HyperNormalTimes

Written by our Director of Equity Advisory, Jeremy McKeown, the HyperNormalTimes provides in-depth and considered long-term commentary on major macroeconomic and market-shaping themes.

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January 23, 2021

Asteroid Strikes & Financial Bubbles – a survivor’s guide

One day, about 65 million years ago, a freak occurrence wiped out some 80% of all life on earth. Although we didn’t appreciate it at the time (it was still another 63 million years before we evolved into humans), if that asteroid had missed earth and hurtled on by, our planet might still be primarily inhabited by dinosaurs. Or maybe eventually some other species would have become the dominant life form in an alternative version of history. What is clear, that day, from a dinosaur perspective, was a bad one. From a mammalian perspective, it was our big break.

I have been thinking lately about bubbles, not bath ones or champagne ones, but financial ones. Financial bubbles get bad press, and it is easy to understand why. When they pop, they upset things, dislocate businesses, cause job losses and leave financial chaos in their wake. The established order, newspaper columnists, politicians and social commentators deplore them and vow that we must learn how to avoid them in the future.

Notably, the two dominant schools of economic thought, Keynesianism and Monetarism, both emerged in response to the aftermath of financial bubbles and how to deal with their consequences. On both occasions, the popular refrain was “this must never be allowed to happen again”, reforms and measures to create stronger institutions and greater financial stability. However, when we move on and regain some normality, due to our behavioural tendency to risk aversion (we hate losses more than we love gains), we rarely notice the benefits that often accrue, slowly but surely, after these crises.

The small mammals that were able to come out from their hiding places when the dinosaurs had died out would never see the enduring long-term benefit that was to come from this massive exogenous shock. We are living proof of the advantages that accrue to the ability to adapt. Similarly, when the dotcom bubble burst in 2001, the focus was on the havoc caused. Worldcom, Global Crossing, Marconi, Pets.com, and Webvan, among many other failures, grabbed the headlines. The NASDAQ composite lost more than half its value in 9 months. The financial dislocation prompted the Fed to sharply reduce interest rates, ironically directly helping to pump-up the nascent subprime housing bubble.

However, the last thing that investors or anyone else wanted to consider was that this very crisis was a critical component for the birth of the internet staples, Amazon, Google, Facebook and Netflix (the FANGs). These giants of today’s financial and business landscape were able to grow on the carcass of the dotcom bubble. The over-investment in telecom networks, routers, semiconductors, and fibre optic cable did not disappear with the corporate entities that built them. It is hard to believe Colt Telecom, an owner of ducting under the City of London financial district, briefly became a FTSE 100 company. Colt is no longer a public company, but the ducting is still there and playing its part in the flow of information within the London financial centre.

Financial bubbles and manias are not good things, but they are not necessarily all bad either. More to the point, they appear to be a recurring feature of our modern world, so it makes sense to try and understand them. Most rational economic assessments of episodes like the global financial crisis, the dotcom boom, or other bubble events treat them as unusual, freakish aberrations, not part of everyday economic life. Indeed most economists who made it their life’s work to understand bubbles, cycles and manias, such as Mises, Schumpeter and Minsky, came from the profession’s fringes. Hyman Minsky, who died in 1996 was largely unknown during his lifetime. However, today he has the term Minsky Moment named after him, which is commonly referenced by investors and financial market commentators to describe the turning point from manic enthusiasm to despair, such as in the market of 2008.

A valid question in 2021 is, are we in a financial bubble? Fortunately, after the last one economist, Robert Shiller gave us a checklist to help us work this out. Shiller said that to determine if an asset is in a bubble, it should show most of, or all of, the following criteria:

1. Sharp increases in the price

2. Great public excitement about said increases

3. An accompanying media frenzy

4. Stories of people earning much money, causing envy among people who are not

5. Growing interest in asset class among the general public

6. ”New era” theories to justify unprecedented price increases

7. A decline in lending standards

Most of these checkpoints can be ticked for the shares of electric vehicle companies, most cryptocurrencies, and probably certain blank cheque, SPACs (SPACs that buy electric vehicle companies are double bubble). These bubble-like markets indeed appear to have been inflating rapidly over recent months and tick most of the above criteria. Albeit, these checkpoints don’t necessarily apply to the broader equity market, on a global basis.

