Waiting for the bubble to burst

Anyone looking at the world through the bubbly prism of the financial markets would conclude that not only has the recession ended but we are on the brink of a stonking boom.

Most of the world's stock markets are up about 50 per cent on the meltdown levels of March, and are up on the year; commodity prices are also hitting new peaks and, in the case of gold, an all-time high of over US$1100 ($1479) an ounce; even the commercial property sector is enjoying a surge.

Credit default swap spreads and other measures of risk aversion are at levels not seen since before the collapse of Lehman Brothers last October; the corporate bond markets are issuing paper; banks have got rights issues away; the Kraft-Cadburys fight shows M&A activity is also back; and other measures of growth, trade and investor optimism such as the Baltic dry index are pushing higher.

Watching the markets, in other words, you would not think we are at least four years off getting GDP back to 2008 levels; nor that unemployment, bankruptcies and repossessions are still climbing.

So are the markets running ahead of themselves? Has the massive programme of credit easing by central banks round the world - including the Bank of England's own £200 billion ($449 billion) effort - merely created a set of new asset bubbles? Are the markets getting ahead of reality (hardly a shock)?

Some people think so. David Jones, the chief market strategist at IG Index, said there may be an "element of twitchiness creeping back into the market" as many of the world's major indexes approach their highest levels of the year, and most of the indices have shown some reluctance to breach the "resistance levels" stock-market analysts arbitrarily determine. The bank's chief economist, Spencer Dale, has also worried aloud about new (though unspecified) asset bubbles.

Disentangling the suds is tricky. Some of the bubble is technical, as commodities are priced in dollars. Take gold: roughly half of the rise in the price of gold reflects the dollar's fall: since its trough in November 2008, gold has risen 55 per cent in dollar terms - but only 29 per cent in euros. The "bubble" also doesn't look so impressive in a longer perspective: Even now the London market is still 25 per cent below the zenith of almost 7000 climbed on the last day of the last millennium.

So "bubble" is a relative, and undefined, term and asset prices are intimately linked to each other. The rise in commodity prices, linked to a weak dollar, has itself done a good deal to boost mining and oil shares markedly higher, and these have been a significant factor in the general resurgence in equities. The rise in equity and other capital markets has also boosted the value of investments held by the insurance companies, banks and, more particularly, the investment banks. Hence the rise in bank share prices.

The Chinese stock market is where these interrelationships have created the biggest feedback loops, with speculation whipping things up still more.

Key to whether any of the revival in capital markets is sustainable is trying to discern how much is actually due to the vast fiscal and monetary stimuli applied by the world government and central bankers since March. Well, a rise in asset prices was an aim of that policy. The worry for the last year has been of a Japanese-style generalised deflation in asset prices - housing, shares, bonds, the lot. A debt-deflation cycle, as first identified by the American economist Irving Fisher, a contemporary and rival of Keynes, can leave an economy languishing in depression for many years if not decades, as we saw before World War II, and has been gripping Japan since 1990 or so. Falling asset prices mean higher real terms debts and sell-offs lead to more sell-offs in a downward spiral.

If that is allowed to take hold it is impossible to dislodge. That it has not happened is a cause for some celebration and a reason to compliment Gordon Brown on the leadership he showed in the G20 on this issue. One can only say history may be kinder to him than the press.

The money pumped into the world's economies through purchases of government securities has stimulated the demand for alternative assets, as the yield on government paper has become more and more depressed. Investors looking for reasonable returns have turned to riskier assets as the months have gone on, a more productive "search for yield" than the one that got us into so much difficulty before.

Everything from emerging market funds to buy-to-let residential properties are starting to look attractive. Hence the return of "risk appetite". As asset prices rise people feel wealthier and more confident about borrowing or spending, the key to avoiding rampant deflation. Bold, worldwide credit easing has thus boosted confidence to levels unthinkable in the spring.

What happens when the exit strategies are in place? The modest rise in the bank's quantitative-easing programme last week, and a slowdown in the pace of gilt purchases, suggests a pause may be near.

The optimistic case is the bubble will merely subside, more like a saggy balloon than a soap bubble.

- INDEPENDENT