A world of permanently low nominal and real interest rates, as well as permanently low inflation, is implied by the current values attached to the US equity market. Our own view is somewhat different – the world is moving gradually along the road to normalisation.
The balanced portfolio – how should it be weighted for the next 18 months. More or less in equities – Risk on or risk off.
The global portfolio manager has become noticeably uncertain about the global growth outlook and the outlook for US interest rates. The day-to-day volatility of share, bond and currency markets reveals this. More risk means higher required returns and thus lower valuations, and vice versa.
The twin concerns (global growth and US rates) are not independent of each other. Faster growth would normally lead to higher interest rates and higher rates might then be regarded as a welcome indicator of faster growth under way. Slower growth would ordinarily lead to lower rates. In a normal environment, good economic news could mean higher interest rates, but also increased revenues and profits for listed companies, so would therefore be well received in financial markets.
But the times are not normal. The developed economies (apart possibly from the US) appear to be suffering from growth that is too low for comfort and inflation rates that are too low for the comfort of central banks. The emerging economies, particularly the commodity producers, are suffering from slow growth as well as weak demand and lower prices for their exports – leading to pressure on their exchange rates. Devaluation of emerging market currencies brings higher rather than lower prices in its wake and possibly (and ill advisedly), higher interest rates that in turn would reduce growth rates further. The emerging market policy makers would prefer faster growth in the developed economies they supply and lower interest rates to take pressure off their currencies and inflation rates.
Ideally, lower interest rates designed to stimulate faster growth in the high income world, would be broadly welcome in the financial markets. There is however the problem that interest rates, more particularly real, after-inflation interest rates, are already at historically low levels. How much further can they be made to fall? There are, for practical and theoretical reasons, lower bounds to interest rates.
Quantitative easing (QE) may become the only tool available to central banks when fighting deflation, has become their primary objective and when interest rates are very low, perhaps even below zero. But even supplying more cash to the banking system may not work if the banks prefer to hold the extra cash, in the form of extra deposits with the central bank, rather than put them to work funding additional loans and overdrafts. QE may have saved the financial system, but the rate of growth in bank credit has remained very weak in Europe while somewhat more robust in the US.
In a world where prices are falling, it might take interest rates well below zero, that is well below the rate of deflation, to stimulate more borrowing and spending; that is to effectively reduce the real costs of borrowing and repaying loans that rise as prices fall. Deflation is helpful to lenders and harmful to borrowers. Inflation does the opposite, which is why expected inflation and / or deflation would always be reflected in the terms lenders and borrowers could agree upon.
Expected inflation brings higher interest rates and expected deflation would result in lower rates, even negative market-determined interest rates. In other words, you could be paid by lenders to issue debt (at negative rates of interest) as governments in Europe are being paid to do. The German government now to offers a positive rate of interest for Bunds that mature only after 2021. Recently the US Treasury has issued three month bills at a zero rate of interest, a record low.
The problem with negative interest rates imposed upon central banks is that negative rates of interest on bank deposits or other rewards for lending provided by financial institutions generally, would have to compete with cash in portfolios. Cash, or rather the notes issued by central banks as well as their deposits, will maintain their money value despite deflation, providing a highly competitive zero rate of interest, when other safe haven rates fall below zero. For wealth owners, holding cash rather than lending or spending it will not help an economy grow faster. Such problems for central banks are exacerbated when deflation is accompanied by a recession.
It is the problem with deflation, rather than inflation, that is occupying the central banks’ minds in the US and Europe. The target for the US Federal Reserve (Fed) is 2% inflation. Anything less than 2% would therefore call for lower interest rates for fear of what deflation could do to spending and economic growth.
The problem for the Fed and Fed watchers is that the Fed has strongly signaled that it will be increasing its key short term interest rates this year. But while such an increase might make sense for the US, given the economic recovery to date, it will not be helpful outside the US. It also makes less sense for the US if it leads to deflation, accompanied as it is likely to be by a stronger dollar and so more deflationary pressures inside and outside the US. There is moreover a more general concern that US growth may disappoint anyway and that any interest rate increase will not be called for.
