Are cheap dollars inflating a new bubble?

ANALYSIS:Asset rises, particularly in emerging markets, might be paving the way for another bust, writes PROINSIAS O'MAHONY

OIL PRICES, up 77 per cent this year; gold, up more than 25 per cent; commodity indices are up by 50 per cent while the commodity-driven MSCI Latin American Index has nearly doubled.

Chinese house prices rose by almost 4 per cent in October, the fastest in 14 months, Hong Kong home prices have risen by 28 per cent this year and Singapore home prices rose by almost 16 per cent in the third quarter, the fastest rate since 1981. The US dollar, meanwhile, continues its seemingly inexorable downward journey.

According to Nouriel Roubini, the iconic economist credited with predicting the global financial crisis, the dollar’s decline is inextricably linked with the aforementioned asset rises. Roubini has been warning that investors are sowing the seeds of the next financial crisis by engaging in the “mother of all carry trades” – that is, by borrowing dollars at near zero interest rates and investing in higher-yielding assets across the globe.

“Everybody’s playing the same game and this game is becoming dangerous,” Roubini said. A flood of liquidity is driving markets higher and carry traders have been further emboldened by the Federal Reserve’s recent promise to keep rates “exceptionally low” for an “extended period”.

Eventually, however, an undervalued dollar will snap back, probably by “25 or 20 per cent”, everybody will have to “close their shorts on the dollar, they’ll have to sell these risky assets across the world and you could have this huge asset bubble going into an asset bust”.

Carry trades are nothing new. For years, investors borrowed cheap money in Japanese yen, fuelling asset bubbles globally. That trade was rapidly unwound last year as investors fled from risk and the ensuing liquidation of positions exacerbated the prevailing sense of financial chaos.

Few doubt that the dollar has replaced the yen as the vehicle of choice for carry traders. “Game on for the carry trade,” said Barclay’s analyst Barry Knapp in the wake of the Federal Reserve’s recent statement on interest rates. Dean Curnutt of Macro Risk Advisers, meanwhile, noted that the correlation between the dollar and other assets rose to more than 50 per cent in September and October, up from about 30 per cent between January and September. In other words, all assets are increasingly “driven by the giant dollar carry trade”.

That doesn’t guarantee another teary boom-bust tale, however. Many, like Goldman Sachs, who predict sizable gains for commodity indices next year, believe recent gains to be fundamentally justified.

Investment legend Jim Rogers is particularly dismissive of the notion of asset bubbles, prompting a war of words with Roubini in the process. “It’s not a bubble if something is up 100 per cent this year, but down 70 per cent from its high,” Rogers said. “That’s not a bubble, that’s a good year. That’s a great year. Maybe it’s too high for this year, but that’s not a bubble,” said Rogers. He noted that Chinese stocks and commodities like oil, coffee and sugar remain well off their highs.

Equity valuations, while appearing stretched, aren’t at bubble levels. The Dow Jones remains approximately 30 per cent below its 2007 high. Cyclically adjusted price-earnings ratios, generally regarded as the most reliable long-term valuation measure, suggest US equities are over-valued by as much as 25 per cent. Similar over-valuations have persisted over the last two decades, however, and most bears envisage a correction rather than a crash.

Even red-hot emerging market stocks in Asia trade at approximately two times their book value – the average for the last 20 years, and well below the 3 to 1 price-to-book-value average that prevailed between 2004 and 2008. The fact that so many institutional investors have been suspicious of the rally off the March bottom, coupled with sentiment surveys that have constantly revealed no major bullishness among ordinary investors, suggests that the current equity environment is not characterised by bubble-like exuberance.

Where there is clear evidence of froth, however, is in Asian property markets. The IMF is concerned that roaring Hong Kong asset price rises are being induced by easy money and are “divorced from fundamental forces”. Authorities in South Korea, Singapore, Hong Kong and Taiwan have all recently either introduced restrictions on property loans or made noises about doing so in order to rein in exuberance.

In China, banks made new loans of 8.67 trillion yuan (€850.2 billion) in the first nine months of this year, 75 per cent more than in all of 2008. RBC Capital markets recently cautioned that “easy liquidity” was “overheating” the property market. Rating agency Fitch regards China as “the most obvious area of concern” due to potential banking frailties, while geopolitical intelligence outfit Stratfor is blunter still. It warns that the Chinese property market is “a burgeoning bubble that is growing bigger and more breakable by the day”.

Chinese equities, too, are attracting liquid investors. Chinese companies have raised $21.9 billion (€14.7 billion) in initial public offerings this year, four times the combined amount raised by US and European issuers. Another $14 billion (€9.4 billion) in Asian equity offerings is coming in the following weeks.

Despite a rise of more than 85 per cent this year, few commentators believe emerging market stocks to be in bubble territory. Notably, however, many expect this to change over the following 12-18 months.

“I have been involved in this area for 30 years and I have never seen such an increase in institutional interest in emerging markets,” said Allan Conway of Schroders Investment Management. “If there’s going to be a bubble it’s likely to be in emerging [markets].”

Investment manager Jeremy Grantham echoes that, saying a new bubble “will suck in the money and it will go higher and higher”. London School of Economics (LSE) professor Willem Buiter last month predicted a “credit and asset market boom, bubble and bust” for the rapidly growing emerging markets. A boom-bust is not “inevitable”, Buiter said. “It is a policy choice”.

Already, Brazilian authorities have tried to cool down their currency and asset markets by limiting foreign capital inflows through the imposition of a 2 per cent tax. Governments around the world remain in stimulus mode, however, fearful that any retreat will jettison economic recovery, while the US Federal Reserve has confirmed that it is more concerned with a deflationary relapse.

Official policy, according to Roubini, is a disaster in the making and will eventually lead to “the biggest co-ordinated asset bust ever”. Another prescient market call or evidence that Roubini is a one-trick pony trading on his ‘Dr Doom’ moniker? In fairness, Roubini acknowledges that most assets are not actually at bubble levels. Whether the current “wall of liquidity” chasing global assets will change that will become clearer in the coming 12 months.