Predicting the growth and bursting of bubbles is a difficult task, even considered as impossible by some. In fact, bubbles can last for a long time and are only apparent when they burst. Calling them too early can lead to suboptimal allocation. However, there are signs of market exuberance, particularly in the tech sector. These high valuations are driven by high growth expectations and, more importantly, ultra-low discount rates, the normalisation of which could trigger a bursting of the bubble. Although a major source of risk for investors, history shows that all bubbles are not equal when it comes to their impact on the economy.
Cycles in financial market segments (equity, housing or credit) are playing an important role in shaping recessions and recoveries. The current recovery has hardly started, and growth might surprise on the upside in the short term. In the US, President Biden’s $1.9 trillion (9% of GDP) fiscal stimulus plan raises concerns of overheating in the second half of 2021. Chinese GDP might grow as much as 9% this year. Europe, for its part, is expected to benefit from two consecutive years of strong growth. Inflation is expected to rise too, in particular in the US. Although it would be short-lived in our view, an inflationary miniboom would also boost corporate earnings expectations and investor confidence. The strong momentum on the equity markets might therefore continue for some time, supported by strong nominal growth.
The most striking feature of this new cycle is the level of indebtedness. Private and public debt post- Covid-19 have surpassed the historical highs reached at the end of WWII. Higher nominal GDP growth might support debtors but at the same time should lead to higher long-term interest rates. It might also put central banks, and the Federal Reserve in particular, under pressure to withdraw their accommodative programmes. However, as we argued in last month’s paper (Taper or not taper), the Fed is unlikely to stabilise its balance sheet and raise policy rates until the economy is well on track: returning to full employment will take much longer than returning to pre-crisis GDP levels. The slack in the job market should prevent wages from soaring (the Phillips curve has flattened) and, in any case, the Fed has adopted for a new strategy (average inflation targeting) that allows it to wait and see if inflation surprises on the upside.
Finally, maintaining bond yields well below nominal potential GDP growth is a prerequisite for public debt sustainability.
Therefore, a potential outcome of this unusual recovery, in which CB balance sheets will continue to grow even as growth accelerates, is an asset price bubble, starting with assets whose valuations are highly sensitive to distant future profits.