This article first appeared in Forum, The Edge Malaysia Weekly on March 22, 2021 - March 28, 2021

TINA, short for “There is no alternative”, is the oft-cited justification for the current stratospheric prices of financial assets. Just about all traded financial assets, excluding bonds — stocks, commodities, Bitcoin and even carbon credits — are at or near historic highs. That there is a broad-based rally in financial markets at a time when the real sector is in the throes of an unprecedented pandemic is an irony.

Both the disconnect with Main Street and the massive reflation in financial asset prices are the direct result of central bank policies. The years of loose monetary policy and rate cuts, particularly in the developed world, have led to historic interest-rate lows. Across the developed world, interest rates are either close to zero or negative.

The Bank of Japan (BoJ), which was the first to experiment with zero and negative interest rates, has been the trendsetter with unorthodox policies such as outright purchases of corporate bonds, stocks, real estate investment trusts, exchange-traded funds and yield curve controls.

As a result, the BoJ is effectively Japan’s largest mutual fund, its largest holder of corporate bonds and thought to have a balance sheet larger than the country’s US$5 trillion (RM20.6 trillion) economy. Ironically, despite years of all this “innovative” central banking activism, Japan’s real sector does not seem to have turned the corner, even some 30 years after its asset bubble burst. Undoubtedly, it is a cautionary tale for other central banks.

Yet, today, the US Federal Reserve, European Central Bank (ECB), Bank of England, and even the central banks of Canada and Australia seem to be following in the BoJ’s steps. All in the name of stimulating their pandemic-ravaged economies and fighting deflation.

The direct result has been twofold — a massive worldwide build-up in debt and a bubble in financial assets. Both emanate from the same root cause: repressed interest rates. Total global debt, which is estimated at US$280 trillion, works out to 360% of the total global gross domestic product.

Managing this overhang of debt is going to be a key challenge going forward. That stocks, especially in the developed world, are in bubble territory is fairly obvious. The stock indices and average price-earnings ratios in these countries are at historic highs, and have been there for quite a while.

Going by earnings multiples, the Dow Jones Industrial Average and Standard & Poor’s 500 have risen 64% and 79% respectively over the immediate year while Nasdaq, despite its recent correction, has risen about 42%. Even Japan’s long-suffering Nikkei 225 recently surpassed 30,000, though still a far cry from its peak of 39,000.

When debt is dirt cheap and easily available, speculative play becomes highly attractive. The choice between low-risk, low-return bonds and higher-risk alternatives becomes stark. When low-risk investment yields pretty much nothing, there is no alternative (TINA) but to seek returns in high-risk assets — hence the rally in everything that we now witness.

Even the oxymoronic idea that this is a “rational bubble” appears to be gaining credence. With the ECB’s recent diktat that it will be even more aggressive with its quantitative easing and with the impending US$1.9 trillion new fiscal stimulus in the US, this bubble is likely to keep frothing a while longer.

The Voclker Commission that was established to look into the sub-prime crisis of 2007/08 had concluded that a key reason for the crisis was the underpricing of risk. When risk is underpriced, the required risk premium is lower than it should be and so, a risky asset will be overpriced.

In the current context, the same underpricing of risk occurs when investors, in the absence of decent (or any) returns on low-risk assets, are forced to move into risky assets, thereby bidding up their prices. Given the current broad-based rally in risky assets, it seems obvious that the same underlying forces that were at work then, are occurring again. Risk is being underpriced yet again.

Unfortunately, this may not be the only perversion. It is well known in economics that high levels of debt give rise to perverse incentives. Repressed interest rates, while helpful to businesses, also allow zombie firms to survive. Thus, the market disciplining that should cleanse out such firms, does not take place. Over time, the presence of such zombie firms saps resources, leading to sub-optimal overall allocation.

Share buybacks by firms, especially when funded by debt, are another bad incentive of ultra-cheap money. Management is incentivised to undertake share buybacks, even at inflated prices, if the funding cost is low. The leveraged restructuring of the capital structure results in a lower overall cost of capital, since debt is cheaper than equity, and so the higher firm valuation.

Clearly, “firm value” is being created here through the rearranging of capital rather than the production of more goods and services as it should be. The ultimate perversion, however, may arise from the implicit “put” option that central banks are providing financial market players.

It appears that central banks are so fearful of pricking the bubble they created, that they are clearly pandering to markets. The ECB, for example, has pledged to “do whatever it takes” to prevent an economic downturn and since crashing financial markets would certainly portend one, the implication is clear.

This everything rally has the potential of becoming an everything rout. But the unprecedented stimulus, with yet more to come, will likely keep the party going a while longer.

Meanwhile, besides inflating asset prices even more and increasing the disconnect with the real sector, the rally is sure to increase income inequality and the wealth gap. The economic distortions arising from the perverse incentives will also worsen, with longer-term consequences. Finally, emerging economies may get squeezed as capital reverts to rejoin a rejuvenated party.

Dr Obiyathulla Ismath Bacha is professor of finance at the International Centre for Education in Islamic Finance (INCEIF)

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