Beware of bubbles—signals of an economic downtown and how to prevent one

Jennifer is the Executive Vice President of Strategy and Development at Beneficial State Bancorp, based in Oakland, CA. 

Here we are ten years after the last market crash. Echoes of what preceded the economic downturn are resonating as potential warning signs of a recession appear. The stock market is trading at an all-time high with price earnings ratios at historically lofty levels. The Case Shiller 20 City Home Price Index exceeded its July 2006 high earlier this year. Yet, despite these robust indications, long-term interest rates are rising more slowly than short term rates are – indicating weakness ahead. Interest rates are pointing to a potential recession: the difference between the rate on long-term (10-year) and short-term (2-year) US Treasury bonds is only a little above zero at about 20 basis points. If the difference becomes negative, it’s called an inverted yield curve. With an inverted yield curve, returns on shorter-term investments are higher than those that are longer-term. This is a departure from the norm in which longer-term bonds usually offer greater returns because an investor’s money is tied up for longer. An inverted yield curve suggests market participants are concerned about long-term growth and has accurately predicted the last seven recessions.

Although we’re not there yet, it might be good to consider how to cushion against an economic downturn.

When speculative bubbles burst, market prices drop sharply.

The Fed has maintained a low interest policy post-recession that facilitated stabilization of the stock market and real estate prices, and as evidenced by high home and stock market prices, likely produced some financial asset bubbles. What is a bubble? Peter Koudijs, a Stanford professor, says bubbles happen when “investors buy an asset not for its fundamental value, but because they plan to resell, at a higher price, to the next investor.” A speculative bubble creates prices that strongly exceed an asset’s worth. When speculative bubbles burst, market prices drop sharply.

The Fed’s view is that it’s not responsible for maintaining stable asset prices, but when asset bubbles burst, the resulting losses threaten economic stability. Low interest rates always prompt companies, individuals and governments to borrow. Borrowing money to increase returns or fund expenses is called leverage. Over-leverage occurs when the amount of debt is such that interest and principal payments are unaffordable. Government debt/GDP was over 105% in the first quarter of 2018, a post-war high.

Corporate debt is also at extraordinarily high levels.  The need to de-lever and reduce spending in a downturn adds to economic woes. Rainy day funds should be established at local, state and federal levels so that government spending limits don’t impair the ability to add fiscal stimulus during a recession.  During the ‘job loss’ recovery after the tech bubble burst in 2001, the Fed’s low-interest policy facilitated the transfer of the stock market bubble into a real estate bubble. Now, we may have both a bubble in the bond market and a real estate bubble. Stability in real estate, stock and bond markets—or, the opposite of what happens in a bubble—should factor into the Fed’s mandate to avoid deep recessions.

Individuals need rainy day funds, too.

Individuals need rainy day funds, too. Personal savings should be strongly encouraged. The Fed’s extraordinarily low interest rate policy sets short-term interest rates below the rate of inflation. As a result, individuals may not be able to find attractive savings and investment options.  Here’s another bubble example: Recently, some very large banks prohibited people from buying Bitcoin using credit cards. This wasn’t a move designed to protect consumers from making a bad investment on credit, instead it was to mitigate the purchase of Bitcoin on credit – because consumers had trouble paying off the card balances when the price of Bitcoin tumbled. Whether due to low interest rates, low wages, or larger systemic issues, such as racial inequities and the changing nature of work, or all of the above and more, nearly half of Americans say they don’t have enough money to cover a $400 emergency expense. The inability for Americans to save shows a savings rate that is much too low and should be increased to provide some security in the event of a recession.

There is no single relationship between money, savings and well-being. However, the relationship between over-leveraging and financial problems is well known. Bubble prevention and prudent financial preparation before a downturn will certainly help avoid a deep recession.

This blog post reflects the author’s personal views and opinions, and does not represent the views and opinions of Beneficial State Bank and/or Beneficial State Foundation.