“Be fearful when others are greedy.”
This famous adage by Warren Buffet is an apt way to sound alarm bells in the current market situation.
As 2020 went along, governments around the world attempted to counter the drastic economic downturn caused by the COVID-19 Pandemic and thus opened up fiscal floodgates in the form of massive stimulus. Central banks worldwide adopted expansionary monetary policy by bringing down interest rates to near-zero levels and trying to spur economic activity through quantitative easing and massively scaling up asset purchases, in an almost synchronized manner. Owing to this, the balance sheets ballooned; and even to record sizes for the Fed and European Central Bank.
Throughout March and April 2020, the U.S. government passed three main relief packages and one supplemental package, totaling nearly $2.8 trillion, along with the Federal Reserve adding trillions of dollars through monetary policy, which has nearly doubled its balance sheet. As this wasn’t enough to boost the economy to any sort of “normalcy”, there is contemplation to bring yet another stimulus package. Cumulatively, the amount of stimulus that the U.S. government is going to put into the economy is likely to be north of $5 trillion. Other governments around the world, including India, have followed suit trying to keep the economy in “a state of coma” through fiscal spending and monetary policy; which has drastically reshaped the way we spend and save. The methodology of central banks is clear and intentional: Snuff out volatility from the bond market and make debt the least expensive it’s ever been to dissuade saving and support investment. The expectation: Cheap money drives organizations to invest and recruit as rising asset prices make individuals more confident and ready to spend. The inescapable side effect: More instability for assets (aside from bonds) as financiers pursue returns all around the world. Also, obviously, the danger: Bloated asset prices pop, sabotaging financial stability before the real economy can benefit from all that cash.[1]
Markets around the world have become highly liquid, and this newfound liquidity is fueling the rise of stock markets around the world and thus inflating asset prices. With valuations going through the roof in an environment where the real economy is clearly in shambles, there is little doubt left as to whether the current stock market rally is rational or not. Employment has fallen, the Debt to GDP ratio of almost every nation has spiked, corporate debt is on the rise, budget deficits are broadening, but, with the availability of abundant cheap money, markets are presenting a buoyant image. [2]Data show stock buying rose further in the U.S. after the last round of pandemic-relief checks, and it isn’t just the retail crowd. Companies with weaker balance sheets are outperforming, which is a function of cheap money that’s emboldening investors to take risks, and is symptomatic of a very frothy and speculative market. For example: a stock that is emblematic of this fact is Tesla. Even though Tesla doesn’t feature among the top ten car manufacturers in the world, nor has it announced any major expansion plans, the stock’s price has jumped about 4 times over the last year from $171 to a whopping $685(as on 4th May 2021).
The Dow Jones Industrial Average index is at 34,113.23 points, the highest it has been in 5 years, the NASDAQ index has almost doubled from 6879 points a year ago to 13,895 points (as on 4th May, 2021) . In India too, the SENSEX crossed the 50,000 mark and the Nifty crossed 15,000 points. Japan’s Nikkei 225 crossed 30,000 points for the first time in 3 decades. In other countries too, like South Korea, United Kingdom, Canada stock markets are largely exuberant. Although highly volatile, cryptocurrencies like Bitcoin and Dogecoin have reported spectacular gains with the former touching $50,000, generating returns as high as 385% over the last year.[3]
For many years, Citigroup Inc.’s chief U.S. equity strategist Tobias Levkovich has been monitoring a “panic/euphoria” index. On this measure, euphoria is currently the highest on record, exceeding even the tech bubble (dot com bubble of the late 1990s).
But let us keep in mind, the liquidity bazooka buys time and pushes up asset prices but has zero value and effect when it comes to improving economic trend growth. The gush of liquidity from major central banks and stimulus packages from governments will not last forever. Sooner or later, this will result in inflationary pressures in the economy which will force central banks to hike interest rates. The faster prices rise in the near future, the sooner that tightening could come. And when that happens, it will cause mayhem in the markets, affecting equity returns and perhaps derailing any hope of recovery. [4]The Taper Tantrum of 2013 is a precedent. When then Fed Chairman Ben Bernanke announced a future tapering of the quantitative easing program, it roiled markets throughout the world. Additionally, higher rates are not without consequence, and if the Fed finds itself pouring cold water on an overheating economy, the risks of another recession will rise. This time around, the exit ramp will be even more fraught with problems, given the larger size of the stimulus.[5]
On Wall Street, higher rates would come as a shock. In emerging markets like India, they would be agonizing. Higher interest rates in America to see off inflation would translate into a stronger dollar and capital outflows from emerging economies. This would imperil their finances and make it harder for them to fight the effects of the pandemic.
