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Money Jun 6, 2013

Must read: UBS thinks there’s a bubble in bonds, EM equities

By Firstbiz Staff

Investment bank UBS has listed down five asset bubble candidates and advised clients to not invest in these as the assets are valued beyond the reasonable bounds of fundamentals and hence could correct rapidly. The investment bank also heaped the bubble blame on the ultra loose monetary policy of the western world.

The quantitative easingsteps in the US and Europe and now even Japan has flooded financial instruments with cheap money so much that asset prices are now commanding valuations way beyond their reasonable 'fundamentals'.

By pushing risk free rates to an unprecedented low level, central banks run the risk of creating a disorderly return to normal in this space. Hence we believe that the real danger zone will come when central banks start to normalise their policy, said UBS analystsStephane Deo and Ramin Nakisa in a note.

Here is a list of the possible bubble candidates:

Risk free rates: Treasuries and bunds are in trouble as they have departed from their fundamental values. According to UBS, treasuries are overvalued but may avoid the bubble pop for now as the US Fed controls the "long part of the curve" through quantitative easing. "Given low US inflation our US economists now believe that the Fed will not reduce the scale of its QE asset purchases until 2014," it said. But the real danger will come once QE slows down and the Fed normalises its policy. UBS expects the slowing of policy in the first quarter of next year.

The investment bank also heaped the bubble blame on the ultra loose monetary policy of the western world. AFP

The investment bank also heaped the bubble blame on the ultra loose monetary policy of the western world. AFP

Similarly, JGBS and gilts are not far from fair value. "A sharp adjustment in JGBs is a distinct possibility if the audacious new policy mix indeed manages to restore growth and inflation. The fair value of JGBs could gap lower. An exodus of Japanese investors to foreign assets would amplify the move," the report said. In other words, if Bank of Japan policy manages to restore growth and inflation, the fair value for JGBs could gap lower. Watch July Japan elections for the next step on policy mixes.

Credit: Overvalued doesn't apply to the US, but does apply to Europe. Rapid adjustment potential is possible for both. "We have been worried for long by the fact that liquidity simply vanishes during volatile periods," say UBS strategists. The timing on this is down to the QE exit for the Fed, which UBS says will turn into "absolute negative returns in credit, which could trigger a sell-off.

Hence, credit space valuations do not look unreasonably stretched but the lack of liquidity in the market could engineer an adjustment that looks like a bubble bursting, the report argues.

Real estate in Asia: Too much cheap money flowing around is bound to find its way into real estate. While UBS has singled out Hong Kong as a bubble waiting to burst, the same is true for Indian property as well.

UBS believes physical real estate in Asia is a bubble waiting to burst, especially in Hong Kong which experienced a rapid increase in price. Since the dip in late 2008, the Hong Kong market has gained 123%, a 28% annualised gain. Since mid 2003, it has gained 305%, a 32% annualised gain. UBS blames low interest rates for this rise in property prices.

"In March this year, 76.5% of the mortgage loans had an interest rate between 2% and 2.25%". In Singapore too prices have inflated due to low mortgage rates.

UBS believes that when the Fed reduces its QE asset purchases and raises rates, this will have
direct repercussions on the cost of funding in Asia, notably for HK real estate. The first quarter of next year is the expected time this pop will happen.

Equity markets in emerging economies: A number of EM equity markets, namely Indonesia, the Philippines, Thailand and Mexico, are likely to pop as these markets are largely illiquid and expensive. Russia, China and India, on the other hand, are safe as they are very 'safe' and 'cheap'.

Poor global growth since 2008 has led Asian economies to rely on cheap money to fuel growth. But if leverage is what is boosting growth, fiscal and current account deficits are bound to soar. Moreover, a dollar appreciation could worsen the situation. In other words, this is a credit-induced bubble "This pattern is typical of an economy over-leveraging, just like Spain did during the past decade."

According to UBS, QE removal would provide the first impact, but that bubble could continue building for much longer. And Mexico is also "very expensive and relatively illiquid." UBS has several sell recommendations in Mexico and sees that correction happening soon. The market is "priced for perfection," and not taking on board the negative side of some positive reforms that are being implemented, warns UBS.

Australian banks: Valuations are very stretched, says UBS due to an increase in risk in their business model. There are several triggers that could pop this market such as a correction in the housing market, funding problems, a downgrade of the Australian sovereign or a general sell-off in risk free rates on the back of the Fed's exit strategy. However, none of these triggers seems likely in the immediate future.

"The hunt for yield and good fundamentals are likely to support OZ banks in the future but the materialisation of one of the triggers identified could prompt the correction. Here too QE exit could play an important role."

by Firstbiz Staff

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