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Understanding the anatomy of a financial Bubble

Infamous for the belief that there is a bubble in long-duration assets, Richard Bernstein Advisors reckon there are sizeable bubbles inflating. A recent report investigates what’s causing such widespread bubbles, their potential effects on the overall economy, and the interesting investment opportunities resulting from the bubble’s misallocation of capital.

1. A huge monetary stimulus
The evolution of the current bubble began with the Federal Reserve and the government’s response to the pandemic with historic levels of stimulus. Short-term interest rates fell to 0% after the global financial crisis resulting in the Fed’s decision to inject additional liquidity by purchasing longer-term maturity debt.

2. A majority of 10-20 year Treasury market
Because the Fed’s activity has been sizable and lengthy, the Fed now owns a majority of the 10-20 year Treasury market. They have effectively “cornered” the treasury market. Cornering a market forces artificially high prices or artificially low yields. The artificially low longer-term Treasury yields have been a primary catalyst to the bubble in long-duration assets.

3. Artificial flattening of the yield curve
Consequently, the Fed has artificially flattened the yield curve. Where the slope of the yield curve has historically been a reasonable predictor of future nominal growth, with steeper curves forecasting growth and inverted curves suggesting recession, one would think that the historic monetary fiscal stimuli would vastly steepen the curve. Yet the curve is remarkably flat despite the stimulus programs.

4. Bank lending lags liquidity
Due to the present artificially flattened the yield curve, bank lending has significantly lagged the liquidity the Fed is attempting to inject into the real economy.

5. Liquidity trapped within the financial market
The result has been that much of the Fed’s liquidity has been trapped within the financial markets and inflated financial assets rather than financing the expansion of the economy. Nonetheless, the Fed’s data show banks have been more willing to lend, but their lending is not keeping up with the massive amounts of liquidity the Fed has attempted to inject into the economy.

6. Misallocation of capital
This subsequently has created a bubble, and the hype of a bubble always results in a misallocation of capital. Investors are hyped about innovation while many industries today are being starved for capital and are significantly underinvesting.

7. Shortage of capital
Previous under-investment has already resulted in shortages in some sectors. It appears the current bubble is following that historical precedent and the shortages could last longer than predicted.

8. New opportunities
However, bubbles create investment opportunities in virtually everything outside the bubble. Bubble investors often believe the hot stories about future growth but ignore the valuation of the assets and ultimately over-estimate their expected returns. The financial markets today appear to be at another opportunity opening like in 1999/2000 in that many sectors around the world outside of the bubble seem attractive. These sectors include those that outperform as nominal growth accelerates such as energy, materials, industrials, smaller capitalization stocks, non-China emerging markets, lower quality bonds, and commodities/gold.

To conclude, the current situation presents tremendous and broad investment opportunities in sectors that are being relatively denied capital.

Next Finance October 2021



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