Does Economic Stagnation Create Dangerous Financial Bubbles?
By Daniel R. Amerman, CFA
The Federal Reserve has a seemingly odd fear about the markets that may appear completely upside down to most investors – but this fear is so serious it is helping to determine the Fed's actions, even as it poses a potentially acute risk for investors. As reported in MarketWatch on February 19th, there was a wide ranging discussion at the January, 2015 meeting about if and when to raise interest rates, and this was part of the discussion:
"Fed members who supported an early move said they were concerned that holding rates low for too long might lead to asset bubbles."
So the Federal Reserve is not raising interest rates in the near term, because the economy is still too fragile and weak to handle interest rates above (effectively) zero percent. Yet what they also fear is that this weak economy will generate stratospheric market prices (i.e. asset bubbles) that could be prone to sudden collapse, which could pose acute risks to the economy, global stability, and investment returns.
That may all sound counterintuitive, as it would seem to make sense that a weak economy should naturally lead to weak markets and falling prices, whereas it's a strong and healthy economy that should create rapidly rising market prices.
However, as explored by some prominent global economists in the recent e-book, "Secular Stagnation: Facts, Causes and Cures", edited by Coen Teulings and Richard Baldwin, the creation of financial bubbles may indeed be the quite likely and expected result of current government policies around the world for dealing with stagnant economies and persistent unemployment. Indeed, the term "rational bubbles" is used to explain the rational reasons for why weak economic times are particularly likely to create irrational prices that foster financial instability.
This then raises an interesting and quite timely question: is the Standard & Poor's 500 stock index above 2,000 and the Dow above 18,000 in spite of still weak economic growth and persistent unemployment problems? Or are stock markets soaring to record levels specifically because of the underlying problems and the government's interventions which attempt to fix those problems?
Most investors would likely agree that with stock indexes in record territory, it is critically important to be able to distinguish between whether the source is 1) the rational result of a thriving economy; or instead 2) the kind of financial bubble that can rationally be expected to be created specifically because of a persistently underperforming economy. So let's take a closer look at why it is that struggling economies can be expected to produce irrationally soaring stock markets and other financial bubbles.
Secular Stagnation & Bubbles
In a previous article, I discussed the general implications of an important new book released by the Centre for Economic Policy Research (CEPR), which suggests that the world has entered a "new normal" of secular stagnation (with secular being economics jargon for long term), with slow economic growth, an indefinite continuation of very low interest rates and – as a matter of deliberate governmental policy – persistent negative investor returns in inflation-adjusted terms.
The contributors to "Secular Stagnation" include Lawrence Summers and Paul Krugman, as well as numerous economists from such institutions as Harvard, MIT, Oxford, Cambridge, the International Monetary Fund and also the Principal Economist for the Executive Board of the European Central Bank.
However, while the face of secular stagnation is one of sustained and almost inescapable low yields – both for fixed income investors as well as the long-term economic growth which underlies rational stock market valuations – there is a glittering exception to this rule.
That is, what concerns these economists is that this environment of sustained very low interest rates combined with few good investment opportunities can be expected to foster the creation of financial bubbles and financial instability.
So that in the short term – and possibly even lasting for years – enormous paper wealth is created as a direct result of secular stagnation, until the bubble finally pops (as they always eventually do) at which time enormous economic and financial damage is inflicted on both investors as well as the financial system.
The danger is described by Lawrence Summers (Treasury Secretary in the Clinton administration, and former Director of the National Economic Council in the Obama administration) on pages 32-33 of the book.
"Low nominal and real interest rates undermine financial stability in various ways. They increase risk-taking as investors reach for yield, promote irresponsible lending as coupon obligations become very low and easy to meet, and make Ponzi financial structures more attractive as interest rates look low relative to expected growth rates. So it is possible that even if interest rates are not constrained by the zero lower bound, efforts to lower them to the point where cyclical performance is satisfactory will give rise to financial stability problems. Something of this kind was surely at work during the 2003–2007 period."
Teulings and Baldwin considered the issue of "bubbles and low interest rates" to be one of the key new challenges created by secular stagnation (SecStag), and they devoted the entire third section of their introduction to the matter. The following quotations are from pages 13 and 14.
"Beyond ZLB issues, which have been the main concern in the SecStag discussion to date, low real rates can produce bubbles and foster financial instability – as Summers argues forcefully in his chapter. When the real rate, r, falls to values close to the economy’s growth rate, g, asset prices start to explode in a ‘rational’ way (as pointed out by Tirole 1985)."