These considerations, especially the explicit Fed concerns expressed about the state of the global economy, convinced the Fed to postpone any increase in short rates at the Federal Open Markets Committee meeting of 23 September. This decision at first was poorly received in the market place. Fed vacillation appeared to add something to the risk premium attached to equities and currencies. More recently, a weaker employment number for the US, that strengthened the case for a postponement of an interest rate increase, saw the risk premiums decline with a much better tone on the equity and currency markets, especially for emerging market currencies.
It seems clear that the developed equity markets would welcome a mixture of stable (or even lower than previously expected) interest rates in the US. The outlook for global economic growth has also been revised lower by the International Monetary Fund and other forecasters, including other central banks, making the case for lower, not higher, interest rates in the US.
Most important for portfolio selections, developed equity markets appear rather pessimistic about economic and earnings prospects. They appear to be already valued for very slow growth. Goldman Sachs, in a recent report on European equities, given an equity risk premium of 5% (that is expected returns from equities 5% above the risk free rate that is close to zero) infers that the Stoxx 600 index for European equities is priced for zero growth in earnings per share, compared to the long term average of 5.1% p.a.
If we apply the same 5% p.a equity risk premium to the S&P 500 Index, using the implied growth in earnings per share as the risk free rate, represented by the 10 year bond yield (currently about 2.10% p.a) plus 5%, less the S&P current earnings yield of 4.93%, we derive an implied permanent growth in earnings per share of about 2% p.a. This is well below the average annual growth rate realised since 1990. With 10 year US inflation-protected bonds currently offering a very low 0.55% p.a, and nominal 10 year US Treasury trading at 2.09% p.a, the compensation for bearing the risks of inflation, or inflation expected by the bond market, over the next 10 years is currently about 1.54% p.a. Thus the implied real growth in S&P earnings per share is less than 0.5% p.a. This confirms that US equities, like European equities, are currently priced for very slow growth.
It would appear that the market is expecting secular stagnation of the developed economies rather than any normalisation of growth rates. A world of permanently low nominal and real interest rates, as well as permanently low inflation, is implied by the current values attached to the US equity market.
Conclusion – our view is different
Our own view is somewhat different. While aware of what is a somewhat confused market place, we are still expecting a further gradual move to economic normalisation. This is a process that followed the global financial crisis of 2008. This will be reflected in a gradual increase in the willingness of households in developed economies to borrow to spend and of banks to lend to them. Household debt to income ratios are in continuous decline, as are household debt to debt service ratios. A decline in these debt ratios points to normalisation of household spending propensities. This process is essential, if aggregate demand is to grow at something like normal rates, given the importance of household spending for GDP in the developed world.
It seems to us that the global economic problem is one of too little demand rather than too little being produced or capable of being produced. The supply potential of developed economies is being continuously enhanced by innovation and improved technology. Addressing the problem of under spending, after the global financial crisis, we appreciate, has taken longer than normal and required very unconventional monetary policy. This may well have had something of a negative impact on business confidence and so slower growth in capital expenditure by firms that has held back economic growth. But if households came to spend more of their incomes and firms exercise more of their capital equipment, they would normally be inclined to add to their plant and machinery and perhaps also their labour forces. Capex, rather than buying back shares or engaging in acquisitions, would then make more economic sense.
Equity markets in the developed world appear undemandingly valued for current interest rates. Interest rate increases, we think, are unlikely to threaten these valuations. Any sense that the developed markets will not slip into recession or secular stagnation will be helpful for equity values. The emerging market economies, where GDP growth and particularly earnings growth, remain under pressure from lower commodity prices, may take longer to normalise. Their progress will depend on the same improved sentiment about global growth that would mean normalisation of developed economies rather than secular stagnation. Our recommendation therefore for the composition of balanced portfolios, those that mix equities, bonds, property and cash, is for a continued modest bias in favour of risk-on, rather than insurance assets.