News

Bubble Trouble

Compared to last week, there have been few changes to the big picture narrative: Thanks to the virus containment efforts enacted by its government, China’s labour force is only now slowly returning to work following an unusually extended Lunar New Year break. But most importantly, factories have restarted, even if at lower output levels than their trading partners would have banked on at the beginning of the calendar year. Because of the global supply chain interdependencies, and the temporary fall in Chinese demand, the resulting slowdown in industrial activity around the world is increasingly seen as a delay to the expected 2020 economic recovery. The upswing is unlikely to come in the first quarter, perhaps not even in the second, but after that activity levels are likely to jump up in the second half of the year.

In the UK, the new government’s actions confirmed our view that austerity is not part of their vocabulary and that we can expect a significant boost in public investment. While much of this is expected to be debt financed, the March Budget may nevertheless bring direct and indirect tax increases, or the government risks losing trust and support from capital markets – which could ruin their fiscal expansion plans. For the moment, fiscal expansion is good news, as it will reduce dependence on export demand. However, alongside Home Office plans to curb “lower skilled” immigration, the fiscal expansion plans have the potential to create wage-driven inflation pressures. That is, unless the government can also coerce businesses into significantly hiking their investment levels to increase productivity, which have been severely lacking recently. Businesses’ workers may well be attracted onto better pay in the government’s infrastructure projects.

We discussed last week how markets appear willing to disregard the unavoidable deterioration of earnings prospects in manufacturing over the first two quarters in return for an enhanced outlook for the second half of 2020. This week continued along the same lines, with the US stock markets once again hitting new all-time highs. But this was not the whole story. So, we devote the rest of this piece to discussing the nature and dynamics of stock market bubbles.

Blowing Bubbles

On Thursday evening, there was a sudden rush to the exit in some of the highest valued stocks in the world. Those who have described current US valuations as being in bubble territory saw this as a vindication of their view. There was no obvious trigger for the sell-off. News wires might point to the rise in South Korean COVID-19 infection cases – but this sounds a bit far-fetched, given the spread is well within expectations from last week.

Current market conditions continue to be mostly about liquidity and investor capital flows – with near-term economic prospects looking sluggish. When market movements are dominated by liquidity flows, it tends to be related to asset bubbles. Bubbles are risky for investors because they eventually deflate, even if it may not feel that way when we are in the middle of one – most investors prefer to be part of a bubble when its inflating. At the same time, investors would like their active managers to use “timing” to get out at the right moment.

Bubbles inflate when most are getting in, but during this phase, some market players try to lessen the risk by “scalping”: buying and then taking a quick, smallish profit. That has the effect of increasing trading volumes and lessening daily volatility. Prices squeeze upwards rather than gapping up. (There are also other reasons for low short-term volatility, related to options trading).

It does not work like that on the way down. Signs of more than expected intraday volatility, as seen on Thursday evening, can be a signal for the longer-term timers to exit. The number of buyers in this sort of market can fall quickly to virtually none.

Of course, short-term volatility is used by many as a primary measure of investment risk. So, the riskier phases in markets can seem like the least risky, which leads back to what we said above, that the riskiness of a bubble building is usually not immediately apparent during the process.

So, are the bears right that a stock market bubble is building, one that will inevitably end in another enduring market correction later in the year? We do not think so – although even we cannot be entirely sure. What we do know is that current market action is ignoring the fact that Chinese and international virus containment actions will lead to lower than anticipated growth rates during the first half of 2020. Should expectations for the virus impact prove correct, and COVID-19 follow similar patterns to flu pandemics of past decades, then a V-shaped recovery later in 2020 is a reasonable expectation. In which case, company earnings should underpin the levels stock market valuations have reached in anticipation of such an outcome.

The discomfort of this market environment is that any bouts of doubt about the benign scenario unfolding leads to potentially outsized market reactions. Such effects can be as short-lived as they were this week, but also slightly longer lasting, as experienced last year in May and August.