"Bubbles are an alternative way for society to deal with excess saving when fiscal policy does not take up the challenge. Buying bubbly assets with the intention of selling them at a later date is an alternative route of saving for future consumption. When nobody wants to invest because r is below g, and hence buys bubbly assets, the price of these assets goes up, yielding windfall profits to their sellers who are therefore able to increase their consumption. This additional consumption restores the balance between supply and demand for loanable funds on the capital market."
"A greater supply of savings is one of the Wicksellian forces pushing the real interest rate down. Hence, ageing societies might run a greater risk of bubbles popping up."
To expand upon these brief quotations, there are several interrelated components which can work together in an environment of secular stagnation to create a financial bubble – or a series of financial bubbles.
While Central Bank interventions mean there is a large supply of low-cost money available to invest – where does one put it if we're looking at fundamental valuations?
Interest rates are very low and are indeed negative on an inflation-adjusted basis as a matter of quite deliberate governmental policy, as further explored here.
Economic performance is erratic at best, unable to deliver sustained and powerful economic growth, thereby eliminating much of the fundamentals-based premise for the valuation of stocks.
There just don't seem to be any good investment alternatives.
Another element – and one of the reasons why some believe that secular stagnation could be our indefinite future – is the globe's aging population, particularly in Europe, and to a lesser extent in the United States.
As the population ages, their economic productivity is likely to be falling, even as their consumption which drives future economic growth is also likely to be falling. Simultaneously, they have the largest amounts to invest in their latter years before retirement and in early retirement that they have ever had.
So productivity and consumption each fall while investable funds are peaking, thereby exacerbating the problem of a large supply of money seeking homes in what is otherwise a low yield environment.
And what happens as a result is that we get upward price movement in a given asset category.
As the prices climb upwards, this starts to produce a level of yields that are simply not available anywhere else. These attractive yields bring in new investors, which increases the prices, which then increases the yields while reinforcing the pattern, which in turn brings in the next round of money.
This pattern of rising prices drawing in money which fuels further rising prices – until rational valuations have been left far behind – is one of the oldest and most reliable stories in the history of finance and markets.
What is different this time around is the ready supply of cheap money, in combination with the lack of fundamental alternatives for investment, along with a large pool of older investors who are desperate for yield alternatives and are seeing attractive yields being created. While it may seem counterintuitive at first, these factors are all accelerants and in combination become the perfect recipe for creating a financial bubble.
And as discussed in "Secular Stagnation", these leading economists – whose policy advice is responsible for so many nations around the world adopting very low interest rate policies as an attempted cure for economic stagnation – are also perfectly well aware that these same economic strategies are creating an ideal environment for the creation and feeding of financial bubbles and financial instability.
Is Secular Stagnation The Source Of Current Stock Index Highs?
Now isn't it fascinating that even as we are six years into a period that many leading economists are now calling a new normal of secular stagnation, we're simultaneously seeing record stock prices with the S&P 500 above the 2,000 level and the Dow Jones above 18,000? (To be more accurate, these are records on a non-inflation-adjusted basis, which is typically how bull markets are presented.)
Is this a coincidence, or could currently soaring stock market levels be an example of exactly the type of secular stagnation-created financial bubbles that are expected by these economists?
Let's consider what's happening.
We have near zero interest rates that are negative in real terms.
As has been reported upon time and again, we continue to have persistent high unemployment in the United States when we adjust for workforce participation rates, even while the headlines focus on the partial measure of headline unemployment.
The United States may or may not have emerged from the "Great Recession" (it really depends upon whatever inflation rate you're using in the calculation of GDP), but Europe, which is a key trading partner and key component of corporate profits for the United States, continues to struggle to emerge from recession.
So we have extraordinary stock valuation levels in a time of still low and unreliable growth, while vast supplies of low cost money flood the financial system as the result of central banking actions.
The other remarkable thing that is happening is that there are various major risks developing in the world even while the stock market is surging.
As one example, after being briefly held back because of the geopolitical risk associated with the Ukraine in particular, the level of 2,000 for the S&P 500 was reached for the first time the very same week that we had credible evidence for not just one, but potentially two different armored columns of Russian troops being placed in the Ukraine in different locations.
Currently we are seeing near record highs even as the election of the far left Syriza party in Greece has created a high risk situation in Europe, as further explored here. Now, as shown in the most recent release of the minutes from the Federal Reserve, the US economy is in their opinion still in such fragile condition that they don't dare raise interest rates in the near term. So we have a weak and fragile economy, even while there is a respectable chance (albeit far from a certainty) that global financial order could be overturned in the coming weeks – and the markets just shrug off those concerns, as prices keep on rising.
As another interesting example, record index levels are being reached at the same time that the hacking of electronic payment systems moves from mere novelty to becoming routine, with news emerging in the last year about numerous major corporations having been compromised.
