Bull Market Creates Global Imbalances the Risk of Mishap Would Be Significantly Reduced If Europe Would Ease Monetary and Fiscal Policy
Davies, Gavyn, The Independent (London, England)
IT IS NOW taken as axiomatic by many economic commentators that share prices are vastly overvalued, especially in the US, and that this will lead to a major market and economic crash in the next year or two. Without question, this is the most important and difficult topic in the world economy today, so it deserves careful evaluation.
The price of equities today is equal to the sum total of future profits,discounted back to the present by a suitable interest rate. A rise in equity prices might therefore signal one of several things - that expected future profits have risen in real terms; that the appropriate real interest rate used for the discounting process has fallen; or that expected future inflation has risen relative to the discount rate, for example.
If either of the first two events are occurring, then it is perfectly appropriate for asset prices today to rise relative to consumer prices, and there is no case for monetary policy to seek to offset this. On the other hand, if the third factor is at work, the increase in equity prices is signalling that expected future inflation has risen, in which case monetary policy should be tightened today, even if the present-day CPI is well behaved. The rise in equity prices would then be rapidly reversed. Which of these three factors is in fact dominant in present circumstances? According to many pessimists, the third factor is dominant, in which case the equity bull market has been a bubble. If this view is right, then the bubble should be burst forthwith by the central banks. However, this is not the conclusion reached by Goldman Sachs' equity strategists. According to their calculations, the entire rise in global equity prices in the past five years has been driven by the first two factors - a rise in real profits, and a drop in the real bond yield. They also calculate that the equity risk premium built into the US stockmarket today is around 2.5 to 3 per cent, which is roughly the average level of the risk premium seen in the past 40 years. (The ex post excess return earned on equities relative to bonds has been closer to 6 per cent per annum in the US, but there is evidence to suggest that this ex post excess return has been persistently higher than expected, partly because of unanticipated declines in interest rates.) Of course, if the real bond yield is too low at present, then it follows that equity and bond prices might both have trouble sustaining present levels. The global real bond yield is currently around 2 per cent, which admittedly is much lower than the 3.8 per cent average seen in the past two decades. However, a plausible reason for this decline is that the inflation risk premium built into the bond market has declined in the 1990s for good and sustainable reasons. This inflation risk premium first rose sharply in the late- 1970s as a result of a burst of double-digit inflation, and it seems to have taken about two decades to remove the impact of these events from the memory of bond investors. With the world standing on the brink of deflation, it is not surprising that bond investors now deem negative surprises on future inflation as being just as likely as positive surprises, so the "insurance premium" previously built into bond prices has now disappeared. In a sense, on this argument, the recent rise in share prices is the mirror image of the prolonged bear market which occurred in the 1970s when the inflation risk premium first appeared in the bond market. Naturally, it follows from all this that any reversal in the recent declining trend in inflation would probably cause serious problems for equities, since real and nominal bond yields, and the equity risk premium, could all rise simultaneously in such circumstances. …