Stocks are never cheaper..according to the Federal Reserve Bank of New York

“We surveyed banks, we combed the academic literature, we asked economists at central banks. It turns out that most of their models predict that we will enjoy historically high excess returns for the S&P 500 for the next five years. But how do they reach this conclusion? Why is it that the equity premium is so high? And more importantly: Can we trust their models?”

Stable low interest rates usually mean a relatively low cost of investment capital, a lower cost for consumer loans, higher profit margins, higher personal disposable income, higher demand growth, investment and hence growth in all its components.   A stable low interest rate environment combined with economic growth would usually be especially beneficial for the absolute expected returns on equities and returns relative to low risk asset classes.

The problem is that interest rates are not low because we live in a stable low inflationary environment, but because we live in a structurally unstable deflationary one.   There a number of factors that currently rule against relying on simple models that may overly rely on earnings yields and interest rate differentials:

  • Still high levels of unemployment, weak income growth and low participation rates; ordinarily, in a typical short lived recession this would be a positive, but sustained levels of unemployment place demands on the state and weak demand growth causes companies to reassess capital expenditure plans. 
  • Still high levels of consumer debt, increasing levels of government debt and still significant government support of a sizeable component of disposable income; weak income growth is a significant barrier to economic growth going forward, especially with the already high levels of personal consumption expenditure relative to GDP. 
  • Low savings rates, too much dependency on consumer demand in GDP (PCE as a % of GDP is still north of 70%) and weakening global economic growth at a time when the economy needs to rebalance away from debt/consumption dynamics to saving/investment dynamics.   This is a critical component in the ability of companies to grow profits from what are historically high levels.
  • Insufficient global consumer demand for exports in an economy dependent on rebalancing for its structural integrity;
  • A very high dependence of asset values on narrow measures of money supply; with historically high levels of profitability, low economic growth and significant structural headwinds, current prices may be over egging the cake.  The margin for error in an environment of low economic growth with significant deflationary risks, needs to be much wider than usual to account for the risk of lower than expected growth and/or risk of loss of productive capital.
  • The impact of large increases in the monetary base on the risk profile of debt and loan capital that risks limiting loan growth; entities and individuals should be less willing to buy debt and make loans with low rates of return on these assets.   This poses a deflationary risk  in the current environment.
  • Historically high levels of corporate profitability; earnings growth going forward, for a wide range of economic growth outcomes, risks being lower than historical growth rates.
  • Aging populations and future liabilities associated with an aging population; the natural growth profile of the world’s developed economies could be changing for a number of reasons.   These all pose risks to future returns on capital and the growth rate of capital accumulation.
  • Large swathes of the developed world experiencing depression like conditions (i.e Europe).
  • Key developing economies coming up against barriers to investment led growth and lower returns on capital (i.e. China).

In the current high risk/low growth environment all the usual drivers of low interest rate stimulated growth are impaired to some extent: low income growth restricts consumer loan growth; low income growth restricts demand growth; this restricts capital investment which increases net depreciation of capital; this restricts productivity and future growth in output.  

Current low interest rates need to be assessed in terms of the deflationary risks they are intended to prevent.   

However, the world’s central banks are trying reflate demand by manipulating asset prices, and this is a risky method of initiating demand growth.   The transmission mechanism depends on the distribution of wealth, which is a significant barrier, and is also dependent on the expected risk of the asset classes themselves: with low returns on cash and fixed interest investments, the transmission mechanism is more dependent on expenditure from volatile asset classes, which may well be under owned by the demographics that need to increase expenditure. 

The QE route assumes that consumption demand is related to risky asset dynamics: what if low demand was more a function of structural domestic and global economic imbalances and a much lower underlying real growth rate in developed economies?  Then we are in a bind.

If price inflation does rise then P/E ratios will likely contract and the risk premium will disappear based on current prices.  If price inflation does not rise then it is likely that we will be experiencing low growth to deflationary conditions: this is not good for bonds and  the real return on risky assets.   Either way, there appears to be constraints on expected returns from risky assets.  Additionally, there are also complex dynamics in the interplay between monetary stimulus and support of government debt markets. 

The Federal Reserve Bank of New York analysis of risk premiums is terribly and dangerously narrow.  From an academic exercise it may have merit, but only in stimulating debate as to the risks to return and the full spectrum of those risks.   As it is, perhaps the Fed has a conflict of interest, given that it needs asset prices to rise, and as such this article is unashamedly a cheerleader of its strategy.

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