Gillian Tett at the Financial Times wonders today about how long the stock market rally will continue. Her argument is that we see data that are at odds with historical norms: the stock market goes up when unemployment is still rising in Europe, earnings come short of expectations and the rally continues. uncertainty is still high but spreads are low. How can this be? Her explanation:
“It is easy to identify the reason for this: as this data has gone haywire in the past couple of years, western central banks have been unleashing an estimated $7tn worth of quantitative easing. This has lowered interest rates on government bonds, forcing investors to search elsewhere for yield.”
So it is the Central Banks and quantitative easing that is supporting the behavior of financial markets and we need to worry about how sustainable it will be. Gillian Tett refers to the 2003-2007 experience when we witnessed something similar and we know how it ended.
This is now a common argument and a concern, that the behavior of central banks and the enormous amount of liquidity that they are introducing in financial markets is simply creating mispricing and bubbles in financial markets.
While it is possible that periods of low interest rate create behavior in financial markets that is associated to bubbles and potential instability, the argument that puts all the burden in central banks and liquidity is simply wrong. In fact, articles like this one reminds me of how disconnected the analysis of prices in financial markets is from the analysis of fundamentals and it is this disconnect and what you read in the article that makes me worry about instability in asset prices. Let me explain.
The first source of confusion is to that rates and returns are low just because central bank actions. As I have argued before, interest rates are low because of a trend that started in the mid 2000s of increased saving in some emerging markets and the effects of the great recession that increased saving in advanced economies and made investment collapse. When no one wants to invest or consume, interest rates are low. And they are unusually low this time because the patterns of investment and saving are driven by a crisis that is very large compared to historical patterns. As a reminder, interest rates are low everywhere not just in countries where quantitative easing is taking place:
The chart above (from the most recent IMF Asia Pacific Regional Outlook) shows that real rates are negative in all countries in the Asia-Pacific region. And, sure, you can still blame Ben Bernanke for all this by arguing that the liquidity that he is creating is crossing oceans and reaching all these countries but that is just nor right. The right explanation is that in a world with fairly well integrated capital markets, returns are similar everywhere.
And this basic fact: that it is the balance between real flows that is mostly behind the abnormal behavior in financial markets is wildly misunderstood. Here is a quote from the Financial Times piece:
“(Quantitative easing) has lowered interest rates on government bonds, forcing investors to search elsewhere for yield. But what has intensified the crunch is that, while central banks have been gobbling up bonds, the supply of assets has declined.”
Why is the supply of assets declining? There must be a reason why companies or individuals do not borrow (or borrow less). Equilibrium is about demand and supply. Why is it that companies are not borrowing in what seems to be extremely favorable financial conditions? When asset prices are too high and the cost of capital is below its fundamental value we should observe an excessive amount of (real) investment. But we do not see it. Isn’t it more natural to think about an equilibrium where relative high saving and low investment are resulting in low returns and yields across all assets? It is, but it is probably less interesting to write an article about it.
The final confusion is about how low interest rates (or equilibrium returns) should be reflected in asset prices. If markets suddenly learn that the fundamentals of the world economy are pushing the real rate on safe assets down, we expect asset prices to increase to adjust to this new equilibrium. What we should NOT expect is that stock market returns are higher going forward. In fact, stock prices should go up so that equilibrium returns are lower across all asset classes. And this is the biggest source of confusion in the commentary we often read about the stock market rally. The question is always: “How long will the rally last?” as opposed to “Are current stock prices supported by fundamentals?” Bubbles occur when markets think in terms of arrows and not in terms of levels. Some of the rally in the stock market now, as well as in 2003-2007, is associated with the fact that the market is learning that interest rates and equilibrium returns are going to be lower for longer than what they though (this is what some call the search for yield). Asset prices increase to reflect this new equilibrium. But this increase, this “rally”, leads to a reading in terms of the high short-term returns that it has generated. And then investors extrapolate and assume that they have finally found a place where yields are high! This is a bubble. When asset prices are not consistent with fundamentals.
The current value of the stock market is consistent with a world where returns are likely to remain low (by historical standards) across all assets, and this is why stock prices are high. But this story is inconsistent with a world where stock prices keep going up and generate an excessive return in the future. If we keep looking at the stock market in terms of arrows we will end up once again in a very unstable world. And it will not be the liquidity of central banks who caused it but the lack of understanding about some basic principles of asset pricing.