Now taking into account that the great majority of the United States economy is based on the electronic flow of money, let me suggest that this new reality of the electronic flow of money from consumers to companies being much more vulnerable than previously recognized – with the exploitation of these vulnerabilities perhaps not entirely coincidentally often coming from predominantly Russian and Eastern European hackers – is an extraordinary threat to potential future profitability.
And yet, The Party goes on, creating its own weather pattern that seems near oblivious to these emerging risks.
Markets that effortlessly shrug off dangerous developments as if they never happened and just keep on surging are nothing new; it's a well-established pattern that we've seen many times before. But when we put all of these real-world components together, we realize that the sources for the surge in the S&P 500 may be quite different indeed from what the overwhelming voice of The Crowd has been telling us. Which brings to mind a quotation from Charles Mackay, in his classic work "Extraordinary Popular Delusions and The Madness of Crowds":
"Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."
A Potential Nightmare Scenario For Retirement Investors
Once we leave the dry and impersonal language of economics behind and consider the very personal implications for us all, what is being described in the Secular Stagnation e-book is a potential nightmare scenario for society as a whole, and for older investors in particular.
As a quite deliberate matter of government policy and as explained here, savers likely face years of negative returns (when adjusted for inflation), because the prevailing view among economists is that forcing negative returns on savers is the best way to fight economic stagnation. So if we stick with conventional investment strategies, there are virtually no yields available unless one either ups the risk or participates in the bubbles that are likely to be created as a direct side-effect of those same stagnation-fighting policies. And if one participates in a bubble then one takes one's chances, because that's the thing about bubbles – you never know when they're going to pop.
What is someone to do?
If we go with the comfortable familiarity of The Crowd and bet everything on prosperity – but it turns out that we instead bought into a secular stagnation-created bubble, then we could lose almost everything, particularly if the popping of the bubble brings on a broader financial crisis.
On the other hand, a decision to not participate doesn't necessarily protect those following conventional investment strategies either.
If we bet on economic stagnation, then for an indefinite period of economic stagnation we must find a way to earn significant yields on an after-inflation basis or there is no building of wealth. This is a very challenging task in its own right.
Compounding the difficulty in finding a viable strategy is that at any tim,e there could be a collapse of one of the series of financial bubbles "blown" by the three-way combination of very low interest rates, lack of investment alternatives and an aging population, meaning we have to also simultaneously be prepared for a deep financial crisis, potentially worse than we saw in 2008.
However, while risk premiums have been stripped out by very low rates and economic stagnation, the actual risks of financial instability may be greater than ever, which could leave us with low yields right up until the time that the crisis eventually hits and slashes the value of our principal.
Yet, if we commit to the usual financial disaster preparation strategies but stagnation persists, and a mega crisis doesn't arrive for another five or ten years ─ if at all ─ then we have virtually no earnings in the interim, and in fact on an inflation-adjusted basis are likely taking losses the entire time period. If on the other hand genuine and sustainable prosperity does find a way to return, from a strategy performance perspective traditional crisis preparation strategies fare even worse, as there is the 1-2 combination of likely ongoing negative inflation-adjusted yields, even while there is the opportunity cost of not participating in surging markets.
This is a very powerful but real dilemma, with few solutions when it comes to either the usual mainstream financial choices or the conventional crisis preparation choices. I do strongly believe there are solutions, but they are not the usual solutions, and education is the first step.
What you have just read is an analysis about just one of the ways in which a rapidly shifting world is removing the foundations beneath conventional investing - even while most investors continue to follow the traditional strategies, unaware of just how much the financial playing field has changed.
Another "eye-opener" tutorial is linked here, and it shows how governments can use the 1-2 combination of their control over both interest rates and inflation to take wealth from unsuspecting private savers in order to pay down massive public debts.
An "eye-opener" tutorial of a quite different kind is linked here, and it shows how governments use inflation and the tax code to take wealth from unknowing precious metals investors, so that the higher inflation goes, and the higher precious metals prices climb - the more of the investor's net worth ends up with the government.
Retirement lifestyle is determined by both benefits and savings, and the "eye-opener", linked here, examines retirement benefit decisions. As this step-by-step analysis explores - the most common advice about what age to start claiming benefits just could be dead wrong, and the advantage to early collections may be much stronger than most realize.
If you find these "eye-openers" to be interesting and useful, there is an entire free book of them available here, including many that are only in the book. The advantage to the book is that the tutorials can build on each other, so that in combination we can find ways of defending ourselves, and even learn how to position ourselves to benefit from the hidden redistributions of wealth.
