I won’t pretend to know a lot about finance or economics, but I sold all my positions in June on the belief that there is a massive bubble in asset prices – which I feel must pop sooner rather than later. I’ll give my thoughts here, and then hopefully some people can come back with some refutations and differences of opinion – as I’d like to get a better understanding of the counterarguments.
As far as I can understand it, the traditional method of dealing with recessions in the past was to decrease interest rates. This allows for cheaper borrowing by companies, who can then invest the money they borrow into the production of future growth. This should then increase the size of the economy overall, resulting in a net creation of wealth. The negative effect of low interest rates is that it makes capital allocation less efficient. This is because companies need to produce a smaller amount of growth from the borrowed money in order to pay it back – encouraging less efficient companies to take out loans. This has resulted in ‘zombie companies’, whose profits can barely cover the tiny amount of interest required to service their debt. If interest rates were to rise even a small amount, these companies would quickly be unable to service their debt obligations and would face defaulting and bankruptcy.
I believe the ideal approach is to lower interest rates when times are hard – to encourage borrowing, but then to gradually raise them as the economy improves, in order to improve the efficiency of capital allocation, and to provide a buffer for reducing interest rates in the future. However, this has not been the strategy used in the past, and central banks have struggled to raise interest rates to previous levels after each successive crash without causing disruption to the markets and economy.
In 2008, during the global financial crisis, the rates were already relatively low before the crisis began. This meant that lowering the rates to zero was not enough to provide the required liquidity to the market, so an alternative approach had to be undertaken. This is known as Quantitative Easing (QE), and – to my understanding – is the purchase of government and corporate bonds by the central bank. The purpose of QE is to inject liquidity into the market while locking up assets in a way that the created money does not flow into the economy and cause high inflation – as would be the case if money was simply printed.
Again, I believe that the goal with QE is to provide short-term liquidity to the economy when times are bad, which is gradually rolled back as the economy improves, resulting in the selling of these assets into the market. Again, to my knowledge, this has not been accomplished effectively since 2008, resulting in a climate of low interest rates, and high levels of risky corporate debt held by central banks.
Now, we get to the COVID crisis, whereby the economy shrinks rapidly in response to lockdowns, lack of travel etc. The market takes a deep nosedive off this news, as companies begin to draw on credit lines to carry them through the downturn – resulting in a loss of liquidity. Central banks respond to this by cutting rates to zero. As the interest rates were still extremely low before the crash, this did not provide the required liquidity – so a huge amount of quantitative easing was required – over double that which was introduced during the 2008 crisis.
The rates being so low encourages spending rather than saving. However, in the COVID economy, there is nothing to really spend money on – there is no point in investing in productivity or future growth as sales and revenue are expected to be lower, not higher. The supply of bonds is also low, due to the huge amount of quantitative easing. This means that there is no place left for this additional liquidity to go – other than the stock market, further inflating a huge asset bubble. This is caused by the influx of retail investors into the market, stock buybacks by corporations, and financial firms having no other place to invest their money for a decent return.
I believe there are several key risks for the near future.
- The extremely high level of bad corporate debt and the high number of zombie corporations means that a tiny hike in interest rates would cause a huge downturn in the stock market and would mean many companies face bankruptcy.
- Any reduction in the stimulus provided by central banks would cause a credit crunch as companies try to draw on huge amounts of cheap credit.
- A reduction in QE would mean there are no buyers for junk corporate bonds, meaning that companies cannot refinance their debt and will face default and bankruptcy.
Does anyone see a way this can all return to more sensible levels without a huge bubble popping? And is there anywhere in my post where I’m way off the mark? As I say, I’m not an expert on this at all.
Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence or consult your financial professional before making any investment decision.