Bubble trouble

The financial crisis was caused in part by an enormous bubble in the credit markets. Where will the next bubble arise?

There are two major imbalances in the world economy. The first is that we consume too much in the West, relative to our output. So much so that we are borrowing from the East to enable our consumption. The second is the "greying world" phenomenon; as the world gets older there are more and more people who are saving for their old age, and fewer young borrowers.

The financial crisis was caused by an excessive supply of credit and too few quality borrowers (both companies and individuals). As a consequence, elaborate off-balance sheet tools were created to provide credit to unsuitable borrowers and spread the risk to all types of investors.

Although it seems that lessons have been learnt from this crisis, questions are being asked as to where the next bubble will be in the UK.

Sovereign debt

Until recently demand for UK gilts (called gilt-edged because of the government's ability to meet payments by taxing the populace) has been robust, keeping prices high despite quantitative easing. Fearful of risk, investors have accepted low yields and high bond prices. However this fear has started to abate as other asset classes ride up on cheap funding (low interest rates) from government securities. Watch out for long-term investors getting hurt as prices decline when inflation fears and interest rate hikes are realised.

Bubble rating: 3/5

Credit

The days of easy credit won't return to these shores for some time. Much tighter lending criteria, stronger regulatory controls and higher interest rates will keep a lid on credit lending, although high yields will persevere for those in the business of lending to desperate borrowers.

Bubble rating: 1/5

Currencies

Sterling is falling, reflecting the long term view on the economy. With low interest rates at home, carry trades (which borrow in the UK to invest abroad in higher yielding currencies) have become popular and helped its decline. A weaker pound should help boost exports leading in turn to job creation. However Japan's recent history provides a warning. During the 1990s Japan saw low interest rates combined with deflation. Things only got worse when the US lowered interest rates: the carry trade reversed and made Japanese exports expensive. This led to a large decline in Japan's GDP. Could we yet see that happen here? Interest rates would have to rise at some point. If this happened and one of our major trading partners kept interest rates the same, sterling would strengthen and hurt the competitiveness of our exports.

Bubble rating: 3/5

Commodities

The UK has little influence on commodity prices, being a price taker on the world stage. With North Sea oil depleting, we will become increasingly dependant on foreign hyrdrocarbons, leaving the UK vulnerable to price fluctuations in the commodity markets. Once world demand normalises, commodity prices should rise in any case due to all the easy money being printed by central banks worldwide and growing energy demands from Asia. There may well be mini-bubbles as new price levels are determined. Off-setting this is the focus on green clean energy which, if economical, could move energy demands from traditional sources.

Bubble rating: 3/5

Equities

A curious feature of the FTSE 100 is that only 20 per cent of its revenue is generated in sterling. This helps corporate earnings as other currencies strengthen against the pound. A weaker domestic economy could be offset by growth in foreign earnings. If UK corporate earnings can pass on inflation costs to consumers, there could be bumper returns. The danger is what happens if the pound strengthens.

Bubble rating: 2/5

Property

Discredited by many as an asset class (rises having been fuelled by access to cheap credit), values are likely to deteriorate for some time. Low interest rates and reasonable rent levels (kept up by a shift of would-be homeowners becoming tenants) have stopped a collapse in the price of property. If interest rates rise and UK consumers remain debt-laden, we can expect the property market to decline severely. The two possible supports - at least in the home counties - are the continued attractiveness of London as a base for migrant labour (providing a ready supply of tenants) and the weak pound, which allows foreigners to invest cheaply in UK real estate. However, it is unlikely that we will see a bubble in real estate for some time.

Bubble rating: 1/5

Derivatives

Over the counter (private agreements between corporates and banks) derivative products are still largely unregulated and present the greatest threat to creating the next bubble. As a risk transfer mechanism they are efficient, but the danger is that strategies can be employed to take risk off the balance sheet until it suddenly (and catastrophically) reappears at a later date, as happened with AIG. The firm sold insurance on loans which materialised and sent the company bust overnight. There has been a lot of talk of using derivatives to share risk in pension products. There could be a bubble if the market for this picks up.

Bubble rating: 4/5

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