However, there is a longer-term super-bubble that has not received so much public excitement or media frenzy. It is a bubble that has enriched most of us with new era thinking, of its day but thinking that we now regard as mainstream. The world’s bond markets have been steadily blowing themselves up into the biggest bubble of them all, and all asset owners have been beneficiaries. This super-bubble began life in the aftermath of the inflation-riven 1970s and the Volker monetary shock, imposed at the behest of newly elected President Reagan. Since the early 1980s long-term interest rates have steadily fallen to the present day effective rate of zero. We are now at ground zero, and in some instances below, we are facing the prospect of negative rates. In this context, with the Federal Reserve explicitly targeting higher inflation levels, it is little wonder people are increasingly choosing to seek the protection of real assets such as gold, commodities, fine wine, classic cars and yes, bitcoin.

So if the next asteroid to strike the global financial markets is a bursting of the bond bubble, what are the implications?

In short, it would be devastating to the valuation of all financial assets. It would be their dinosaur moment. In theory asset values are ultimately based on the future cash flows or earnings streams discounted to the present. In reality, the shock of say, a jump to double-digit long-term interest rates applied to current unprecedented debt levels would wipe out most financial institutions and trigger the ultimate Minsky moment.

The profound implications of this bubble bursting are also the main reason it is unlikely to happen. Every central bank’s unstated ambition is to quietly deflate their sovereign debt burdens via the instrument of inflation. In this manner, the UK government issued war loans to fund the war effort and then left the gold standard after the 1929 financial crash. A Labour politician would later write of the war loan bonds, “no foreign conqueror could have devised a more complete robbery and enslavement of the British nation”. This is the policy of financial repression.

With its general equilibrium, rational expectations and efficient market approach, classical economics struggle’s to say about such emotional events as financial bubbles. A few outsiders have offered more dynamic models of business cycles and credit expansions. Rather than distilling everything to numbers and equations, these business cycle economists used behavioural descriptors, taking into account the institutional framework and treating them as complex adaptive systems rather than physical particles. Evolutionary biology and psychology were the preferred scientific analogs, not physics and higher maths.

So what are today’s bubbles telling us about the future? First of all, it is worth saying that one man’s bubble is another man’s bull market; it largely depends on whether you have a dog in the fight. (I own Google, Facebook, Amazon and bitcoin, all bull markets. I don’t own Tesla or any SPACs, both bubbles). But the reality is most bubbles, bubble for a reason. They tend to contain at least a grain of truth, and they point the way for future growth. The Dutch tulip mania, often considered a wasted exercise in collective human delusion with reports of a single bulb changing hands for the price of an Amsterdam townhouse (remind you of anything)? But the result remains to this day that the Dutch own the fresh flower market and a strong international competitive advantage in horticulture. The UK railway mania of the mid 19th century resulted in over expansion and widespread corporate failure, but London has the glorious edifice of St Pancras Station to this day.

An old market adage about bubbles is that investors overestimate the impact of technological change in the short term, but underestimate it in the long term. This has been true of the introduction of all era-defining networks such as canals, railways, and the internet. Maybe it will be true of cryptocurrencies and the digitisation of money, perhaps not. (It will almost certainly be true of electric vehicles and probably their offshoot, autonomous vehicles). One plausible future is the adoption of Central Bank Digital Currencies (CBDCs) to implement negative interest rates and accelerate money circulation. The financial equivalent of mainlining liquidity straight to the arteries of the economy. The unintended consequence of this may be to disintermediate the banking system. Still, these analogue dinosaurs are increasingly looking like they are just lumbering about waiting for the asteroid hit of fintech and decentralised finance.

The lesson from our fortunate past is that we need to invest in resilient companies, adapt to unknown risks and unexpected events, just like our small mammalian ancestors millions of years ago, they need optionality. As Kay and King pointed out, we need to prepare ourselves for radical uncertainty, not just increased asset price volatility. The returns to the victors in these types of circumstances are skewed overwhelmingly towards the fat tail. I am pretty sure in 2001 when Amazon lost 80% of its equity value; not many people thought that it would now be the world’s largest company, even fewer thought that its dominant profit contributor would be cloud computing services, a business that didn’t exist at the time. Likewise in those days, Netflix was a DVD postal service company nipping at the heels of the video rental establishment that offered itself for sale to the mighty Blockbuster for an outrageous $50m. Fortunately for Reed Hastings and his investors, Blockbuster haughtily declined his offer. The rest, as they say, is history.

 

Jeremy

Ealing

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