The Next Big Bubble Ready to Burst

Historical fact #1. The Fed’s 7-year money frenzy forced the hand of other major central banks around the world — the Bank of England, the European Central Bank and the Bank of Japan — to also open their money floodgates in tandem. Ditto for many emerging market countries and even frontier economies. 

Historical fact #2. The near constant gusher of liquidity into the global economy — considered by investors to be almost as reliable as America’s famous “Old Faithful” geyser — gave rise to a series of speculative bubbles:

• Commodities went through the roof, led by oil, up to $130 per barrel.

• Stocks in major emerging markets like Brazil, Russia and China exploded higher.

• Junk bond issuance in the U.S. surged to $1.81 trillion, nearly double their high-water mark just prior to the 2008 debt crisis.

• Investors plowed into the riskier small-cap stocks, valued at $2.2 trillion, also far exceeding pre-2008 peak levels.

• And globally, corporate debt grew to levels beyond the danger zone reached just prior to the 2008 debt crisis.

Historical fact #3. The first two of these bubbles have already burst:

• From peak to recent trough, crude oil has plunged 74.3%. Silver has plummeted 72.1%. Copper has crashed 52.5%. And gold has been hammered to the tune of 42.8%.

• Stocks in emerging markets have taken an equally big beating: China down 53.5% from peak to trough; Brazil, down 42.2%, and Russia, down 27.4%.

Historical fact #4. The three other speculative bubbles — small cap stocks, junk bonds, and other corporate debts — have not yet burst; they’re still largely intact. But past cycles tell us that these three sectors are very sensitive (and vulnerable) to any kind of money tightening.

 2015: Now, junk bonds are back – in a big way. While the real estate markets have been less leveraged and more subdued, junk bonds have suddenly emerged as the poison of choice for yield-thirsty investors. 

Nevertheless, junk bonds are a giant house of cards, waiting for the day when the Fed decides to throws up both hands and eject investors into the real world. 

When will that begin? There are some early signs it already has begun:

• Junk bonds issued by energy companies, coal miners and metals producers (about one-third of the junk bond market) have already been falling all year — along with the plunge in commodity prices. But the idea that investors could escape the carnage simply by avoiding commodity-related junk isn’t working anymore.

• For example, Moody’s recently downgraded much of Sprint’s junk bonds to Caa1, precipitating a chaotic and fierce market response. Sprint’s $2.5 billion of bonds maturing in 2028 plunged as low as 80.8 from 88.4 the day before, while $4.2 billion of its notes maturing in 2023 fell to as low as 90.1 from 98.6. For bonds, which rarely move by more than a point on any given day, that was the equivalent of a big crash.

• Junk bond mutual funds and ETFs have also been a big part of the junk bond bubble with over 200 funds in all. But in recent months, more than $8 billion of investor money rushed for the exits, a prelude to the stock market exodus we saw in August.

DYI