Commentary on Political Economy

Wednesday 27 December 2023


The great spec­u­lat­ive era has defied war and dis­ease and will not be stopped lightly

In most Hol­ly­wood hor­ror movies, the mon­ster is incred­ibly hard to kill. Not until the final moments of the film will it be dis­patched and, even then, enough doubt will be cre­ated to leave room for a sequel.

So it has been with the great spec­u­lat­ive era on the fin­an­cial mar­kets. A pan­demic, a Russo-Ukraine war and even sub­stan­tially higher interest rates have not fin­ished off the risk-tak­ing bon­anza.

Take the tech­no­logy sec­tor as a starter. Much of its value lies in the future profits com­pan­ies are expec­ted to earn because of their super­ior growth poten­tial. When bond yields rise as they have this year, investors should in the­ory use a higher rate to dis­count those future profits tak­ing into account the time stocks have to be held to receive them.

That means valu­ations should fall, not rise. But the price/earn­ings ratio of the US tech­no­logy sec­tor is well above its three-year aver­age and the sec­tor’s shares have jumped more than 50 per cent so far this year.

Second, take the over­all mar­ket valu­ation, as meas­ured by the cyc­lic­ally adjus­ted price/earn­ings ratio, or Cape. This aver­ages profits over 10 years to allow for the eco­nomic cycle. In March 2022, as the US Fed­eral Reserve star­ted to push up interest rates, the Cape was 34; on the latest fig­ures, the ratio has dropped only to 31, still well above the his­tor­ical aver­age. And mar­kets have con­tin­ued to rally in Decem­ber.

Then there is bit­coin. The late, lamen­ted Charlie Mun­ger, the longterm col­league of War­ren Buf­fett, said that invest­ing in crypto­cur­ren­cies was “abso­lutely crazy, stu­pid gambling”.

As if to prove his point, the past 18 months have seen the col­lapse of the crypto exchange FTX, and Bin­ance — one of its biggest com­pet­it­ors — suf­fer­ing a $4.3bn fine for money laun­der­ing and the forced depar­ture of its founder.

There could not be more alarm bells sound­ing if the entire New York City fire depart­ment was racing, with sirens blaz­ing, past investors’ doors. But the bit­coin price has more than doubled this year. One explan­a­tion for the con­tinu­ation of investors’ risk appet­ite is that, while nom­inal interest rates have risen over the past couple of years, they have been out­paced by infla­tion; the real returns on cash and bonds have not been attract­ive. That has main­tained the allure of risky assets.

Now infla­tion has fallen, real interest rates are mildly pos­it­ive in the US, mak­ing cash and bonds the­or­et­ic­ally more appeal­ing. But investors do not expect this to last. The stock mar­ket rally in Novem­ber was driven by the wide­spread expect­a­tion that the Fed­eral Reserve would be able to start cut­ting rates in 2024.

But there is more to the frenzy than the pro­spect of a change in mon­et­ary policy. Sur­veys show that Amer­ican voters are not happy with their eco­nomy, even though it has actu­ally been doing remark­ably well. In the third quarter, gross domestic product grew at an annu­al­ised rate of 5.2 per cent.

The eco­nomy has been sup­por­ted by fiscal policy, with the budget defi­cit run­ning at about 5.7 per cent of GDP in the cur­rent year. In other words, Amer­ican pock­et­books are suf­fi­ciently flush that they can afford a little gamble.

So what could finally bring the spec­u­lat­ive era to an end? In any indi­vidual asset class, a col­lapse usu­ally arrives when investors lose con­fid­ence in the fun­da­ment­als that have been driv­ing prices higher.

For tech stocks, this could occur if reg­u­la­tion (or geo­pol­it­ical ten­sions) severely dam­age their profits out­look, For crypto, reg­u­la­tion is also a risk, as is the col­lapse of an exchange that res­ults in big losses for insti­tu­tional investors. But it does not seem as if the boom in tech stocks and crypto is being driven by the use of large amounts of lever­age. His­tor­ic­ally, the trig­ger for a more gen­eral col­lapse in risk appet­ites has been a tight­en­ing in credit con­di­tions.

That was the reason for the plunge in mort­gage-backed secur­it­ies in 2007 and 2008, which then filtered through to con­cern about the bank­ing sys­tem. So it might be that a sharp fall in tech stocks or crypto would simply cause spec­u­lat­ors to switch to another asset class.

A more gen­eral col­lapse in risk appet­ite may require a dra­matic geo­pol­it­ical event, such as war between the US and China over Taiwan, or a cent­ral bank mis­cal­cu­la­tion in mon­et­ary policy, either by fail­ing to con­tain infla­tion or being too tight for too long and caus­ing a deep reces­sion. These may seem like extreme out­comes but it usu­ally takes an explo­sion to kill a movie mon­ster.

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