risky.
We prefer to focus on identifying bubbles so we can avoid them entirely. Bubbles inevitably attract attention from the masses, causing them to miss opportunities elsewhere. We are finding lots of attractive long-term investments currently being overlooked by the consensus that we’ve discussed before and summarize in our portfolio strategy section. Now, let’s focus on the phases of a bursting bubble:
- Correction: The catalyst for the initial correction varies widely but is usually policy induced. Central banks raising interest rates or governments taking action to reign in rampant speculation.
- Bounce: Falling prices initially brings in new buyers, who missed out on the initial speculative mania and were waiting for a chance to buy-in. Existing investors view it as an opportunity to add exposure by buying-the-dip.
- Crash: The post correction bounce typically fails to reach new highs as the correction phase sowed the seeds of doubt in existing investors, who begin to take profits. Unfortunately, the pool of new buyers is limited as investors realize that valuations have dramatically overshot fundamentals. This phase is rarely a straight line down and often experiences brief counter-trend rallies. There is usually one significant rally that sucks some investors back in before prices roll over once more, collapsing to fresh flows.
- Revulsion: The crash ultimately ends when valuations fall below fundamentals, which is typically before prices first went exponential. At this point, the investment tends to perform in line with the broad market. Bubbles are far less likely as investors adopt a “never again” attitude towards the asset they once adored. As memory fades and a new generation of investors gain prominence, the probability of new bubbles rises once more.
Now that we have a framework for the various phases of a bubble, let’s look at some historical examples.
HISTORY'S BIGGEST BUBBLES
History is riddled with examples of financial bubbles. One of the earliest was Tulip Mania, which peaked in February 1637 when some tulip bulbs sold for more than 10x the annual income of a skilled artisan. If you think a tulip bulb being worth as much as a house is crazy, it’s not even the biggest financial bubble in history, which peaked just 3 decades ago in Japan. This bubble was so massive, Japanese stocks fell 80% in the following decade and only recently achieved new highs!
It began with reconstruction efforts in the aftermath of WWII. Their success led academics, international businesses and investors to believe Japanese knowledge, work ethic and culture was economically superior and would lead them to become the next great superpower. As the US struggled with inflation in the 1970s leading to high interest rates and stagnating growth, international investment capital flowed into Japan driving up prices. This supported the Yen which kept import costs down, capping inflation which allowed the Bank of Japan (BoJ) to keep interest rates artificially low. This fueled a speculative frenzy which led to some truly staggering statistics by the bubble’s peak in 1990:
- Japan’s land value was 4x that of the US despite being 25x smaller.
- The grounds of the Imperial Palace alone were estimated at more than all Canadian real-estate combined.
- Trailing Price/Earnings on Japanese stocks exceeded 60x.
Eventually rising inflation forced the BoJ to materially increase interest rates causing the bubble to burst. This caused a massive deflationary shock that drove down global interest rates and sowed the seeds of US dot-com bubble.
The pace of development in Silicon Valley at the time had already created a strong investment narrative. Liquidity from lower interest rates and a flood of capital exiting Japan was like pouring gasoline on a fire. As prices rose it generated a media frenzy, envy inducing stories of everyday people getting rich, growing interest among the general public and “new era” theories to justify excessive valuations (i.e. FOMO). Tech stocks soared 12x through the 1990s before peaking in March 2000, at which point the NASDAQ plummeted 78% by October 2002.
THE BUBBLY 2020s
We’re only 4 years into this decade, yet we’ve already seen multiple asset bubbles. The reason is that the three key elements to create a bubble have been in overabundance. The shift to online communication and social media has made FOMO inducing storytelling commonplace. Meanwhile, the pandemic caused central banks and governments to unleash record amounts of stimulus. With everyone locked down there weren’t many things to spend this money on, so the majority flowed into asset prices inflating bubbles in real-estate, cryptocurrencies/NFTs, growth/innovation stocks, particularly those benefiting from the pandemic driven switch to remote living.
The initial surge in inflation and interest rates burst these bubbles. Unfortunately, it appears central banks have pre-maturely declared inflation dead. They have begun to broadcast interest rate cuts at a time where the global economy is already strong. This is particularly true in the US, Eurozone and emerging market economies which have significantly less consumer debt making them less sensitive to higher interest rates. As a result, bubbles in cryptocurrency and US technology (particularly AI) have re-emerged.
PORTFOLIO STRATEGY
It’s always possible the current bubbles inflate further, but as you’ve seen in this newsletter investing in them is a very risky game to play. Timing the different phases only appears obvious with the benefit of hindsight. We prefer to avoid bubbles entirely and focus on creating a diversified portfolio of investments at reasonable valuations that are not reliant on low inflation and falling interest rates. These include short-term/floating rate debt, value stocks, Europe, Japan and emerging market equities.
Our hope is that by providing a framework to understand the lifecycle of bubbles, you’ll be able to avoid their devastating impacts. It’s easier to identify bubbles when you’re on the outside looking in, so if you think a friend or family member is caught up in one, consider sending them this commentary