Beware The ‘Froth’: Deutsche Bank Delivers Epic Warning To Investors

I’m looking for the vision. What’s the plan? If the goal is to end inflated assets, crisis-rate levels or obscene balance sheet sizes, then say so.

That’s from former FX trader Richard Breslow who, as noted earlier this morning, is “outraged” to start the week.

Of course central banks are trying to communicate the “plan” and the “goal” as clearly as they possibly can without triggering an outright panic.

It’s become abundantly clear that, to quote Deutsche Bank’s Francis Yared, “central banks need to tighten policy to stand still.”

That’s a reference to the fact that financial conditions keep getting easier despite efforts to explicitly tighten (in the Fed’s case) and implicitly tighten (jawboning from the Fed’s European counterparts). Here are the visuals:

Policy makers know good and well that this is contributing to bubbles in financial assets and so, the “shadow mandate” or the “third mandate,” has taken precedence over inflation of late.

Well on Monday, Deutsche Bank economist Mikihiro Matsuoka is laying things out as clearly as absolutely possible for you in a note called “Financial Markets Entering Frothy Territory.”

There are all kinds of quotables in the piece, particularly the bit about how an end to accommodative policy is likely to have a far greater impact on the psychology around inflated risk assets than any of the idiosyncratic factors that have caused crises of confidence in the past.

Find some excerpts below and do note the bolded and underlined bits (we bolded them and underlined them for a reason)…

Via Deutsche Bank

Equity market in developed countries entering ‘frothy’ territory

Stock market capitalization in the developed countries as a percentage of GDP has already approached levels very close to previous peaks recorded in 2000, 2008 and 2015. We believe that the financial markets seem to have entered frothy territory (even if not being in a bubble). In the first place, we would never know if this is a bubble until it bursts. The reason we believe it is entering frothy territory is that an eventual turnaround of monetary policy after a long period of post-GFC accommodation is under way in major developed countries, which in our view, raises the returns on safe assets and lowers the valuation of risk assets.

Figure 1 shows stock market capitalization of seven leading countries with relatively large market capitalization for which statistics are available back to 1991 (Australia, Canada, Germany, Japan, Switzerland, UK, US). We calculated the average and standard deviation for each country for 1991-2016, standardized them assuming a standard normal distribution with zero mean and unit variance, then obtained the simple average of the seven countries. According to this, local peaks were 1.45 in August 2000, 1.61 in May 2007, and 1.34 in May 2015, while the figure has risen to as high as 1.30 in May 2017 and 1.29 in June 2017 (preliminary).

Figure 2 shows the stock market capitalization as percentage of GDP in major developed countries (not standardized). The current levels of many countries have been very close to their respective historical peaks. In the process of “self-defeating financial deepening” as the author imagines it, the stock-to-flow ratio (e.g. ratio of financial assets to GDP) attempts to maintain an upward trend along with economic growth. However, an upward trend line cannot be justified and occasionally the ratio undergoes a major correction (decline), after which a new trend upward to the right resumes.

P/E already on a slow but persistent rising trend after GFC

A financial surplus in the non-financial business sector of developed countries has contributed to stable low interest rates through an increase in the funds for the “search for yield”, but it also reflects the loss of investment and profit opportunities (an end to capitalism).

These are near-term support factors for asset prices but eventually push valuations on risk assets too high. For example, the 12-month forward P/E, measured by the median of 15 developed countries and that of 19 EM countries, has been on a slow but persistent rising trend following the GFC (Figure 6). The cyclically-adjusted P/E in the US has already started to exceed pre-GFC levels (Figure 7). A further expansion in the differential between nominal GDP growth and the long-term bond yield would be needed to justify these circumstances, but this is unlikely to happen under the monetary policy turnaround.

Monetary policy turnaround as clear force toward asset price corrections

The first sign of the GFC was a suspension of the redemption at a hedge fund. At that time for many people, this did not mean anything substantive. When a bubble bursts, many seemingly idiosyncratic and unrelated events take place one after another, and we finally realize ex-post that they are symptoms originating from a single common cause. This time, such a symptom may include the deterioration of the quality of securitized products of US auto loans, and/or the deterioration of the financing of EM countries following a rise in US interest rates.

We all know that financial markets are fickle, in which one event influences investors’ psychology and this spreads to many areas to quickly and totally alter the landscape.

We believe that a turnaround of monetary policy in major developed countries, or at least its revelation, is a much clearer cause (not a symptom) of downward forces on prices of risk assets through a rise in the return on safe assets, than the suspension of redemption by a hedge fund.