Of bubbles and balloons

This is the seventh of a series of monthly articles compiled by Curmi & Partners Ltd, that cover a mixture of educational topics, general market commentary on both local and foreign markets as well as topical subjects that impact your wealth.

We seem to be living in an era of continuous bubbles in the financial markets. An ability to spot a bubble from a justified rise in the price of a financial asset is proving to be a crucial tool in the world of investment. But is a bubble always a bubble?

Bubbles have been present in one form or other for many a year. Dating back to the infamous Tulip bubble when the price of a simple tulip cost more that the price of an average home in Amsterdam or the asset price bubble in Tokyo when the value of a particular palace was greater than all of California, bubbles are not uncommon.

They simply reflect human psychology i.e. the desire to chase a rising price in the eternal belief that the price of that asset will continue to rise (wishful thinking). Other more recent bubbles include the technology price bubble of the late 1990s together with the speculative rise in other equities that occurred at the same time.

Here in Malta one can look back and argue that we were not insulated by what happened in foreign markets and our own little exchange suffered a tremendous retreat from its highs.

Today however the focus is not on the equity market but more on the bond and property markets. Here too one can draw comparisons to what is happening overseas. And once again the question must be asked - is this a bubble or is it a sustainable move backed by real economic fundamentals?

In order to answer this question one needs to look at the underlying fundamentals backing the move in prices while always bearing in mind that markets will always overshoot, both on the upside and on the downside - another trait in the wishful thinking aspect of investors.

In any developed market investors can rely on a series of checks and balances built into the financial environment that assist in countering these excesses when they occur. Particularly this has been the case with the development of technology and the speed that information is passed onto those people interpreting data.

Central to the rise in the prices of bonds and property has been a highly accommodative monetary stance that has assisted in the reduction of interest rates to a 40-year low in the US. The driver behind this stance has been the effort to stave off a deflationary environment that can be extremely dangerous to any economy (see Japan) at a time when other external forces (global terror) are also playing their part.

Meanwhile the knock on effect of this loose monetary stance is twofold. Firstly inflation is at a multi-year low so it is natural that bond yields should also be at multi-year lows.

Secondly the low interest rates have made credit easily available. Consumers have seen their interest bills fall dramatically and hence have been more willing to take on debt as the net effect of the increased debt is neutralised by the lower interest rates.

This willingness to take on more debt and its availability by the banks has fuelled demand for assets - mainly property and bonds.

The real question therefore is whether the level of interest rates we are seeing today are sustainable in the medium term. The answer to this question reveals the extent to which the affordability of assets can be sustained.

Over the last month expectations of where interest rates might go in the medium term changed dramatically with bond markets suffering their worst one month decline since 1987. This signals that expectations of permanent lower interest rates were overdone (remember the overshooting of markets mentioned above).

But the productivity gains made in various economies around the world should ensure that inflationary pressures remain subdued for the foreseeable future. Thus interest rates should not need to head northwards just yet. However the movement in bond prices over the last month clearly indicated the extent to which investors are exposed to bonds. And this is the risk.

Bond investors should now be weary of continuing to chase long term yields in foreign bonds and bide their time in shorter dated bonds.

But what of asset/property prices? Malta is very much in play here too as the property market appears to be in a frenzy. Here the answer lies in affordability. Buyers of property can justify higher prices only if the rises in prices are matched by income gains in the long term.

Clearly demographic trends, housing formation and the availability of credit all impact. Yet in the long term affordability is purely a function of disposable incomes. While these have risen significantly in many countries over the years thereby justifying to some extent the housing boom, it is important that any investor in property keeps his feet on the ground and does not end up drifting pleasantly in some hot air balloon.

All balloons need landing at some point (ask Mr Branson about this). The trick is to avoid crash landing.

The EU Stability and Growth Pact - what now?

Italian Prime Minister Silvio Berlusconi recently got into some hot water when he suggested that a certain German politician would do well playing a Nazi guard in a forthcoming film. Consternation all round. Eurosceptics hoping that this would throw a spanner in the wicked EU works were disappointed when Berlusconi backed down from his colourful comments.

Hope springs eternal, however. Since the EU is a conglomerate of the diverse, there is always scope for opposing and destabilising forces to manifest themselves. And we're not talking about the Eurovision song contest...

According to the EU Website, the "Stability and Growth Pact (SGP) is the concrete EU answer to concerns on the continuation of budgetary discipline in Economic and Monetary Union (EMU)." The EU has always been good at grand ideas. Apart from the contentious use of the word 'continuation', it has been apparent for some time that the 'concrete' is crumbling.

Adopted in June 1997, the SGP aims to close off the loopholes in the Maastricht Treaty.

Germany was concerned that the Maastricht Treaty did not ensure fiscal discipline and feared that certain countries (read Italy, for example) would adopt loose policies once they joined EMU, safe in the knowledge that this would not lead to higher debt servicing costs. (It later transpired that Germany had under-estimated the resourcefulness of their Italian colleagues when Italy proceeded to raise a repayable tax and arranged currency swaps that substituted low yen interest charges for high lire charges, but that's another story).

The SGP aims to achieve medium-term budgetary positions close to balance or in surplus which will allow all member states to deal with normal cyclical fluctuations while keeping the government deficit within the reference value of three per cent of GDP.

How ironic then that it is Germany, as well as its traditional ally France, whose budget deficits are forecast to rise to well above three per cent of GDP this year? But, surely they will be punished for their naughty anti-European behaviour? Think again.

The SGP is not legally binding. It "solemnly invites all parties, namely the member states, the council and the commission, to implement the Pact in a strict and timely manner." This is the usual eurospeak we have become accustomed to, impressive in style but less impressive in substance. So while the SGP aimed to close off the Maastricht Treaty loopholes, it is itself a massive loophole since it is not legally binding.

One could reasonably have predicted that if a big hitter (such as Germany or France) were to fall foul of the rules, they would be fudged.

And now it is happening. Jacques Chirac wants a 'temporary softening' of the three per cent limit, yet at the same time he asserts that this would not modify the Stability Pact. (It would be interesting to see what would constitute a modification/destruction of the SGP in Monsieur Chirac's mind).

Where we go from here in respect of budgetary discipline is not clear at this stage, but one thing is certain: the Stability and Growth Pact is in trouble. The economic consequences will be far-reaching, as will the potential impact on equities, bonds and the Euro. We await developments with interest.

HSBC results

HSBC have reported their interim results for the six months ending June 30. The group has made solid progress on a number of fronts.

Profit after tax increased 20% to Lm8.5 million. The dividend was raised a hefty 35% to 10.8c.

Despite an adverse economic environment and the eventual erosion of foreign exchange dealing profits, we retain a positive outlook on the shares at current levels. BUY (A more detailed report on the results is available on request).

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Curmi & Partners Ltd are licensed to conduct investment services business by the MFSA and are members of the MSE. The value of investments and the income derived therefrom may rise as well as fall. Past performance is no guarantee of the future. Any opinions expressed are those of the authors and are subject to change without notice.