3 - The bubble bursts: what does history's experience tell us? (2)

Firstly, while asset bubbles vary in size and form, one thing is abundantly clear: for an asset bubble to burst, central banks would need to not only tighten monetary policy, but also raise short-term interest rates to the point where they would invert the yield curve. This historical regularity is too powerful and compelling to be ignored.

Secondly, the rapid expansion of monetary aggregates brought about by massive quantitative easing by central banks is a new and different point compared to the historical financial environment. There is no doubt that this is positive for asset prices, as the rapidly expanding monetary stock enhances the ability of economies to tolerate higher asset prices.

Similarly, if CPI inflation starts to accelerate, it will contract the liquidity available in asset markets. This is why rising inflation is almost always positive for asset markets.

Thirdly, stock market valuations are a tricky issue because equity values are affected by multiple forces. Nominal GDP growth largely determines corporate earnings, while the level of bond yields profoundly affects the pricing of those earnings. Equity market valuations must therefore be combined with the level of interest rates and, in particular, long-term bond yields.

Source: Alpine Macro 2021

The chart above depicts the 10-year US bond yield versus the S&P 500 return since 1900. The difference between these two metrics is the equity risk premium - over time, and investors have been paid more than the risk-free rate of return.