Are bonds and equities a bubble? Wrong question…

Domainfax has a piece today debating whether equities and bonds are a bubble:

One of the big questions being tossed around global markets at the moment is if shares and bonds are overvalued.

One side says clearly yes, pointing to historical averages, while the other side argues it’s different this time, pointing to record-low interest rates that – despite some noise – are unlikely to rise significantly anytime soon.

Capital Economics belongs to the latter camp, conceding that valuations of both bonds and equities are higher than their long-run averages, but saying sharp falls in their prices are unlikely.

“This is because we believe their equilibrium valuations have risen,”says chief markets economist John Higgins.

The reason for higher equilibrium asset valuations has been a decline in equilibrium real interest rates (ie ‘the new normal’ in rates), stemming from slower potential economic growth, an increase in the desire to save and a decrease in the desire to invest, he explains in a note to clients.

A key piece of evidence that supports the idea that equilibrium real interest rates have fallen is a lack of inflation, despite the fact that central banks have been setting real policy rates at lower and lower levels, Higgins says.

“Real policy rates affect real interest rates in the economy. If these real interest rates are permanently below their equilibrium levels, demand will eventually exceed potential supply, leading to higher prices.”

Higgins admits that there is asset price inflation, but challenges the view this has contributed to slower growth in the real economy.

“Some claim that central banks are responsible for a bubble in these prices, which has actually contributed to slower potential economic growth by, for example, facilitating the misallocation of capital and increasing inequality.

“In our opinion, though, higher asset prices are mainly the consequence rather than the cause of a decline in equilibrium real interest rates.”

Rather obviously it is both. The equilibrium interest rate falls as economies become debt-saturated. Once you add a shock and some deleveraging it gets worse again. As central banks try to boost flagging demand through monetary easing, they unwittingly prevent creative destruction and we end up with oversupply as well as poor demand and inflation falls even further.

Naturally, as the risk free rate falls the price of yield rises.

When applied to today’s emerging volatility, then the reverse is also true. As the risk-free rate rises then the price of yield falls. Thus any bond back-up will today choke equities. But given the underlying circumstances of debt-saturation, lacking demand plus artificially supported over-supply, just how far do you think that yields can back up before the pain caused by crashing asset prices hurts demand and drops inflation even further?

Rinse and repeat. So I wouldn’t call it a bubble so much as it is the death throes of an entire monetary system.

The only way out is get rid of the debt. That can be done through productivity gains via reform, through a jubilee, or through printing money for government’s to invest to grow incomes and the economy. Only one of these is politically easy so that’s the one we’ll choose. But not before further exhaustion of the present system.

The question before investors today is not whether or not assets are a bubble, it is who will own the right to create money in future and what does that do asset prices?