The bubble will burst (just don`t ask me when?)

WIN_20141008_160548 (2)Have you ever known a bubble not burst? Here we are talking about the financial bubble in asset prices that has been created by damagingly low interest rates on official borrowings and which in turn has pulled down all other savings rates.

Six years of low, and more recently negative rates of interest, around the world have inflated asset values particularly in the ownership of shares, houses and other forms of property that have a speculative value. For the sake of brevity we will refer to all of these as assets that will be effected when the bubble bursts although the impact will vary between share prices which will lose value more quickly and to a greater extent than houses because of their intrinsic value. To develop our understanding of this problem we will need to define savings as assets whose nominal value is protected and investments as assets whose nominal value is at risk.

The current bubble started to inflate as Central Banks around the world reacted to the financial crisis which developed rapidly through 2007/8/9. Almost without exception Central Banks started to reduce their base interest rate to unprecedentedly low levels in order to offset the threat of a deflation in average prices and a depression in their respective real economies.

The bubble was slow to develop as people perceived of these low rates as temporary emergency rates that would soon return to “normal” levels. Being normalised in the UK meant returning from 0.5% to 5%ish. However as the years have gone by so the perception has changed and is changing to one of a feeling that the official bank rate is likely to remain at its current level into the foreseeable future. This is the same in all the other major economies including the USA and the Eurozone. This means that the bubble in asset prices is being fuelled by people moving out of fixed nominal savings contracts into higher risk investments. There are two reasons for this: firstly the dividends on shares are better, even with increased risk, than the return on savings and, secondly because a capital gain will increase the rewards over and above the dividend return. In addition to this people, seeing share prices rising alongside very cheap loan availability, will be attracted to borrow and buy shares. This last point will ensure the bubble bursts rather than slowly deflates.

At this point some simple maths may be helpful if we look at savings rates and investment returns including capital gains. Going back a few years let us remember that a normal rate of return on savings was about 4% and, given a risk premium, the rate of return on investments was about 6%. At that time share prices would reflect a higher dividend yield, say 6%. Following this let us suppose that the Central Bank base rate is reduced and savings rates fall to 2% and this is perceived as a long term rate going forward. Share prices will gradually rise until dividends are 2% plus a risk premium. For sake of argument a 3% average return on shares will mean that stock market valuations will have doubled.

Now let us look at the reverse of this position given the situation in the UK. On March 5th 2009 the Bank of England lowered bank rate to 0.5%. Initially this was seen as a temporary or emergency rate that would soon be normalised. Because of this it did not have a significant effect on people`s permanent perception of saving rates, investment returns and capital values. However as time has gone by and savings rates have continued to fall close to zero so people holding savings have been attracted to invest in equities. This increase in demand for equities has caused their price to rise and the dividend yield to fall. Suppose the best savings rates are currently a little over 1% then people will expect dividend yields to be over 2%, but they may lose sight of this if they are overcome by capital gains and only see share prices continuing to rise.

We are now travelling well into bubble territory. Not only are the dividend and capital gains encouraging people to move into shares so other people are being encouraged to add fuel to the fire by borrowing to invest; something that was rife just before the Wall Street Crash.

No sensible person considers a Bank rate of 0.5% as a normal sustainable rate and at some point in the future interest rates on savings will begin to rise unofficially if not officially. The result will be that share prices will start to fall, capital losses will offset dividend yields, the professionals will be the first ones into cash followed sometime later by amateur investors. Stock markets will rapidly lose value to reflect higher savings rates and the bubble will have burst and even worse this will be happening all around the world.

John Hearn 10/4/2015

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