The million-dollar question, which hangs around all investors’ mouths, is whether the market is facing a financial bubble that will burst or if it’s simply optimistic about the recovery of economies after the pandemic.
El American spoke with investment banker at Liceo Capital Advisors and finance professor Edgar Fernandez, who believes that the market is indeed showing signs of a bubble. He believes that central banks and governments do not necessarily know what they are doing in such an uncertain post-pandemic context.
JFV: Do you see signs of a financial bubble in the markets?
EF: Clear signs, yes. We are in a scenario with savings rates at record highs, stock markets and markets at record highs, and with economies crippled by Covid-19. What will happen when the Covid-19 restrictions end and people start consuming what they have saved this year? We’ll see rising prices.
Inflation will come from the tremendous increase in the money supply that has taken place over the years. That money has been going into the financial markets, but what we see now is that it is finally affecting the real economy.
This possible pickup in inflation will affect the financial markets, especially fixed income, i.e., government and corporate bonds.
States are at peak levels of indebtedness, a rise in interest rates can be lethal for some economies, and this suggests that central banks will prefer to control the solvency of states rather than inflation.
JFV: Jerome Powell says that inflation will indeed increase, but it will be temporary. Do you believe that inflation will return to control itself, or will the Fed have to raise interest rates?
EF: If inflation comes, in my opinion, central banks will not try to stop it immediately, and it could get out of control because for governments to continue to be able to borrow cheaply, central banks will have to increase stimulus to compensate for the flight of fixed-income investors who want to protect themselves from inflation.
If, when inflation arrives, central banks cannot reduce the money in circulation sufficiently, it can get out of control and have to raise rates without hesitation.
JFV: Right now, there is more than $10 trillion of corporate debt in the market of which the Fed has become the biggest buyer. Yet, despite the debt, we see that stock prices and all types of assets, continue to rise. Why is the market so optimistic if it is so indebted?
The market is not bullish; the market is being pushed because there is huge excess liquidity. Central banks buy debt that drives down the price of interest, which causes a crowding-out effect from investors who are no longer compensated for the risk and go to other riskier assets such as equities.
Riskier markets increase in price, and their potential return decreases, again displacing investors to take on more risk. For example, we are at record levels of investment in Private Equity, which is the market for investment funds that invest in unlisted companies.
This drives up the prices being paid for private companies, and even more so, these purchases are normally made with cheap debt. In the end, what we have is a market on steroids.
All markets are in this state, except commodities, where we are now starting to see signs of warming, and if commodities, like food, go up in price, then the real economy is starting to feel it with inflation.
Stock market inflows at record highs, the multiples at which companies are trading at record highs, the ratio of stock market value to GDP at record highs, and the stock market level relative to corporate earnings in recent years record highs.
Whichever way you look at it, we are on the verge of a crash. When it happens, we do not know because it depends on the central banks that can go on and on with the current policies forever, but in the end, inflation will come.
For example, if the Bitcoin increases so much, people no longer trust the central banks and want to protect themselves with a currency they do not control.
JFV: Isn’t Bitcoin also a financial bubble?
It can be, yes, but if what I tell you holds true, Bitcoin will prove not to be a financial bubble, and this is coming from someone who is anti-Bitcoin and who will never invest in it.
JFV: But crypto in and of itself is quite volatile, and its valuation has outperformed that of any company in the S&P500 last year
EF: Yes, that’s true. But if bitcoin is going to become a store of value, it has to increase in price more than 10 times to reach the stock market value of gold. It would have to trade at $1.5 million for each bitcoin to reach the level of gold.
I wouldn’t bet on it, but that’s the narrative behind the pro-Bitcoin folks. It is true that volatility is gradually decreasing, and an increasing percentage of large investors are not trading and are holding their positions.
JFV: Many investors have been alarmed because the 10-year treasury yield has surpassed 1.6% interest rate.
EF: Because it means that investors are asking for higher returns as they expect inflation to pick up. Treasury debt’s interest rate shows you two things: inflation expectations and default risk.
The US’s default risk is minimal, if not 0, at least compared to other countries. What is being discounted is a rebound in inflation: think that if the yield is at 1.6 %, but inflation rises to 2 %, investors will be losing 0.4 %.
JFV: Do you think that the U.S. housing market may go down like in 2008?
EF: There is talk about it. Some analysts say that by the end of this year, we will see a housing crash. I don’t see that so clearly. For me, if the housing bubble has to burst, they should raise interest rates first and then go into a process – not entirely quickly – in which mortgages stop paying. But I don’t see it that close.
JFV: ¿Cómo ve la recuperación del sector real de Estados Unidos?
EF: Well, the recovery is going slower than originally expected; it has stalled a little bit. I think the first quarter of normal post-covid, supposedly the third quarter, will be very good.
The U.S. is a very flexible country, and if the authorities don’t mess around, it should be the economy that pulls the world. But, honestly, I find it very difficult to project scenarios; this situation is unprecedented, and I don’t think anyone can imagine what is going to happen in the future.
JFV: Do you believe that Biden’s stimulus plan could help accelerate the economy’s recovery?
EF: It will accelerate the arrival of inflation. The economy does not grow by consumption, the economy grows by investment. Of course, if consumption increases, GDP increases, but it is not a healthy and sustainable growth.
If consumption were the solution, Venezuela would be the richest country in the world because they spend everything on consumption, on bread and the few things they have. The advantage of the United States is that it is a flexible market; it adapts quickly. But the stimulus plans are an absolute mistake.
JFV: Do you think Biden’s plan will accelerate the bursting of the bubble?
EF: If inflation has to come, which we don’t know for sure, this plan will accelerate it because it is no longer money that is injected into the markets forcing investors to invest in riskier assets. It is money going directly into the hands of citizens who are eager to spend as soon as we get back to normal.
JFV: Now for the million-dollar question, when do you think the financial bubble will burst?
EF: Whew…I don’t like those kinds of predictions.
JFV: Or what indicators would you look at to anticipate a possible crash?
EF: Gold and silver. If they start to rally simultaneously as yields continue to rise, investors will be clearly saying that they are really expecting inflation and, with it, the crash.