Tuesday, October 6, 2009

Is The Next Bubble Unavoidable?

Before I discuss my latest topic, a follow-up note on my last comment on private equity. I spoke with a senior private equity pension fund manager this morning (great guy who really knows his stuff) and he told me the secondary funds are not doing as well as you'd think.

I was surprised given that many endowments, pension funds and insurance companies are looking to unload some private equity stakes. He told me that the "bid-ask spread in the secondary market is too high". He was waiting for some correction in the markets to see if they come in.

He also told me that the days of loading up debt to the max are over. "More and more private equity deals are being done with a lot less leverage." He added "there is no more rising tide" to reward you for taking on leverage.

According to him, many GPs are scared to death that LPs will not be able to meet their capital calls. I told him that private equity is better than real estate, but it will take some time before it recovers.

One thing that scares him (and me) is the influx of sovereign wealth money from China and other places coming into private equity. If they start bidding deals up then valuations will get all out of whack.

That gets me into my latest topic. On Monday, the first rate hike marked a shift, igniting markets:

Australia broke ranks with other industrial economies Tuesday in a policy reversal that sets the stage for other central banks to follow suit, as they, too, become more concerned with preventing an outbreak of inflation than propelling economies out of recession.

The Reserve Bank of Australia boosted its key lending rate by a quarter of a percentage point to 3.25 per cent, and Governor Glenn Stevens signalled that further hikes could follow.

The move reverses a series of sharp cuts made in the wake of the collapse of Lehman Brothers last September and the ensuing credit crunch that slammed strong and weak economies alike and brought international trade, Australia's lifeblood, to a near standstill.

The central bank's unexpected move was widely viewed in the markets as a confirmation that the global economy is on the mend. Investors rushed into the Australian dollar and other commodity-based currencies, including the loonie.

Gold climbed to a record $1,043.20 (U.S.) an ounce and the U.S. dollar plunged, as less-fearful investors rowed away from what they had considered a safe harbour in uncertain waters.

The key question now is whether other central bankers looking at stabilizing employment and brightening growth prospects will similarly move to reverse historically loose monetary policies.

Rumors are that Norway's central bank will also raise rates. But there is no chance that the Fed or the Bank of Canada will raise rates anytime soon. The Canadian dollar surged following the Australian rate hike and Bank fo Canada has already repeatedly expressed its concern over the rising loonie.

As for the Fed, they're in no hurry to lift the fed-funds rate. With the US dollar depreciating and interest rates next to zero, financial conditions remain very accomodative. In my opinion, the Fed will wait to see unemployment falling a full percentage point before considering raising the key rate. And that won't happen until mid 2010 at the earliest.

Of course, growth could surprise to the upside, especially in a V-shaped recovery, and that will force central banks around the world to carefully coordinate the gradual withdrawal of all that stimulus.

In the meantime, stock markets will continue to grind higher. I have seen this all before. Stocks typically surge at the initial rate hikes as they see this as confirmation of global economic recovery. Will it go parabolic from here? Who knows?

Reporting for the Business Insider, John Carney writes Is The Next Bubble Unavoidable?:

The Federal Reserve is now faced with a challenge that is akin to threading a needle by throwing a spool of thread across a football field.

It is attempting to keep loose money and quantitative easing policies in place long enough not to stymie the nascent recovery while pulling them back in time to avoid massive inflation. It's a Hail Mary pass with an impossibly small target while facing a blitz.

In today's Wall Street Journal, Nouriel Roubini and Ian Bremmer lay out a series of policy prescriptions for how they think the Fed might be able to avoid creating another dangerous asset bubble without triggering a double-dip recession. They are very clear that this is an enormously difficult task--but even their assessment might be too optimistic.

Here's the problem. They agree that the operations of the Federal Reserve need to be subject to political review because it is clear that the New York Fed has been captured by Wall Street. The Fed's worries about its independence being compromised make no sense when it seems that its independence is already compromised to the our powerful financial firms.

