Issue 113

Bubble risks

Delivered on 24 May 2021 by Justin Pyvis. About a 3 min read.

Bloomberg published an article on Sunday looking at asset bubbles in China:

Home prices are soaring, prompting officials to revive the idea of a national property tax. A surge in raw material prices spurred pledges to increase domestic supply, toughen market oversight, and crack down on speculation and hoarding.

The rapid gains are challenging the central bank's ability to restrain inflation without hiking borrowing costs or making a sharp turn in monetary policy – something the People's Bank of China has said it will avoid. The risk is the government's attempts to curb price increases won’t be enough, forcing the central bank's hand at a vulnerable time for domestic consumption.

Bubbles – particularly in assets – are blowing up everywhere, not just in China. Demand surged on the back of record-low interest rates and gargantuan fiscal stimulus in response to the coronavirus pandemic, despite the fact that it was a supply shock, not a deep demand shock (as after, say, a financial crisis).

There is a reasonable risk that the observed asset price inflation eventually flows through to consumer price inflation, forcing rate hikes and a destruction of company valuations. It's already showing up in China's producer prices – the price of raw materials and goods leaving its factories – which will squeeze the margins of consumer goods vendors, unless they also start to raise prices.

China's bond market isn't concerned about inflation.
Source: Bloomberg

While China's financial markets are "pricing in a relatively benign scenario", and the "10-year government bond yield has fallen to the lowest level in eight months", it's important to remember that bond markets have never actually predicted future inflation but instead move concurrently with inflation, sometimes even with a lag.

There is no evidence to suggest that bond markets are good predictors of inflation.
Source: Peterson Institute for International Economics

We made a prediction of sorts back in December 2020:

Central bankers have been very vocal about suppressing interest rates for, in some cases, up to three years. Whether they'll be able to achieve that stated goal is another question, but you can be sure they'll try for far longer than they should.

But the sheer amount of demand stimulus being injected into the global economy can't go on forever and when it turns, it'll turn quickly. As Hemingway wrote in The Sun Also Rises, you go bankrupt in two ways: "Gradually, then suddenly." That's probably how the latest global debt adventure will also unfold: first with asset price inflation, then with the wealth effect pushing up consumer price inflation, then finally with a sudden crisis as markets, central bankers and governments eventually realise their errors (far too late).

Unfortunately, the madness may continue for much longer than you expect (such is the nature of credit booms).

Asset price inflation, check. We're now starting to see some consumer price inflation – which central banks are claiming is "transitory" – but there's still pressure to come given that the savings rate remains elevated and growth in bank deposits only started to decelerate in mid-March.

However, supply chains are already under pressure from COVID-restrictions and the swathe of order cancellations last year and subsequent investment and production cuts mean prices could respond relatively quickly to additional consumer demand.

Google searches for inflation are back where they were during the global financial crisis.
Source: Google Trends

We don't pretend to know when the music will stop but the recent volatility in equity, commodity and crypto markets, along with rising web searches for inflation, suggests we're not alone in worrying about bubble risks.

Issue 113: Bubble risks was compiled by Justin Pyvis and delivered on 24 May 2021.