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Market Voice: Watching for asset price bubbles

Ron Leven
Ron Leven
Professor of Economics at Duke University

The U.S. Federal Reserve has been aggressively adding to market liquidity, with Wall Street and real estate prices now high by historical standards. The first Market Voice of 2020 uses Eikon charts to see if Fed policies are creating asset price bubbles.

  1. There are fears the U.S. Federal Reserve’s monetary policy stance is potentially creating higher inflation or asset price bubbles.
  2. The U.S. stock market has been at record highs but is not particularly expensive relative to bond yields, with the valuation still within its historical range.
  3. A significant upturn in inflation is seen as the biggest vulnerability for bond and stock markets, with recession the major source of concern for real estate prices. 

As shown in Figure 1 below, last year’s shift in U.S. Federal Reserve monetary policy is apparent in the M1 growth trend, which is used to measure money supply.

M1 growth bottomed out at the end of 2018 as the Fed shifted from tightening rates to a neutral outlook before growth picked up in the second quarter as the Fed contemplated easing.

The Fed’s shift to ease monetary policy in the second half of the year was accompanied by an acceleration of M1 growth, which notably extended into the end of 2019 even though the Fed had moved back to neutral.

Figure 1: U.S. M1 and M2 Y/Y growth and CPI inflation

Graph of U.S. M1 and M2 Y/Y growth and CPI inflation. Watching for asset price bubbles
Source: Eikon – Click on chart to request a free trial

The Fed may have kept liquidity ample into the year-end to prevent disruptions in the repo market, and it would not be surprising to see some moderation in M1 growth at the start of this year.

But what is particularly notable about the recent easing is the more direct feedthrough to higher monetary aggregates — here proxied by M2 — suggesting that easing is having more effect on credit expansion.

M1 is at a two-year high while M2 growth is now approaching the all-time highs seen in the wake of the financial crisis.

With the economy operating at record low levels of unemployment, the Fed’s monetary stance is arguably throwing gasoline onto a well-stoked fire, potentially creating some combination of higher inflation or asset price bubbles.

Record highs for stock markets

Inflation — also shown in the above chart — while firming has yet to move significantly above the Fed’s two percent target rate and has actually moderated going into the end of the year.

As was discussed in last month’s Market Voice, inflation is something that will need close scrutiny in the year ahead.

Last month, we also noted that while the stock market was near record highs it was not particularly expensive relative to bond yields. The rally in stock prices has extended to fresh highs but, as shown in Figure 2, stock valuation remains in its historical range.

The higher stock prices have not materially affected the dividend yield relative to the U.S. 10-year Treasury rate, keeping them roughly in the middle of the post-financial-crisis range. From a rate of return perspective, the SPX looks roughly fair value in comparison to the 10-year bond rate.

Figure 2: SPX and dividend yield relative to 10-Year U.S. Treasury Rate

Graph of SPX and dividend yield relative to 10-Year U.S. Treasury Rate. Watching for asset price bubbles
Source: Eikon – Click on chart to request a free trial

U.S real estate prices

As shown in Figure 3, U.S. housing prices have fully recovered and are now above the pre-financial-crisis peak.

Given how central property over-valuation was to the crisis, there is growing concern in the press that the Fed’s gasoline is particularly evident in inflated real estate values.

While housing is now about 20 percent above the prior high, the SPX is more than double the pre-crisis peak; if equities are not overvalued, it is hard to see how real estate qualifies.

Perhaps a better indicator is housing prices relative to nominal GDP which, as is also shown in the chart, hit an extreme high on the eve of the crisis but are currently stable and consistent with historical levels.

Again, we see little evidence that real estate valuations can be characterized as frothy.

Figure 3: U.S. housing prices and nominal GDP

Graph of U.S. housing prices and nominal GDP. Watching for asset price bubbles
Source: Eikon – Click on chart to request a free trial

Asset price bubbles in Europe?

Unlike the Fed, the European Central Bank (ECB) has been steadfast in its efforts to push up the supply of money. It has continued to add liquidity via bond purchases and went through zero by taking rates into negative territory.

But it is getting a very poor bang for its euro. M1 growth has recently picked up but, despite all the ECB efforts, is barely matching the current pace of M1 expansion in the United States.

A more significant shortcoming is that M2 growth is lagging the gains of M1. Since M1 is a significant component of M2 the lagging growth means that other components are not responding – e.g., the ECB is not getting much traction with credit creation.

Figure 4: U.S. Housing Prices and Nominal GDP

Graph of U.S. housing prices and nominal GDP. Watching for asset price bubbles
Source: Eikon – Click on chart to request a free trial

The failure of significant credit creation would seem to make asset price bubbles less likely in Europe. Nevertheless, concerns seem to be building that European property prices are approaching bubble territory.

Figure 4 — at least visually — gives some credence to the notion of inflated housing prices. Unlike the U.S. market, European property prices did not drop materially in response to the financial crisis and experienced sharp appreciation over the past five years.

But the gains, while optically impressive, amount to a total of only 10 percent, and relative to GDP housing prices are arguably cheap and certainly not in bubble territory.

Watch: Eikon — The ultimate set of tools for analyzing financial markets

Impeachment and the markets update

The House of Representatives formally impeached President Trump on 18 December. As expected, no Republican member of Congress voted in favor of impeachment and the market showed almost no reaction.

With the Senate controlled by the Republicans the general assumption is that there will not be enough votes in the Senate-run trial to force Trump from office.

In addition, as shown in Figure 5 from the Eikon 2020 election site, the impeachment process has not had any meaningful impact on public support for Trump.

The structure of the Senate trial is still being negotiated, but a key issue is whether there will be witnesses – who were prohibited from participating in the House enquiry – to testify.

It is possible that some of these witnesses could provide evidence that is strong enough to sway public opinion and, most importantly, Republican support for Trump.

Republican Senators in tight races may feel compelled to vote for removal if they see a substantial shift against Trump – this seems a low probability but still worth keeping an eye on these poll numbers.

As was noted in November’s Market Voice the very different outcomes of the Clinton and Nixon impeachment processes were both followed by a sustained multi-year stock market rally – clearly a small sample size but still another potential reason for 2020 to be a market-friendly year.

Figure 5: Trump Potential Impeachment Timeline and the SPX

Graph of Trump Potential Impeachment Timeline and the SPX. Watching for asset price bubbles
Source: Eikon – Click on chart to request a free trial

Asset price bubbles: The bottom line

Despite the fact that the Fed and ECB are aggressively adding to market liquidity and asset prices — bonds, stocks and real estate — are high by historical standards, we see little indication that this is a bubbly new year.

But the fulcrum of this view is the low level of bond yields and by inference well-behaved inflation.

A significant upturn in inflation is the biggest vulnerability for both bond and stock markets. But given that real estate prices remain in a historical range versus GDP, recession rather than inflation is the bigger source of concern.

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The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Refinitiv, or any of its respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.