Current asset price bubble more likely to deflate slowly

Serious Money: The current malaise in bond markets is having inevitable knock-on effects on other important asset markets, not least equities.

As US interest rates continue their slow but inexorable climb back to more normal levels, all of the investments that were spawned by ultra-easy monetary policy are gradually being unwound.

The only surprise in all of this is that word "gradually". Pundits of the more gloomy persuasion have long argued that abnormally low interest rates - which were (and, to an extent, still are) pretty much a global phenomenon - have given rise to an asset price bubble. And, so the argument goes, like all asset price explosions, this one will end messily.

But, so far at least, the air is coming out of the bubble relatively slowly. Bond prices have fallen reasonably slowly, credit spreads on corporate and emerging market debt have widened a touch and equities have dropped marginally.

Most importantly, while the dollar has been weak, there have been few signs of a sudden withdrawal of the global capital necessary to finance the US twin deficits.

Unlike the great stock market bubble of the late 1990s, this more recent bout of market madness is not restricted to a singe asset class. All types of bonds have been affected and it is probably still true that investors in, for example, high-risk bonds are not being rewarded for those risks: bond prices remain too high. The only question is whether or not the gradual price-fall gathers speed.

Of course, the asset class that has had the most visible price inflation is property. A phenomenon that used to be restricted to the English-speaking world has now spread to many parts of Europe and is also popping up in other unexpected places.

The inflation vigilantes at the ECB have noticed this and have muttered dark warnings about the awful consequences of further property price rises.

Markets now think that the ECB could join the rate-rising posse of central bankers sooner rather than later, notwithstanding ever-increasing unemployment in euroland's three largest economies.

The last time US interest rates went up a lot - in 1994 - equities fell, but not by very much. Once rates peaked, equities began a prolonged upward climb.

Whether or not stock markets can be as immune to rising rates this time around rests on the speed with which US rates rise. This will depend on the inflation numbers, which are beginning to deteriorate.

Last year, all the analysis of higher oil prices focused on the growth consequences: nobody thought that inflation could be a problem. This time around, there will be more focus on inflation. There are two key points to note here.

First, all of the rate worries are focused on the US: European rates cannot rise by much, for obvious reasons.

Second, the best that we can expect is that US equities repeat the 1994 experience: they are likely to move sideways at best, down at worst.

An obvious conclusion to draw here is that US assets, of all types, are best avoided until we can be more confident about the likely peak in rates.

For as long as markets fret about the ultimate extent of the current rate cycle, we are likely to see equities, as well as bonds, come under pressure. The potential for increased volatility and exaggerated movements in prices should be obvious.

European markets will not be unaffected by all of this of course, but should continue to outperform their US counterparts.

Asian markets will be least affected but no investor should need reminding that all markets are bound together to an increasing extent.

If all of this adds up to a difficult - but not disastrous - environment for stock markets, it might be reasonable to assume that indices have already seen their best levels for the year.

At the very least, it is hard to see much optimism returning to equity markets until that peak in interest rates is clearly visible - and the collateral damage that will accompany higher rates is seen to be minimal.

Some pundits have argued that we are seeing the start of a longer-term trend: both bonds and equities are likely to return only small amounts to investors for many years to come, not just this year.

The years of double-digit returns from stocks, in particular, are over. Equities do spectacularly well when they start from a point of serious undervaluation and/or they go through a period of much-better-than-expected profits growth.

The "low returns" argument rests on the belief that valuations are still far from being cheap, particularly in the US, and that the best period of profits growth is now behind us, at least for the current cycle.

All of this makes a lot of sense. It is still right to expect positive returns from equities but wrong to expect too much. At the overall market level, the best expectation is for single-digit returns. At the individual stock level, there will still be more opportunities to make (and to lose) lots of money: sectors and stocks are likely to move around by much more than the overall market.

For investors, this makes the business of stock (or fund manager) selection even more important. When markets were going up a lot, it was relatively easy to look good.

A few fund managers did well by simply adopting the practice of closet indexing: by buying a basket of stocks that reflected a broad market index like the S&P 500 or FTSE 100, lots of money could be made when markets were trending strongly upwards.

But, in a world of low returns, such practices are being thrown in to an unforgiving light.

Index - or passive - investing can be achieved at low cost by specialist managers. Active managers can no longer hide behind the index: they have to take the risks that justify their higher fees.

All of this explains the rise of hedge funds, private equity and other aspects of a rapidly changing investment business.

The prospect of low returns challenges us all to find - and exploit - profitable niches. Simply sticking a few quid in the market will no longer do.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.