After toil and trouble, is this a new bubble?

The following comment by me appeared in today’s issue of Fund Strategy:

There are broadly two ways to interpret the rising stockmarkets since March. The first is to see them as a sign of recovery, the second is to view them as the reinflation of an asset bubble.

Last week’s American GDP figures gave added impetus to the first explanation. According to provisional figures GDP fell at an annual rate of 1.0% in the second quarter. This may not sound good in the abstract but it compares favourably with the 6.4% decline in the previous quarter.

Britain’s GDP figures are becoming similarly less bad. GDP fell at 0.8% in the second quarter compared with 2.4% in the first quarter.

These figures come on top of better than expected corporate profits in many areas. Many companies seem to be benefiting, at least in the short term, from cutting wages and reducing investment.

All of this lends weight to the view that the stockmarket rises are in anticipation of economic recovery. Equity markets, in this view, are a leading indicator of economic performance.

But there are good reasons to question this rosy scenario. State authorities around the world have pumped huge amounts of liquidity into the global economy. Liquidity has been added both through increased state spending and monetary policy.

The fiscal boost has clearly had a beneficial short-term impact. If anything, the combined impact of low interest rates and quantitative easing is even greater.

This suggests that the authorities could have ¬created another bubble as a consequence of their actions to deal with the bursting of the previous ¬bubble. They have eased economic problems in the short term only to exacerbate them in the longer term.

In effect, their actions have created inflation. But rather than being inflation of consumer prices it is inflation of asset prices, including equities.

There will most likely be some kind of cyclical recovery from the desperate economic lows of late 2008 and early 2009. However, as long as underlying economic weaknesses remain, the world economy will be prone to bubble tendencies.

The most striking expression of this underlying weakness is the secular decline in the rate of profit in the West. This is apparent from the falling level of capital investment in the West as a proportion of GDP.

According to a recent study by CrossBorder Capital, a research firm, capital investment in the West is only about 20%, compared with about 40% in Asia. However, once wear and tear is taken into account, the real level of capital investment is lower still in the West compared with Asia.

This trend will be examined in more detail in a cover story in a couple of weeks’ time.