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Michael Baxter

Bull and bear: Has the Fed created a new asset bubble?

Written by: Michael Baxter on December 14th 2012

Category: Bull & Bear, News

Bull and Bear – an optimistic and pessimistic view of investment news. Today’s stories: Has the Fed created a new asset bubble? China sees another lift. Standard and Poor’s warning. Japan’s improved performance causes it to fall into recession. Companies in the news: John Wood Group, RWS, BG Group

Has the Fed created a new asset bubble?

The thinking seemed to make sense. Get asset prices up, and households, corporates and banks would feel more confident. Consumers would spend more, companies would invest more, and banks would lend more. At least that’s what central banks hoped that QE would achieve.

Well, the first part of that plan has worked. According to Capital Economics, back in March 2009 the cyclically-adjusted price/earnings ratio of the S&P 500 was around 14. Right now it is 21.

Or take the spread between BBB-rated US corporate bonds and treasuries, with between 7 to 10 years to maturity. It has fallen by 66 per cent. To put it another way, in March 2009 it was three times greater than it is now.

So, yes, QE has pushed up asset values. It may have also pushed up asset values we didn’t want to rise, such as oil.

Alas, the other bit has not occurred. Corporates are still sitting on mountains of cash, individuals are still scared to spend like they used to, and banks are reluctant to lend.

So that may be the worst possible scenario. Central banks may have created the conditions for the formation of a new bubble, without even being able to create an economic recovery. That is a  rare achievement: simultaneous boom and bust.

Yesterday, Capital Economics asked the question: Is the Fed sowing the seeds of the next financial crisis?

The good news is that certain things may occur to stop asset prices shooting up much further. For example, the Eurozone crisis may deepen, and end in some kind of mass exit. Alternatively the US politicians may not be able to fix the fiscal cliff. China’s economy may implode. But supposing none of these things happen: “There may be little left to dull investors’ appetite for risk,” suggested John Higgins Senior Markets Economist at Capital Economics.

So let’s re-run that one past you. The good scenario, the one in which a bubble is less likely to form, involves something really bad happening within the Eurozone, with the US fiscal cliff or on the other side of the Great Wall. The bad scenario, one in which a bubble may be created, is if none of these disasters happen.

So good equals bad, positive equals negative; it’s a bit like an episode of ‘Homeland’.

Back in the day, when the global economy was booming and talk of financial disaster looming was dismissed as the ideology of crackpots, Alan Greenspan used to talk about the difficulty of spotting a bubble. Actually, he went further, and suggested it was pretty much impossible. Who was the Fed, he suggested, to tell the markets they had got it wrong?

It’s different now, isn’t it? Well, Mr Higgins said: “It is not obvious from the tone of yesterday’s FOMC statement that today’s policymakers are much more prepared to prick a bubble than clear up the mess once one has burst.” He said: “Don’t count on the US central bank sacrificing its commitment to maximum sustainable employment on the altar of financial market stability.”

Or to put it another way, the Fed and West Ham supporters have one thing in common. They are forever blowing bubbles.

China sees another lift

It was the fourth month in a row. And that is good news.

According to the latest Markit/HSBC flash Purchasing Managers’ Index for Chinese manufacturing, the sector is on its way back.

The December index climbed to 50.9, the highest reading since October 2011, making it the fourth month in succession in which the index rose on the previous month.

In Q3 China’s manufacturing sector grew at 7.5 per cent, good by Western standards, but for China that’s lousy, and not far off suggesting a potential hard landing. However, the PMIs point to Q4 being better.

Even more encouraging is that the new orders to inventory ratio rose to a 15- month high, suggesting that things are set to improve further.

So does this mean we can relax, and conclude the risk of China suffering the much talked about hard-landing are negligible? Alas not. Today’s data is encouraging, but China’s big challenge of adjusting from export to consumer led growth lies ahead. The good news is that its government appears to recognise the importance of this change. But then again, no one really knows what the new look Chinese leadership thinks. Besides, recognising that something needs to happen, and making it happen are two quite different things.

