Wednesday, September 30, 2009

Where Is The Next Bubble?

Look out for the next round of "emerging markets".

In the late 90's the easy money policy coincided with the advent and new-found stability and strength of the Internet, pumping huge amounts of speculative money into dot-com ventures. In the early 00's, the easy money policy coincided with the advent of the new-found stability and strength of credit derivatives. Readers might recall Enron set the stage for a new way to look at derivatives, after which the same geniuses of mind that invented them for energy and bandwidth extrapolated the concept into credit markets like never before. The question for us today is what financial model has the same characteristics that make for speculative exploitation?

First, it must be global in nature -- accessible and understandable to every language, culture, and nation. The last two bubbles occurred everywhere. In fact, there isn't a single nation big enough to absorb all the money in the world by itself. We need a band-wagon big enough for the entire human race.

Second, it has to be relatively new, as in "iteration 3". It has to be a bit of a novelty for the commoner and limitless. Bubbles don't grow where there are walls or boundaries. The Internet iteration 1 was limited to academia nerds, with commoners intrigued by the mystery of the new concept. Iteration 2 of the Internet found some bold adventurists dabbling in newly invented business models that only a very few understood well enough to make sense of. By iteration 3, the commoners began to understand this new business from having been exposed to it as consumers in iteration 2. The Internet had no bounds. So when the easy money politics of Alan Greenspan kicked in, it was a no brainier for high-finance to use that cheap easy money to take extraordinary risk on new ventures into this emerging new opportunity called "The Internet".

In the case of credit markets, collateralized debt began with mortgage backed securities, invented and implemented first in the federal lending agencies created in the 1930s and later. In the 70s, securitization of those mortgages was invented. (source: "Introduction to Commercial Mortgage Backed Securities (CMBS)"). For years they mostly sat their as a tool for the nerds of finance. With the advent and spread of computers, the agency bonds became a common investment playground of everyday finance. By the time Greenspan stepped in to rescue the markets from the dot-com bust with round two of ridiculously low interest rates, the collateralized debt instrument was so well established and proven it was now ready to exploit that cheap easy credit through the carry trade, in which even Japanese housewives were speculating.

Now that Ben Bernanke is fully entrenched with round three of subsidized and ridiculously low interest rates, where will that money go? It might very well be the Asian and South American emerging markets. In the '90s, a wave of free market economics swept the globe. The managed economy fell into disrepute. Small and large nations alike abandoned their commanding heights and implemented market reforms. In this iteration 1 of emerging markets, only the nerds of economics understood what was going on. No common investor in their right mind would gamble on such a large experiment in finance as to invest in a former dictatorship. By the time the collateralized debt machine was in place, these nations had established themselves as more than just a wild experiment. Their reforms actually appeared to be working. Business ventures in these nations seemed to be sticking. Policy official spoke the same language as industrial nations. Global trade and open markets were working. During the 2000's, the term "Emerging Market" and BRIC became reputable areas of interest for normal investment firms. Average investors were leery, but interested, and willing to dabble with 10% exposure to this "industry" as the bulk of their portfolio focused on Real Estate and domestic equities. Most importantly, they were learning the lingo of international investments and cursory knowledge of foreign economics.

Enter iteration 3 of emerging markets. The fuel for such an explosion could very well be the U.S. carry trade. If Bernanke can keep interest rates unnaturally low "for an extended period" like he has said, it just might fuel a new round of exploitation in those growing non-US markets, which would lock up huge amounts of US Dollar assets in foreign debt at absurdly low rates, and drive the price inflation we should have seen in the US into those other markets instead. The confirmation of this new bubble will be normal asset allocations in the high double digits in emerging markets by Western investors. The peak will come when taxi drivers and hair dressers share tips about the nations they are exploiting.

If Carry Trade Wave 2 is funded with dollars, we would not see significant price inflation in the US. Instead, price inflation will be "exported" to emerging markets as an ample supply of funds flows to them. Just as "credit risk" became a thing of the past in the last bubble, "foreign investment risk" would be a thing of the past in this bubble, as their GDPs explode in what would be sold as the new age of international trade. That would be the ultimate confirmation, when broker pitches include the assurance that foreign investment is nothing to fear as emerging nations support each other without the 'need' for the U.S. economy to sustain them.

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