This post is a guest contribution by Niels Jensen*, chief executive partner of London-based Absolute Return Partners.

Asset bubbles are strange animals. Ideally, you would like to punch the air out of them early before they become a real danger but, in practice, it is not quite so simple. Ben Bernanke and Alan Greenspan have actually both argued that asset bubbles cannot be detected and monetary policy should therefore not in any way be used to offset suspected bubbles.

I am not sure I agree with the two gentlemen, but that is less relevant for now. What is important to understand is what happens once the asset bubble bursts. In my experience, almost all post-bursting bubbles share two characteristics:

1) At the very least, asset prices revert to the mean, although many actually overshoot on the downside.

2) A long (and often painful) period ensues, where asset prices gradually claw back lost value. History suggests that this period is measured in years and sometimes in decades; never have asset prices recovered from a deflated bubble in just a matter of months.

The recent collapse of residential property prices – at this point still more advanced in the US than in Europe – is a classic asset bubble which is now deflating. The reason I have decided to write about it this month is because the “green shoot” campaigners are missing a hugely important point about the effect that falling US property prices are going to have – not just on the US but also on the global economy.

Recovery will prove temporary

Make no mistake. I always expected and continue to expect an economic revival later this year, which unfortunately will prove temporary. There are many good reasons to expect such a short-term recovery, as I discussed in detail in the April issue of this letter. However, it is what happens afterwards that I worry about. The economic uplift is likely to last no more than one or two quarters after which we will have to face more gloom and doom.

There are at least two reasons property prices are so important to the overall economy. The first reason has to do with leverage. There has been a lot of talk about de-leveraging in recent months, and the consensus seems to be that most of it is now behind us. Perhaps, in the narrowest possible sense, that is correct.

But leverage is not confined to hedge funds and banks. Many private households run heavily levered balance sheets as a result of their home ownership and it is this leverage that is rapidly growing at the moment. Why is that? Because leverage is a function of both the numerator and the denominator and, as American home owners are about to find out for the first time, falling property prices can have a devastating effect on your balance sheet.

Secondly, property wealth has become an important part of many people’s lives. In both the US and the UK (and in numerous other countries as well) many people have directed their savings towards property in recent years, and no small part of the profits have been recycled into the economy through equity withdrawal schemes. This has created a level of consumption which cannot be sustained if property prices do not continue to rise.

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* Niels Jensen has 24 years of investment banking, private banking and asset management experience. He founded Absolute Return Partners LLP and is its chief executive partner.

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