CHEAP CREDIT AND INFLATED ASSETS
Tharindra Gooneratne wonders where in the world the next market bubble might come from
Three interesting facts stand out when reviewing this year’s economic data: firstly, real estate prices in San Francisco are at historic highs – nearly 40 percent above their long-term average; secondly, US household debt is at record levels; and thirdly, legendary investor Michael Burry is predicting an impending crash in financial markets.
That’s because there’s an eerie similarity between today and incidents that occurred a decade ago at the edge of the Great Recession. There’s another similarity between the two periods: the world is again awash with cheap credit. Over US$ 10 trillion of debt currently trades at negative interest rates, a phenomenon that was not witnessed even at the peak of the pre-recession boom.
A side effect of excess liquidity and rock-bottom interest rates has impacted the risk return tradeoff. Low rates have seriously depressed investors’ cost of capital, which has pushed valuations of several asset classes beyond sustainable levels. Of these, the bubble in global equity markets has been extensively covered by numerous analysts.
But how about the two other asset classes that are overpriced and at risk of major price depreciation?
Former Federal Reserve Chair Alan Greenspan recently commented that “we are experiencing a bubble not in stock prices but bond prices.”
For example, the 10-year US Treasury bond that yielded above four percent before the financial crisis currently yields below 2.5 percent (lower yields correspond to higher bond prices). These low yields are mainly driven by unprecedented bond buying programmes initiated by central banks globally. It’s estimated that currently, the Fed is the single largest holder of US federal debt, accounting for 15 percent of total outstanding debt. Similarly, the Bank of Japan and Bank of England have become their respective governments’ largest debt holders in the post-crisis era.
As developed markets enter the beginning of the inflation cycle and central banks start unloading bonds worth trillions of dollars that have been accumulated over time, a correction in bond prices is inevitable. And the speed and magnitude of this correction will determine the overall impact on financial markets, and the broader global economy.
An even more dangerous bubble is taking shape in the global junk bond market, which has benefitted in no small measure from lower interest rates.
The total value of junk bonds in issuance has doubled from 2010 levels and is currently estimated to be over two trillion dollars.
With energy companies accounting for about a fifth of high-yield issuances, continuously depressed crude oil prices pose a serious risk to the high-yield market. In addition, rising interest rates are expected to increase corporate default rates over the coming years, adding even more pressure on junk bonds.
A decade after being shunned as ‘the asset that led to the crisis,’ real estate has once again become a leading choice of investors across the world. According to Global Property Guide, 18 of 23 major European housing markets witnessed a boom last year with global real estate funds recording double digit returns. In the US, prices of over a third of houses have appreciated to pre-crisis levels and commercial real estate loans recently topped three trillion dollars for the first time in history.
Going forward, rising mortgage rates are also expected to have a direct bearing on defaults in the US and subsequently on overall housing prices. This problem is exacerbated by the fact that millennials (who are more sensitive to interest rate changes due to lower income levels) are estimated to have accounted for 40 percent of new home purchases since 2008.
Another significant headwind for commercial real estate has been propelled by e-commerce; 147 million square feet of retail floor space is expected to become vacant this year as a result of mall closures in the US, whichis the size of 2,500 football fields.
According to the Financial Times, the impact on the real estate market as a result of such closures could be larger than that created by subprime loans during the financial crisis of a decade ago.
In addition to bonds and real estate, two other assets that have ballooned in recent times are loans for automobiles and student debt.
Driven by low interest rates, subprime automobile loans have peaked to pre-crisis levels. More worryingly, over six million people in the US are currently late on their car loan repayments. As for student debt, the average student has US$ 37,000 of debt in the US and over 55,000 dollars in the UK. In the US alone, total student debt is 1.4 trillion dollars and almost 15 percent of borrowers are currently in default.
Will the collapse of one or more of these asset classes spark another great recession?
Perhaps not, given that financial institutions today are much better capitalised and have more stringent risk mitigation techniques in place.
The more important question is which of these bubbles will burst first when central banks decide to pull the plug on cheap credit?
Unfortunately, that is anybody’s guess.