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Last Updated: Thursday, 14 June 2007, 04:53 GMT 05:53 UK
Are global market bubbles set to blow?
By Ben Richardson
Business reporter, BBC News

How can you tell the difference between a boom and a bubble?
There is a strange fascination in blowing a bubble, when despite your better judgement, you keep willing it to get bigger regardless of the dangers.

Then, suddenly, the violent pop that leaves you picking bubblegum off your eyebrows, or crying soapy tears.

For many observers, global markets are getting dangerously close to such a bursting point.

Until recently, we have been living in a period of low global interest rates that have let consumers and companies borrow money cheaply.

That has driven demand for mortgages, let companies pay increasingly large sums for takeovers, and allowed consumers to spend freely.

And the results of this credit splurge are hard to ignore:

  • UK house prices have doubled in the past 10 years.
  • China's main stock index has quadrupled in value since the start of 2006.
  • The UK's FTSE 100 and US S&P 500 stock indexes are at levels not seen in almost seven years.
  • Commodity prices have been buoyed by strong global demand, pushing some such as copper to records.
  • Merger and acquisition activity has taken off, and private equity firms are now in control of some of the world's biggest brands.

But as the records have continued to tumble, concerns have kept on mounting.

Credit crunch

One of the main reasons for the current uncertainty has been the significant changes and volatility in the US bond market.

The price of 10-year US government-backed bonds has fallen, pushing their yields above 5.25% for the first time in five years.

Simply put, this means that investors are not expecting interest rates to fall anytime soon, especially as the Bank of England, the US Federal Reserve and European Central Bank have all been lifting borrowing costs in recent months.

UK interest rate graph

What has many observers worried is the sudden speed with which the change occurred and the fact that it seems to confirm the view that the era of low interest rates has ended.

First and foremost this will make it more expensive for companies and consumers to get their hands on cash.

That in turn could lead to fewer private equity deals, and a cooling of the housing and stock markets.

Home improvements

In recent years consumers have benefited from the largesse of lenders, taking on larger mortgages and increasing personal borrowing to levels many now see as unsustainable.

The bond-market turmoil may turn out to be the beginning of the end
Robert Peston,
BBC business editor

On Tuesday, figures from the Council of Mortgage Lenders showed that first time buyers borrow an average of 3.33 times their incomes to buy a home. Other measures show they are using 18.7% of their incomes to meet mortgage repayments.

Pessimists also point to a wobble in the US housing market, where prices have started to soften and high levels of sub-prime lending to people with poor credit histories has fanned fears of a surge in mortgage defaults should interest rates rise.

At the same time, some very canny real estate operators have been selling up, signalling that, for them at least, the market could not get any richer.

London estate agency Foxtons was sold to private equity firm BC Partners for a reported 400m in May, and US property magnate Sam Zell has offloaded his main investment vehicle.

Topping off

There have also been signs that the private equity boom, which has fuelled merger and acquisition activity in Europe and the US, could be hitting a peak.

So far this year, the total value of deals done is almost double than at the same point in 2006.

At this stage of bull markets larger corrections become more frequent
Morgan Stanley

And companies today are having to pay a premium of as much as 30% to secure takeovers, compared with premiums of about 20% a few years ago, analysts said.

At the same time, the low interest rates and an ever increasing hunt for profits have seen banks relax their restrictions on lending, producing a new breed of loans called "covenant-lite".

Borrowers have fewer restrictions on what they have to do with the money or business, something that has led to a decline in standards of due diligence, according to Jon Moulton, chairman and founder of Alchemy Partners.

While that may not matter when there is a lot of cash sloshing about, risky deals are often the first to collapse when interest rates climb, analysts said.

Market timing

Critics say that the huge amounts of cash companies had at their disposal meant that they could buy back stocks to boost share prices and inflate equities by over-the-top acquisitions.

Certainly stock markets are exhibiting some classic warning signals as well.

Wall Street giant Morgan Stanley told investors that its indicators were showing a "full-house" in terms of sell triggers, and that this had only happened five times since 1980.

Each time, global equities have lost an average of 15% over the following six months, it said.

FTSE 100 graph

"At this stage of bull markets larger corrections become more frequent," Morgan Stanley said.

And yet, despite the pessimism there are plenty of reasons to believe that a meltdown is not on the cards.

True markets have surged and corporate profits in many industries hit record levels, but indicators are a long way from the scary heights that preceded previous crashes.

In the US, the average price earnings ratio - a measure of the share price when compared to future profits - is about 18 times at present; in the lead up to the dotcom collapse it was at least double that level.

Volatility normally increases ahead of a slump, with corrections of as much as 10% happening regularly, though this has not been the case with the S&P over the past four years.

World view

Elsewhere there have been wobbles, such as in China where a 9% one-day drop in the stock market shook global indexes.

However, many analysts argue that even though the Shanghai stock exchange may seem overvalued and there may be concerns about the veracity of corporate reporting, the long-term prospects for China outweigh many of the risks.

People worry a lot. There can be a boom, but it doesn't mean it is a bubble
Jim O'Neil, Goldman Sachs

Instead of a collapse, analysts say there will be corrections in a bull market that will see equity prices continue rising and profits keep growing.

The key to this approach is taking a long-term outlook and buying into the view that the so-called Bric nations of Brazil, Russia, India and China are reshaping the world economy.

Already the changes are being felt and in the first three months of this year China accounted for a greater proportion of the global economy than the US.

Jim O'Neil is chief economist at Goldman Sachs and is the man who coined the term Brics.

"People worry a lot," he explained. "There can be a boom, but it doesn't mean it is a bubble."

Flattening out

The view of the optimists on the housing and private equity markets is not so different.

  • It may become more expensive to get mortgages and do deals, but that is likely to slow rather than reverse the current trend.
  • Rather than the bursting of a bubble, expect a plateau of demand.
  • UK house price growth probably will slow, though a lack of new homes will help underpin the market especially in prime areas such as London.
  • Though real interest rates have risen, they are still low by historical standards.
  • Real estate bubbles may appear but they will be localised and dictated by special circumstances.
  • Mergers and acquisitions are unlikely to stop as there are compelling arguments for consolidation in many industries, such as banking.

The problem for investors and consumers watching events unfold over the next few months will be determining whether the commentators have got it right or wrong, and if it really is time to head for safety before things blow up in their faces.

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