Rajan and Smithers: Fault Lines, Bubbles, and Clean-Ups

Raghuram Rajan, Governor of the Reserve Bank of India

By Ed Bace, CFA

In separate sessions at the 64th CFA Institute Annual Conference last week, Raghuram Rajan, professor of finance at the University of Chicago Booth School of Business, and Andrew Smithers, founder and chairman of Smithers & Co., which provides economics-based asset allocation advice, delivered presentations based on their most recent books, Fault Lines and Wall Street Revalued, respectively. Their message to investors: be wary of economic fissures and market bubbles.

Rajan, an ex-IMF economist, analyzed the fault lines in the global economy that he says aggravated the financial crisis — and threaten to delay a recovery. Smithers focused his talk on equity and housing market bubbles which he says are (still) driven by leverage, not economic growth, and are exacerbated by misguided encouragement from central banks, which he says must instead “lean” or be forced to “clean” — that is, “lean” against asset bubbles or face a big clean-up when they burst, as bubbles inevitably do.

Rajan identified three major global economic fault lines. The first is rising income inequality in the United States.  He traces the origins of the subprime crisis to political measures designed to foster home ownership, but that ended up providing credit to many homebuyers who were unable to service their loans — all in a misguided effort to boost wealth and consumption. Low-quality, subprime mortgage-backed securities were created as capital from governments and private-sector banks chased higher yields. Financial innovators responded by creating seemingly sound asset-backed securities that in fact relied on ever-riskier loans, resulting in a disastrous credit crisis.

The second crack in the global economy, Rajan contended, is the inadequate social safety net in the United States, particularly short-lived and small unemployment benefits. Meager benefits worked well in the relatively brief post-war U.S. recessions, but have failed in the current recession and have resulted in persistently high unemployment figures. The use of aggressive monetary policy to address joblessness in the face of enormous political pressure hasn’t worked — and is in fact creating another asset bubble.

Rajan said that a third economic fissure stands in the way of relying on emerging markets to pull the world economy forward: their export-led growth, which has carried their economies at the expense of domestic demand and consumption, and which shows little sign of changing. Resistance from some emerging economies to devaluing their currencies has led to commodity price increases that have triggered rising inflation in emerging and developed markets alike.

Andrew Smithers, who called the top of the U.S. stock market in 2000 (in a book he co-authored called Valuing Wall Street), once again regards equity prices as overvalued based on the q-ratio, the market value divided by replacement asset value, which he says is still well above its historical average. Housing, he added, also looks frothy: Despite the fall in U.S. house prices, the ratio of residential real estate to disposable income has only just returned to the post-war average of 1.4X. The UK housing market is even more inflated, Smithers contended, with residential real estate exceeding 4X disposable income.

Debt has created asset bubbles, he argued. In the U.S, private sector debt to GDP has ballooned to 250%, up from 50% in 1950. Meanwhile, corporate debt is at an all-time high (50% to 60% of net worth), and U.S. corporate profit margins are at worryingly unsustainable record levels, he added. In the wake of the financial crisis, some of this debt has been transferred to the public sector and is now being supported by taxpayers.

Neither Rajan nor Smithers is especially optimistic. Japan does not offer an attractive investment environment and Europe’s banking system looks undercapitalized, Smithers said. And although equities may look favorable in the short term, he added, investors with longer horizons should proceed very cautiously.

Rajan, for his part, described the outlook for the global economy as “partly sunny with a chance of thunder showers.” Over the medium term prospects look a lot better, he said, but hinge on a key question: can countries reform their economies? Emerging markets have never been able to manage a big expansion of domestic demand particularly well, he noted. And the relative loss of position in industrial countries could cause governments to fight change rather than adapt, creating the potential for political backlash.

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