Standard and Poor’s warning

And then along came a credit ratings agency and spoilt George’s party. Or to be precise, it joined the other party poopers.

Earlier this year, Fitch and Moody’s put the UK on negative watch, meaning the UK’s triple A credit rating is being considered. Now Standard and Poor’s has joined the club.

The agency said: “The outlook revision reflects our view that we could lower the ratings on the UK within the next two years if fiscal performance weakens beyond our current expectations…We believe this could occur in particular as a result of a delayed and uneven economic recovery, or a weakening of political commitment to consolidation.”

It’s tricky one. So S&P is fretting about the political commitment to consolidation, and the failure to cut debt. Some might say that it is the very act of consolidation that is causing the debt to rise.

So if the UK does what the credit agencies suggest, and cut some more and these cuts lead to less growth, and rising debt to GDP, one assumes the agencies will cut the credit rating.

The real point is that it does show that it’s very hard to define a fix to the UK’s woes. The credit ratings agency does not know the future; it just thinks it knows the UK must reduce debt.

But if the UK’s rating does finally fall it may not be that big a deal. On the news that S&P had put the UK on negative watch the yield on UK ten year treasuries soared from not far off an all-time low, to just a few hundreds of a per cent higher. To put it in context, a week ago the yield on UK ten years was in the low 1.70s. At the time of writing it is 1.8577. In short, the yield is still extraordinarily low.

Japan’s improved performance causes it to fall into recession

Earlier this week news broke to reveal that Japan was in recession.

Actually it was all a bit odd. Official data on Japan’s economy was revised upwards, but concluded Japan had fallen into recession. Yes that is hard to fathom.

It turns out Japan did better than thought in Q1 this year. So that was good. The data also said that the Japanese economy is bigger than originally estimated. In fact the revision of GDP data had the economy no less than 3.3 trillion yen, or 0.6 per cent of GDP larger than the previous set of data estimated. Reason for celebration, you might think.

But not so fast, data for Q2 was not subjected to the same degree of upwards revision, and actually had the economy contracting by an annualised rate of 0.1 per cent in Q2. Previous data saying Japan contracted at an annualised rate of 0.9 per cent in Q3 was confirmed.

So there you have it, because Japan did better at the beginning of this year than previously thought, it turns out the country is in recession.

But looking forward, things seem set to get worse. The Japanese Tanken index out this morning pointed to a sharp deterioration in business conditions in Q4. The index fell from minus 3 to minus 12, the lowest reading since March 2010.

You may know that it’s election time on Sunday, with the Japanese electorate due to vote for a new make-up of the Lower House. The election was the price extracted by Japan’s opposition parties for support in agreeing to an extension of Japanese borrowing limits. It was Japan’s own fiscal cliff. The problem was solved, with the election being the result.

It could be said that holding an election just as your country falls into recession is not normally a good move for an incumbent government.

Companies in the news

Bull:       This morning Tempus in the ‘Times’ was in more of a bullish mood. It reviewed energy services company John Wood Group,  which Tempus said performed extraordinarily well during the downturn. With a valuation of around 11 times value, it said the company looks like good value.

Also coming under the Tempus spotlight was RWS, translation to companies issuing patents. The patent business has been pretty buoyant of late. Not always for the good, but in the Far East especially, it is becoming more important, meaning opportunity for RWS. Tempus reckons the current share price makes a good level for entry into this company for its long term potential.

Meanwhile at the ‘Telegraph’, Questor took a look at BG Group. The company has seen a change in management, and has warned that production in 2013 will be flat. But Questor reckons problems can be solved, and that globally markets are structurally short of energy. It concluded the shares are a “buy for recovery”.

These views and comments are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees

Tags: BG Group, China PMI hard soft landing, Fed asset bubble, Japan recession, John Wood Group, QE asset bubble, RWS, Standard and Poor’s UK credit rating

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