The Bubble Galaxy. Where are the bubbles today? #2
Short volatility strategies
Prolonged QE and the resulting search-for-yield activity have compressed market-priced volatility and led to a surge in short volatility strategies, as we discussed in The Silver Bullet | The Low Volatility Trap. Open contracts held in inverse VIX ETFs have grown by over 700% since 2012, but more importantly investors have also been selling volatility in FX, rates and credit, driving risk premia lower across assets. So far such strategies have produced attractive risk-adjusted returns, as global central banks take turns to add to the QE punch bowl. Meanwhile, political and geopolitical risks are rising, creating a divergence between real world uncertainty and market-priced volatility.
This appears to be a potential bubble, as the risk of a sharp repricing in volatility following central banks’ QE exits remains high: investors who have grown so used to the central bank put may need to adjust from their buy-the-dip, low volatility environment.
Cryptocurrencies
Advocates of cryptocurrencies may argue that they represent a form of disruptive technology, similar to how fiat money replaced the gold standard. However, the fundamental difference between cryptocurrencies and fiat money is that they may not yet qualify as “money”. As per the IMF, money can be anything that can serve as:
1) a store of value;
2) a unit of account to provide a common base for prices or;
3) a medium of exchange.
Taking BitCoin, the most well-known cyptocurrency, as an example, currently its acceptance at merchants is low and getting lower, putting its potential as a medium of exchange or a unit of account in doubt. Its high price volatility and susceptibility to regulatory risks also make it a poor store of value: a warning by the Chinese central bank in 2013! against treating BitCoin as legal tender triggered a 60% decline in its value.
Since the crash, BitCoin has resumed its upward trend and appreciated by more than 15 times since 2015, largely due to investor speculation rather than more visibility on its intrinsic value or wider acceptance at merchants. The fast price appreciation and lack of rational analysis by investors chasing the trend mean that BitCoin and other cryptocurrencies are likely a growing bubble.
Real estate
Cheap credit, relatively scarce supply and strong domestic and foreign investor interest have driven rapid price increases in several real estate markets, most obviously Australia and Canada. With real disposable incomes having been fast outpaced by prices, and a rapid build-up of leverage we are ready to call a bubble, though we are not the first nor we suspect the last. Other niches of overvaluation include large international cities like London or Hong Kong, where limited supply, low interest rates and loose regulation have favoured cash inflows which use property assets as a cash-park.
The Martian economist beams back a memo to the Interplanetary Economic Council:
“Earth has improved, but the humans are still prone to the same fallacies. Short-sighted use of resources, search for utopian never-ending wealth, irrational behaviour and euphoria and lack of long-term balance. There is no need to invade yet. Without a change in policy and incentives, they will probably self-destruct over the coming century.”
Conclusions
Navigating the Bubble Galaxy A multi-decade credit expansion in developed markets, followed by prolonged central bank easing to fight the crisis has created asset bubbles in financial and real assets. Today, investors need to navigate this environment and position for a potential normalisation in monetary policy.
The Bank for International Settlements has long called for monetary policy normalisation, on the basis that inflation may be structurally lower – as we argued in previous Silver Bullets. Central banks seem to be finally following this advice, as recently shown by the Bank of Canada, Bank of England, the European Central Bank and the Federal Reserve.
That said, normalising policy will not be easy and may take longer than expected. This means that asset overvaluation may persist, and that countries in a better position to normalise will see their currencies appreciate.
The bubble galaxy may end up deflating slowly, rather than in a big bust. We remain cautious and position for the few remaining areas of value. In fixed income markets these are areas to which markets still apply unreasonable tail risk, in our view, like the Eurozone periphery including Greece as well as bank debt. We continue to think that Sweden and Norway, as well as the Eurozone, will have an easier time normalising policy than the UK, despite the recent hawkish rhetoric by the Bank of England, as we discussed recently in the Financial Times.
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