You would never know it listening to the market cheerleaders but asset prices, both real and financial, are, once again, at extreme valuation levels relative to the trend economy. The valuation reality coupled with the prevailing, but false, “don’t worry” market narrative sets us up for another major financial crisis.
A third major crisis in 20 years? These are only supposed to happen once in every 100 or 1,000 or 10,000 years, so say the rocket scientists. Blame it on fat obese tails.
Asset Markets And GDP Growth
The chart below illustrates that household net worth, as measured by real and financial assets minus liabilities, which just hit a record high at around $102 trillion, is, once again, totally divorced from the economy. Note that one of the reasons why the highest level U.S. policymakers missed the last financial crisis is because they were too focused on this indicator, which also hit a record high in Q3 2007. They failed, or chose not to see, the massive leverage as the root cause driving up assets prices.
Their error was twofold: 1) not fully recognizing or believing the risk of asymmetric mark-to-market, where asset prices are variable, while liabilities remain fixed, and 2) not understanding the economy had morphed into a giant asset-driven feedback loop, where the wealth effect drives growth (both consumption and investment confidence), which drives asset prices, which drives the wealth effect. Wash, rinse, repeat.
It’s clear from the chart which variable is leading the other since the mid-1990’s. Asset prices are no longer driven by the economy but now drive the economy, and have become the main transmission mechanism of monetary policy.
We find it laughable when analysts pontificate that asset markets have been driven by fundamentals and profits, and fail to understand and internalize the loopy connection between asset markers and the economy, and by extension “the fundamentals.”
Asset markets have been inflated by the central banks, which has lifted economic growth and positively influenced the “fundamentals”, such as profits and consumer demand, and to, some extent, business investment. These same analysts have the gall to mock the global macro community, who have been trying to enlighten and warn them of this new economic reality.
But, hey, we get it and have been there. Gotta make the annual nut to get the annual bone. To make the nut, “as long as the music is playing, you’ve got to get up and dance.” That is how the system works.
We shall see who still has their family jewels when the tide goes out and asset markets regress to their long-term mean valuation. Even just a moderate bear market will have an outsized impact on the economy given our model.
We suspect the monetary authorities understand this, and is the reason why they have been so timid about removing the I.C.U.- like accommodation almost 10 years after the financial and economic train wreck.
One thing is certain, however, it will be one mean regression to the mean. The question is not if, but when.
The above chart also illustrates that a structural divergence of asset prices from the economy began around 1995. Before this, assets values fluctuated around trend nominal GDP growing on average about the same rate as real economic growth plus inflation for almost 50 years. The market trajectory made perfect theoretical sense.
So What Happened In The 1990’s?
We suspect mainly globalization.
This is the period of China, India, and Eastern Europe’s entry into the global labor force, the rise of the internet, and the beginning of large foreign capital flows into the U.S. financial markets, especially the U.S. Treasury bond market.
Furthermore, Mexico had just experienced an existential balance of payments and currency crisis, soon to be followed by the Asian financial crisis in 1997, and the Russian debt default in 1998. These countries learned the hard lesson that allowing short-term capital inflows to revalue their currencies causing unsustainable current account deficits was a recipe for economic collapse. The global shift in exchange rate regimes in the emerging markets during this period was a major factor in what former Fed chairman, Ben Bernanke, the rise of the global savings glut.
Emerging market central banks began to intervene in their foreign exchange market leading to a massive build in global currency reserves, which were then predominantly recycled back into the U.S. financial markets. The liquefaction of U.S. markets by the foreign private and official inflows provided much of the fuel for the dot.com and housing bubbles.
The current economic and asset bubbles has been driven, mainly, by central bank liquidity, although still dependent on foreign inflows.
The End Of Globalization?
Now the President of the United States (POTUS) is the poster child of anti-globalization. Whether he sticks to his guns as the markets crumble remains to be seen. If we learned anything from 2008 crisis is that markets can get away from the policymakers and lead to nonlinear market dynamics. Once unleashed, it is difficult to put the volatility genie back into the bottle.
Asset Prices Are 40 percent Overvalued
We charted the difference between the net worth and GDP trend lines, which now estimates asset prices are overvalued by more the 40 percent. That is an average of financial and real assets, and assumes they should reflect politically sustainable long-term economic fundamentals.
Regressing to the mean economic fundamental value will be an extremely painful event.
Justifying The Divergence
Some argue the divergence is sustainable, that margins will continue to expand, that asset prices can remain inflated, and price-to-earning ratios are reasonable.
Traditional valuation metrics are now distorted, especially with the massive buybacks. We therefore ignore most of them, except the Buffet indicator, which measures market capitalization to nominal GDP, as reflected in the above charts.
How can stocks and housing be cheap if they trade at 180 percent of GDP? Is the stock market pricing infinite margin expansion and labor costs converging to zero? Good luck with those politics.
We also maintain the cheerleaders completely ignore the political reality that is now gripping world markets. The specter of anti-globalization and tribalism is now beginning to take hold. If not reversed, and quickly, the consequences will be disastrous.
The New Supply-Side Bubble
Finally, the unwind of this bubble should be more tortuous and take longer as it is driven by restricted supply and less so by leveraged demand. In stocks, the result of buybacks; and in housing, the result, among other things, private equity taking a massive supply of homes off the market for rentals.
Flash: Peter Navarro is out on CNBC as we write trying to calm the markets. Don’t you think our trading partners see this, that the administration fears a market downturn, and can play hardball until the U.S. caves? Let the game(s) theory begin!
As always, with the caveat we could be wrong.
We will have much more in later posts.
Global Macro Monitor 