The coordinated effort undertaken by central banks around the world to keep rates lower and indulge in unconventional monetary policy to combat the economic downturn has lulled market participants into a false sense of security, with cheap money further encouraging them to send risk assets like stocks and cryptocurrencies higher. Cheap money is generally a precondition for a bubble, and its removal is almost universally the catalyst for collapse. This is a temporary situation and when the fiscal taps run dry and monetary policy tightens to combat rising inflation, the bubble of bloated asset prices would pop, given the evident disconnect between the booming markets and the uneven and uncertain economic recovery.
The time for peak bullishness: when policy makers are going all-in to jump-start their economies, may be coming to an end, leaving a trickier period looming on the horizon. Bubbles building due to gravity defying rallies will eventually burst no matter how elevated valuations may become before this happens. The question is not whether it’ll happen. The only unknown in the equation is, when?
By Kanishq Chhabra A First year Undergraduate student at SRCC
References
1.Pandemic-Era Central Banking Is Creating Bubbles Everywhere. (2021). Bloomberg. https://www.bloomberg.com/news/features/2021-01-24/central-banks-are-creating-bubbles-everywhere-in-the-pandemic?utm_source=url_link2.Frothy Markets Spark Worries of Bubbles in European Assets. (2021). Bloomberg Quint. https://www.bloombergquint.com/markets/reddit-boom-and-bust-shines-light-on-european-market-bubble-risk3.CryptoCurrency. (2021). Market Watch. https://www.marketwatch.com/investing/cryptocurrency/btcusd4.Equity market bubble will “end in tears,” Rosenberg warns. (2020). BNN Bloomberg. https://www.bnnbloomberg.ca/equity-market-bubble-will-end-in-tears-rosenberg-warns-1.15333995.How rising inflation could disrupt the world’s economic policies. (2021). The Economist. https://www.economist.com/leaders/2021/02/10/how-rising-inflation-could-disrupt-the-worlds-economic-policies?utm_campaign=later-linkinbio-theeconomist&utm_content=later-14415538&utm_medium=social&utm_source=instagram
This famous adage by Warren Buffet is an apt way to sound alarm bells in the current market situation.
As 2020 went along, governments around the world attempted to counter the drastic economic downturn caused by the COVID-19 Pandemic and thus opened up fiscal floodgates in the form of massive stimulus. Central banks worldwide adopted expansionary monetary policy by bringing down interest rates to near-zero levels and trying to spur economic activity through quantitative easing and massively scaling up asset purchases, in an almost synchronized manner. Owing to this, the balance sheets ballooned; and even to record sizes for the Fed and European Central Bank.
Throughout March and April 2020, the U.S. government passed three main relief packages and one supplemental package, totaling nearly $2.8 trillion, along with the Federal Reserve adding trillions of dollars through monetary policy, which has nearly doubled its balance sheet. As this wasn’t enough to boost the economy to any sort of “normalcy”, there is contemplation to bring yet another stimulus package. Cumulatively, the amount of stimulus that the U.S. government is going to put into the economy is likely to be north of $5 trillion. Other governments around the world, including India, have followed suit trying to keep the economy in “a state of coma” through fiscal spending and monetary policy; which has drastically reshaped the way we spend and save. The methodology of central banks is clear and intentional: Snuff out volatility from the bond market and make debt the least expensive it’s ever been to dissuade saving and support investment. The expectation: Cheap money drives organizations to invest and recruit as rising asset prices make individuals more confident and ready to spend. The inescapable side effect: More instability for assets (aside from bonds) as financiers pursue returns all around the world. Also, obviously, the danger: Bloated asset prices pop, sabotaging financial stability before the real economy can benefit from all that cash.[1]
Markets around the world have become highly liquid, and this newfound liquidity is fueling the rise of stock markets around the world and thus inflating asset prices. With valuations going through the roof in an environment where the real economy is clearly in shambles, there is little doubt left as to whether the current stock market rally is rational or not. Employment has fallen, the Debt to GDP ratio of almost every nation has spiked, corporate debt is on the rise, budget deficits are broadening, but, with the availability of abundant cheap money, markets are presenting a buoyant image. [2]Data show stock buying rose further in the U.S. after the last round of pandemic-relief checks, and it isn’t just the retail crowd. Companies with weaker balance sheets are outperforming, which is a function of cheap money that’s emboldening investors to take risks, and is symptomatic of a very frothy and speculative market. For example: a stock that is emblematic of this fact is Tesla. Even though Tesla doesn’t feature among the top ten car manufacturers in the world, nor has it announced any major expansion plans, the stock’s price has jumped about 4 times over the last year from $171 to a whopping $685(as on 4th May 2021).
