Overheating Markets – What to Do?

Published on 2014/07/22
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Time and again, in this publication, I have voiced my concern that the irresponsible policy of the central banks will generate bubbles clear across asset classes. The other day, I cited the examples of government bonds in one of my commentaries. The rate of return on Spanish ten-year bonds is now the lowest it has been since 1789 – and returns on government bonds in Ireland undercut even those of the United States.

“Why is no one talking about the bubble on the bond markets?” I wondered. Lately, things have started to move, though. Bloomberg wrote last week: “These are boom times for complacency. To gauge just how comfortable the world of debt has gotten, consider: Bond buyers handed $2 billion last month to Ecuador, whose socialist president forced a default during the financial crisis while calling creditors ‘true monsters.’ … Halfway through a sixth year of near-zero interest rates by the Federal Reserve and unprecedented central-bank stimulus from Brussels to Tokyo, almost any borrower is able to raise debt with few questions asked even as the World Bank cuts its outlook for global economic growth.”

I am not quoting myself here, but the renowned financial market news agency Bloomberg. In a recent warning to central banks, the Bank for International Settlements (BIS) suggested that low interest rates and the unchecked leakage of liquidity provide the fuel for ballooning equity, bond, and property prices.

Even in the corporate bond market, the formation of a bubble is well under way. In May, investors pounced on a bond sale by Clear Channel Communications Inc. As a result, the US radio broadcaster, whose credit rating implies that “default is almost a certainty” (Bloomberg), more than doubled the offering to a bond volume of 850 million US dollars.

The total value of high-yield bonds listed in the “Global High Yield Index” has surged to over 2 trillion US dollars (!!!). This means the index doubled its volume in just four years. Meanwhile, the yields paid by junk bonds plunged from more than 23 percent to a mere 5.6 percent.

All of this means that the question whether or not we have a “real estate bubble” on our hands is missing the magnitude of the problem. Since supposedly safe government bonds are only paying between 1% and 2% anymore, more and more institutional investors are buying high-risk securities – be they corporate bonds from companies with dubious credit ratings or government bonds from countries that must be considered absolutely unreliable. Yield rates in these segments have declined as a result, while risks are no longer factored in.

The trend is matched in the real estate sector, even though the situation has not deteriorated to the same degree as that of bonds. Anyone recognising the trend in good time may rejoice of tidy returns. Some years back, a friend of mine bought up prefab housing in Halle / Saxony-Anhalt for three times (!) the annual net rent, and resold them for a multiple of seven. The buyer has since put them on the market for multiples of ten or eleven. Even those who bought high-yield junk bonds will have earned very handsome returns. Indeed, investors in junk bonds have turned a profit of 157 percent since 2008, beating even the 123 percent rate of return reported by the World Index of stocks.

So is there a way out of the dilemma? What do we do now? There is no easy answer to the question. Not to invest at all and to leave the cash in call deposit accounts is hardly an option for institutional investors. Neither does it qualify as a long-term strategy for private investors.

No one, not even the brightest asset manager, can steer clear of the market. If nothing else though, this is precisely the type of situation that makes it prohibitive to compound the market threats by buying into risks that are based in the daftness and ineptitude of asset managers and fund managers.

People often come to me and ask how I am handling the situation.

  1. Here is what I did: I have kept my residential properties in Berlin and Bremen, and am delighted by the prospect of getting to refinance these for a pittance at the end of the fixed-interest period. For a block of flats I bought in 2004, I just renewed a loan – at an interest rate of 2%.
  2. I am hanging on to the bullion because I do not trust the current development of things. So this will remain my insurance against the next major financial crash.
  3. I have entrusted some of my money to the best asset managers on the market, and these are investing in US real estate and German housing in Class B cities. I am well aware that the overpriced market makes acquisitions very hard even for these professionals. But I expect them to make the most out of the difficult situation.
  4. A few weeks ago, I disposed of a large part of my stocks. I did so not because I assume that a setback in share prices is imminent. But I do know that you rarely if ever catch the cycle right at its peak, and at the moment I feel much better off to have downscaled my equities commitments, and am content with whatever returns I collected.

About the Author

Dr. Rainer Zitelmann is one of the leading experts for the strategic positioning and communications of companies.