Should We Worry About An Asset Bubble?

Earlier this week, Nouriel Roubini had a column in the Financial Times warning that an asset bubble is forming. He asserts that investors are taking advantage of low interest rates and a weak dollar to speculate on assets, driving up prices. I think he's probably right. He worries, then, that this is forming yet another bubble. That might be true as well, but I need a little more convincing that this asset bubble will be as severe as Roubini appears to believe in the U.S.

Really, Roubini's argument is more about global assets, but let's consider what might specifically happen in the U.S. Here's some of what he says:

Since March there has been a massive rally in all sorts of risky assets - equities, oil, energy and commodity prices - a narrowing of high-yield and high-grade credit spreads, and an even bigger rally in emerging market asset classes (their stocks, bonds and currencies). At the same time, the dollar has weakened sharply, while government bond yields have gently increased but stayed low and stable.
. . .
But while the US and global economy have begun a modest recovery, asset prices have gone through the roof since March in a major and synchronised rally. While asset prices were falling sharply in 2008, when the dollar was rallying, they have recovered sharply since March while the dollar is tanking. Risky asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals.

I've argued something similar myself -- that the stock market, in particular, can't be an accurate reflection of what the recovery will look like. It's not going to be nearly as steep a recovery as the climb of the Dow would indicate.

But here's a question: what if the U.S. experiences significant inflation like some economist fear? What if 2011-2013 average, say, between 5% and 10% inflation? One of the best hedges against such high inflation is assets, like equities, energy and commodities. Real assets will continue to be traded in nominal dollars, so inflation will be largely included as their prices changes.

So if those pessimistic inflation expectations are right, then that would serve to make the asset bubble less severe than it would otherwise have been, because inflation will increase the nominal value of assets beyond what economic growth alone would have done.

Let's think of how this would turn out for a few scenarios:

Scenario #1: Low Growth, Low Inflation
- The asset bubble's pop will have very ugly consequences.

Scenario #2: Low Growth, High Inflation
- Assets were overvalued, but not significantly.

Scenario #3: High Growth, Low Inflation
- Assets were overvalued, but not significantly.

Scenario #4: High Growth, High inflation
- There was no asset bubble, as current prices accurately reflect the future.

If you're really worried about the asset bubble, you'd expect Scenario #1. I think most of Wall Street might expect Scenario #4, or at least only that scenario would best justify current asset prices. But if either Scenarios #2 or #3 turn out to be accurate, then the asset bubble's pop might not be too catastrophic in the U.S.

Of course, if an expectation for high growth is, indeed, expected by most investors, then they may be in for a very rude awakening sooner than later if the economy proves sluggish during all of 2010. That could lead to asset prices falling sooner, before inflation really even has time to take hold. So the timing matters too.