FYI | Nov 14 2006
“The place where optimism most flourishes is the lunatic asylum.” – Havelock Ellis.
Market strategist Doug Noland has been tracking the credit bubble for some time. (Debt market bulls, look away now.) According to Bloomberg, US corporate bond sales hit a record ($677 billion) in early November. According to ratings agency Standard & Poor’s, defaults on international high yield, high risk bonds fell to a record low in September.
Paul Davies and Gillian Tett for the Financial Times recently pointed out that the cost of buying credit protection has also fallen to its lowest ever levels – blame either bullish views on debt, or protection selling related to structured products. Either way, the figures are eye-watering. US bank credit year-to-date has expanded by $629 billion or an annual rate of 10.1%.
The year-to-date tally for loans and leases swelled by $492 billion (10.9%). US real estate loans are up on average by 15.7%. Money fund assets in the US have grown by $208 billion (12.0% annualised) and total commercial paper is up by $259 billion (also 12.0%). According to Bloomberg’s Alex Tanzi, international reserve assets (excluding gold, which can’t be conjured into existence by means of simple financial alchemy) are up by $636 billion year-to-date or 18.6% annualised, to a record $4.7 trillion.
Notwithstanding US base rates at 5.25%, the world is drowning in easy money. From an inflationary perspective this would be problematic even without US labour market data – as Doug Noland points out, the US unemployment rate, at 4.4%, is now lower than the 5.6% rate that pertained when the Federal Reserve started its tightening cycle back in June 2004. And corporate profits remain hugely impressive. S&P 500 earnings are currently 23% above those for Q3 2005. Doug Noland also points to the tell-tale strength of financial sector profits – what he views as prima facie evidence of “a Prevailing Inflationary Bias”. This is not a call for an imminent correction in credit spreads or overall market conditions.
Credit bulls might simply wish to ponder how long this extraordinary rally can last. In US real estate markets, of course, the party is over. According to Mizuho strategist Patrick Perret-Green, 63% of US bank assets comprise real estate – a record high. One’s exposure to financial services stocks, therefore, should be very selective. less rather than more desirable, particularly when new supply is overwhelming. The mundane reality is that with the world awash with liquidity, discernment tends to get put to the sword, leaving the field to undiscriminating capital. If the past is any guide, a very limited number of hot money funds will be able to cash in at the market top, leaving the avalanche to take down spurious market sophisticates and the lazy or uninformed economic agents who simply went along for the ride.
The etymology says it all. The innocuous-looking ‘credit’ has its origins in the Latin word for trust and belief. The cynical might suggest that, given the current state of the credit cycle, a historical association with the source of the adjective ‘credulous’ is also highly appropriate; in the context of the global credit market, investors seem touched by a desperate eagerness “to believe on weak or insufficient grounds”.
Scour the world, and you still won’t find evidence of rising risk aversion. Yet. At the time of writing the VIX Index, a market estimate of future volatility culled from Chicago-traded S&P 500 contracts, was hovering just above new all-time lows. Ditto the MOVE Index, a yield curve weighted index of implied volatility on US Treasuries. Ditto the EMBI+ Index of emerging market debt spreads. Put to one side the fact that investor psychology tends to win out over rationality – all things being equal, higher prices should make financial assets
But the other lesson from the last major financial market bubble is that, as Keynes famously observed, markets can remain irrational longer than you can remain solvent. Calling a market top is a fool’s errand. Almost perversely, even after the sustained rally of the last three years, some major markets still feel reasonably rather than excessively priced, and western equity markets are among them. This time round we seem to be caught in a slow and insidious bubble of general credit distortion. Last week saw European short yields rise above 10 year yields – a situation historically associated with recession. Yield curves in the UK and US are also inverted, the UK’s having been for some time. But perhaps abnormally low long term yields owe less to fears of imminent economic slowdown than they do to excess global liquidity and some fairly undiscriminating institutional buying from managers with no personal skin in the game. Say what you like about supposedly grasping hedge fund partners – when it all goes sour, they do tend at least to go down with their own ship. How many managers of bond funds can claim to be co-investors alongside their customers ? Investing into expensive markets without conviction isn’t so different from playing roulette with someone else’s money.
It seems increasingly likely that we’re trapped in a global credit bubble. For those investors who aspire merely to survive rather than thrive in such an unforgivingly speculative environment, the answers include asset class diversification; a concentration on quality assets; and extreme, bottom-up selectivity. One could of course go along for the ride, but not everyone gets out of this room alive.
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(FN Arena thanks Tim Price for his kind permission to re-publish his column on our service).