The Dow Jones Industrial Average index is at 34,113.23 points, the highest it has been in 5 years, the NASDAQ index has almost doubled from 6879 points a year ago to 13,895 points (as on 4th May, 2021) . In India too, the SENSEX crossed the 50,000 mark and the Nifty crossed 15,000 points. Japan’s Nikkei 225 crossed 30,000 points for the first time in 3 decades. In other countries too, like South Korea, United Kingdom, Canada stock markets are largely exuberant. Although highly volatile, cryptocurrencies like Bitcoin and Dogecoin have reported spectacular gains with the former touching $50,000, generating returns as high as 385% over the last year.[3]
For many years, Citigroup Inc.’s chief U.S. equity strategist Tobias Levkovich has been monitoring a “panic/euphoria” index. On this measure, euphoria is currently the highest on record, exceeding even the tech bubble (dot com bubble of the late 1990s).
But let us keep in mind, the liquidity bazooka buys time and pushes up asset prices but has zero value and effect when it comes to improving economic trend growth. The gush of liquidity from major central banks and stimulus packages from governments will not last forever. Sooner or later, this will result in inflationary pressures in the economy which will force central banks to hike interest rates. The faster prices rise in the near future, the sooner that tightening could come. And when that happens, it will cause mayhem in the markets, affecting equity returns and perhaps derailing any hope of recovery. [4]The Taper Tantrum of 2013 is a precedent. When then Fed Chairman Ben Bernanke announced a future tapering of the quantitative easing program, it roiled markets throughout the world. Additionally, higher rates are not without consequence, and if the Fed finds itself pouring cold water on an overheating economy, the risks of another recession will rise. This time around, the exit ramp will be even more fraught with problems, given the larger size of the stimulus.[5]
On Wall Street, higher rates would come as a shock. In emerging markets like India, they would be agonizing. Higher interest rates in America to see off inflation would translate into a stronger dollar and capital outflows from emerging economies. This would imperil their finances and make it harder for them to fight the effects of the pandemic.
The coordinated effort undertaken by central banks around the world to keep rates lower and indulge in unconventional monetary policy to combat the economic downturn has lulled market participants into a false sense of security, with cheap money further encouraging them to send risk assets like stocks and cryptocurrencies higher. Cheap money is generally a precondition for a bubble, and its removal is almost universally the catalyst for collapse. This is a temporary situation and when the fiscal taps run dry and monetary policy tightens to combat rising inflation, the bubble of bloated asset prices would pop, given the evident disconnect between the booming markets and the uneven and uncertain economic recovery.
The time for peak bullishness: when policy makers are going all-in to jump-start their economies, may be coming to an end, leaving a trickier period looming on the horizon. Bubbles building due to gravity defying rallies will eventually burst no matter how elevated valuations may become before this happens. The question is not whether it’ll happen. The only unknown in the equation is, when?
By Kanishq Chhabra A First year Undergraduate student at SRCC
References
1.Pandemic-Era Central Banking Is Creating Bubbles Everywhere. (2021). Bloomberg. https://www.bloomberg.com/news/features/2021-01-24/central-banks-are-creating-bubbles-everywhere-in-the-pandemic?utm_source=url_link2.Frothy Markets Spark Worries of Bubbles in European Assets. (2021). Bloomberg Quint. https://www.bloombergquint.com/markets/reddit-boom-and-bust-shines-light-on-european-market-bubble-risk3.CryptoCurrency. (2021). Market Watch. https://www.marketwatch.com/investing/cryptocurrency/btcusd4.Equity market bubble will “end in tears,” Rosenberg warns. (2020). BNN Bloomberg. https://www.bnnbloomberg.ca/equity-market-bubble-will-end-in-tears-rosenberg-warns-1.15333995.How rising inflation could disrupt the world’s economic policies. (2021). The Economist. https://www.economist.com/leaders/2021/02/10/how-rising-inflation-could-disrupt-the-worlds-economic-policies?utm_campaign=later-linkinbio-theeconomist&utm_content=later-14415538&utm_medium=social&utm_source=instagram