But Congressional oversight is likely to result in pressure to keep monetary policy too loose for too long. Pulling back on easy money when the financial system recovers but the real economy is still shaky, will elicit howls of protests from politicians whose constituents are still out of work, loosing their homes and seeing their credit lines closed. There will be intense political pressure to repeat the "fateful mistake" of the last recession, keeping monetary policy too easy for too long.

Roubini and Bremmer's way out of this trap is to recommend better supervision of banks, including the creating of a new insolvency regime for the most important financial institutions and better capital requirements. This too is harder than it looks. Politicians, especially in Europe, are more attracted to regulating banks through regulating pay than the complex and costly job of reforming capital requirements. And policies that regulate 'too big to fail' institutions run the risk of creating the impression of a government guarantee.

Is there are way out? Unfortunately, the way out may be the way back. The government, including the Fed, need to restore the credibility of market processes by letting a too big to fail institution go insolvent. In short, we need another Lehman. And a policy that depends on failure to succeed is certainly not a happy one.

I quote the following from Ian Bremmer's and Nouriel Roubini's article in the WSJ, How the Fed Can Avoid the Next Bubble:

As for the exit from monetary easing, the Fed must learn from the fateful mistake it made after the 2001 recession. Then, the central bank cut the federal-funds rate too much and kept it too low for too long. It also moved far too slowly when the normalization occurred—in small increments of 0.25% from summer 2004 until the summer of 2006, when it peaked at 5.25%. Normalization took two full years. It was in that period of slow normalization that the housing, mortgage and credit bubbles spiraled out of control. The lesson learned: When you normalize, move rapidly, or prepare for another dangerous bubble.

Of course, this is easier said than done. From 2002 to 2006, the Fed moved slowly because the recovery appeared anemic and because of significant deflationary pressures. This time around, the recession is more severe—unemployment is at 9.8% and is expected to peak above 10%, and we are experiencing actual deflation. Therefore, the incentive not to exit too soon will be greater and the risk of creating another bubble is greater. Indeed, the sharp increase in the stock market and commodities, and narrowing of credit spreads since March, are partly due to a wall of global liquidity chasing assets and already causing asset inflation.

If the conflict between economic growth and financial stability requires that monetary policy remain loose, then it is critical that the supervisors and regulators of the banking sector move aggressively to prevent another bubble from emerging. Thus they should quickly adopt the regulatory reforms agreed to by the G-20—including a new insolvency regime for financial institutions deemed "too big to fail," a serious approach to limiting "systemic risk," and appropriate rules governing incentives and compensation for bankers and traders.

Good luck. I see more bubble trouble on the way. Risk assets are being bid up all over the world as investors look for higher yields. I already spoke about overheating in Brazil but another stock market bubble is happening in India (hat tip Fred):

India’s stock market recovery over the last six months is a bit too remarkable for comfort. From its March 9, 2009 level of 8,160, the Sensex at closing soared and nearly doubled to touch 16,184 on September 9, 2009. This is still (thankfully) well below the 20,870 peak the index closed at on September 1 2008, but is high enough to cheer the traders and rapid enough to encourage a speculative rush.

There are two noteworthy features of the close to one hundred per cent increase the index has registered in recent months. First, it occurs when the aftermath of the global crisis is still with us and the search for “green shoots and leaves” of recovery in the real economy is still on. Real fundamentals do not seem to warrant this remarkable recovery. Second, the speed with which this 100-percent rise has been delivered is dramatic even when compared with the boom years that preceded the 2008-09 crisis. The last time the Sensex moved between exactly similar positions it took a year and ten months to rise from the 8,000-plus level in early 2005 to the 16,000-plus level in late 2007. This time around it has traversed the same distance in just six months.

Forget fundamentals. Hedge fund flows, investment banking flows, sovereign wealth fund flows, pension flows, and retail speculation will drive equities and other risk assets much higher. How long can it last? Remember the famous quote from John Maynard Keynes: "The market can stay irrational longer than you can stay solvent."

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