Bubbles and bricks and mortarAug 9, 2013·Alasdair Macleod
Many think that interest rates will increase sometime leading to a significant fall in all asset prices. A version of this logic casts all markets as being overdue a collapse. Another school of opinion rides the wave and doesn’t think too much.
A lot of the time it doesn’t pay to think too much: it’s called following the trend. And the problem with calling bubbles is that while you may be right you can look very foolish in the short-term. But there is another approach, and that is to judge the prospects for assets in the context of monetary inflation.
The fact that central banks are pumping huge amounts of newly-issued currency into capital markets artificially depresses interest rates. There can be little doubt that the high valuations for all financial assets stems mostly from this fact, and that this is where the newly-issued currency is going. It is equally clear that when interest rates increase, values of many financial assets will fall. Particularly at risk are bonds; but there are other assets which are valued on factors besides interest rates.
For instance, equity markets will also take into account prospective corporate profits. So long as interest rates do not rise too much and the economic outlook improves sufficiently, equities can continue to rise. And property usually performs well in the early stages of an interest rate rise until the rise gets too much.
However, this is not a normal credit cycle. Instead we have global monetary stimulation on steroids. The result so far has been asset inflation, which raises an important point: given that asset inflation is associated with monetary inflation, should we be worrying about that rather than the interest rate outlook? Does an asset offer protection against the falling purchasing power of currency, rather than be tied to yields?
Protection from hyper-inflation of currencies is best obtained by owning precious metals and related investments such as gold and silver mines. This is followed in the scale of protection by bricks and mortar, which can rise spectacularly in a monetary collapse, but are hampered by non-payment of rents and rental income that falls in real terms. Equities follow, but many businesses are wiped out by monetary chaos so become valueless. Inflation-protected bonds are likely to have their terms changed by issuing governments to the detriment of the bond-holder, and the worst categories of all are fixed-interest bonds and bank deposits.
Property is therefore the interesting asset class. It is notable that money is now moving from Wall Street into residential property, sufficient to raise prices significantly. We could be looking back in a few years’ time and concluding that it was a manifestation of the hyper-inflation of money supply, which so far seems to have confined itself to purely financial activities.
It is hard to see how hyper-inflation of the money-quantity can be halted. The choice is either to cut public spending and bring about a reallocation of capital that will inevitably lead to bankruptcies in businesses and the banks, or to continue to create yet more money. In this regard the Fed’s mandate is to pursue only the latter course.
So the recovery in property prices increasingly appears to be based on an inflationary or hyperinflationary outcome to current events, rather than a speculative bubble. The implications of this important signal are profound and must not be ignored.