The great man George Soros said in 2009, “when I see a bubble forming I rush into buy, adding fuel to the fire… that is not irrational.” In his theory of reflexivity, price itself can influence economic fundamentals by affecting perceptions of risk. Bullish sentiment may cause prices to rise and rising prices in turn motivate consumer spending or corporate investment in a positive feedback loop. Put differently, there is a two-way reflexive connection between perception and reality which can give rise to a self-reinforcing, but eventually to a self-defeating boom-bust process, or bubble.
A key source of oxygen for a financial boom is liquidity or credit. In 2018, the tightening in offshore US dollar liquidity following normalisation in US interest rates and the Federal Reserve Balance sheet started to infect US credit conditions by the fourth quarter. The following the rapid and emotional correction in December 2018, the Fed pivoted along with many global central banks cut rates and increased liquidity. While that cyclical correction commenced much earlier outside the United States, it is probably not a coincidence that world equity markets also pivoted higher after the increase in global liquidity (proxied below by world M2 money supply – chart 1). The key point here is that liquidity is clearly important, but it is not the only factor driving price, risk perceptions and fundamentals. Profits also matter and the underperformance of equities in the World-ex US was also a function of relative growth and earnings throughout most of this cycle.
It is important to note that the extension of the rally in equities since October 2019 has also likely been supported by the belief that policy is now asymmetric. That is, the hurdle to hike rates (or withdraw liquidity) is greater than the motivation to ease if growth or inflation expectations disappoint in the future. That appears to be supporting desire to add equity risk on any draw down. There are historical parallels to the episode in 1998 in the lead up to the 2000 technology valuation bubble. The fuel for that bubble was plentiful liquidity, but also the belief in tech productivity growth and new valuation paradigms. Taken to its logical extreme if you lower the discount rate to zero on long duration cash flows valuation is almost infinite. Of course, in reality valuation had very little to do with it. The 2000 technology bubble was primarily a huge leveraged momentum trade driven by valuation expansion rather than earnings (chart 2).
In the current boom or the most recent cycle, advertising, semiconductors, social media, electric cars and smart phone sales have been supported by a financialised easy money cycle. Looking forward, 5G, cloud computing and further tech productivity growth is anticipated to lead to further software and hardware advances and demand for semis and processing efficiency. Many of the developments are genuine. However, the belief in future growth and returns can be euphoric and non-linear, particularly in an environment of cheap capital and plentiful liquidity. The good news in Asia is that while the MSCI technology sector has re-rated over the past few months, valuation is still well below 2017 peak levels (chart 3). Moreover, most of the rally in this cycle has been warranted by earnings (chart 4).
The final point to note, is that Asian tech is highly correlated to a re-acceleration in US and global manufacturing new orders (chart 5). Of course, price and valuation have already partly re-rated to reflect that belief. Nevertheless, the current valuation remains modest relative to the US technology and sector and in the context of a potential liquidity driven bubble. In the 2000 cycle, Asian tech rallied to over 5 times book value. In the current environment, a euphoric bubble in the sector is plausible again.