Double, double, toil and trouble.
The world's financial markets are facing only two witches stirring the pot, but between them they're quite capable of adding a third bubble and bust in 2011 to the run of busts that began in 2000 and continued in 2007-08.
I'd be a lot less worried about a potential financial bubble if it were just the Federal Reserve stirring the pot by setting 600 billion greenbacks loose on the global financial markets by the end of June 2011.
But the Chinese government, with its $2.65 trillion in foreign-exchange reserves, can be as much of a force -- possibly more so -- in the inflating of any new bubble.
China's effort to give that cash a home, and earn a decent return on it, is pushing up the price of iron mines, oil fields, gold and the value of bonds denominated in Aussies, loonies and reals.
That makes figuring out what to do about a potential 2011 bubble and bust -- following in the footsteps of the bear market of 2000 and the financial crisis and bear market of 2007-09 -- so difficult. But in my Nov. 8 column on the potential for a bubble ("Oops, has the Fed done it again?"), I said I'd try.
So here's how I'd approach the possibility of another bubble and bust.
In that column, I laid out the reasons to think that the Federal Reserve might be creating another bubble, so I'm not going to cover that ground again. But let me take a paragraph or so to explain China's role in any potential bubble.
China's rise pushes prices higher
China currently plays two roles in inflating asset prices around the world.First, China's extraordinary 10% growth rate becomes an excuse for investors to bid the price of global assets higher. Oil should sell for higher prices, for example, because China will need so much more of it in the coming decades. On Nov. 9, the International Energy Agency forecast that China's demand for energy will jump 75% by 2035. China alone will account for 36% of the growth in global energy use during that period.
The same story is used by traders and investors and Wall Street analysts to justify ever-higher prices for copper, corn, iron ore, nickel -- you name it.
Those two factors set up the likelihood that at some point, China's demand for these commodities will disappoint investors even if China continues to grow at today's stunning rates.
Second, think about what eventually happens to all those cash surpluses that China accumulates. They don't just sit in a vault somewhere; they get managed. That means China buys things: U.S. Treasurys, Canadian debt, gold, iron ore mines, Greek government debt. And whatever China buys trades at a higher price than it otherwise would have.
Money needs a home
In one critical way, the $600 billion let loose by the Fed's program to buy Treasurys and China's $2.65 trillion in foreign-exchange reserves have the same effect. All this money -- from other sources -- is looking for profitable homes. And as it flows to whatever assets and markets promise those homes, the total $3.5 trillion (or more than $5 trillion, if you add in the $1.75 trillion in the Federal Reserve's first program of quantitative easing) bids up the prices of the assets in those markets.And the biggest effect is on asset prices -- whether for stocks, real estate, iron ore mines or oil fields -- in developing economies. Yields are higher, growth rates are higher, recent and potential returns are higher there. Why wouldn't money searching for a home head in that direction?
But as I noted in my Nov. 8 column, developing economies don't present the largest and most liquid markets. India, for example, is struggling to absorb the $25 billion -- the highest amount on record -- that has flowed into Indian stocks from overseas equity funds in 2010.
Looking for Mr. Bubble
So $25 billion is a problem when the Federal Reserve and China are talking about trillions? Do you see the mismatch that might lead to an asset bubble in the world's developing economies?How close are these markets to bubble territory? They're on their way, according to research from Morgan Stanley.
The good news is that at 22 times earnings adjusted for the economic cycle, the emerging markets traced by the MSCI Emerging Markets Index are just slightly more expensive than the Standard & Poor's 500 Index ($INX), which trades at 21 times cyclically adjusted earnings. In further good news, the MSCI index is 14% below its 2008 peak. (By the way, the exchange-traded fund that tracks this is the iShares MSCI Emerging Markets Index (EEM, news, msgs).)
So we've still got a way to run, right?
The picture isn't quite so reassuring, however, if you take apart the index and separate the still-below-peak valuation markets from the already-above-peak valuation markets.
Morgan Stanley reports that the stock markets of Colombia, Chile, India, Indonesia, Peru and the Philippines are all trading at multiples more than 50% above the average for the MSCI Emerging Markets Index for the past five years. (The corresponding good news is that Russia, Hungary, Poland and South Korea all trade at least 25% below the emerging markets average for the period.)
Continued: Not all bubbles explode
