Academic journal article National Institute Economic Review

Nigel Pain, Rebecca Riley and Martin Weale. (Commentary)

Academic journal article National Institute Economic Review

Nigel Pain, Rebecca Riley and Martin Weale. (Commentary)

Article excerpt

There have been two significant developments in the last three months. First of all, international share prices have fallen sharply, to or below the levels seen briefly in September of last year. Secondly, there has been a sharp change in the exchange rate of the US dollar against the euro, with related changes for other currencies. At the same time the British economy seems to have shown rapid economic growth in the second quarter after six months of stagnation.

Share prices

The downward movement to share prices inevitably creates concern about a second recession following on the heels of the pause to growth last year. The mechanisms by which share prices can influence the real economy are reasonably well understood.

Lower share prices reduce household wealth and, as a consequence, might be expected to encourage saving relative to consumption. They also raise the cost of equity finance and thereby discourage investment. We find the first of these two effects to have the larger impact on overall output. The consequence of the reduction in household wealth may be to encourage saving rather than consumption. Nevertheless, it has to be remembered that share price falls do not necessarily lead to recessions; even the crash of 1973/4 when both the London and New York markets fell by around 70 per cent, and oil prices also rose fourfold, was associated with the mildest of the three post-War recessions identified by Dow (1999). The media interest in stock market movements makes it easy to overstate their importance for the economy as a whole.

There has been a wide consensus in the past few years that shares were expensive relative to historic norms. Wadhwani (1999) looked at the US stock market from a number of perspectives and came to the broad conclusion that the US stock market was overvalued by 20-30 per cent. It is currently about 20 per cent below its value when Wadhwani was writing. Since then US earnings have declined and, of course, there has been concern about the integrity of the reported earnings; his analysis therefore probably implies that there is room for further decline.

Nevertheless the fact that shares were expensive relative to historic norms would be perfectly sustainable if investors were prepared to accept returns lower than they had received in the past. This in turn would have been intelligible if the risks associated with equity investment relative to other financial assets had declined. However, the odd feature of the market boom was that investors seemed to believe high share prices were justified by high returns on capital rather than a consequence of likely lower returns on capital. Wadhwani noted that investors did nor appear to be prepared for the low returns implied in the high valuations.

Our previous forecasts have included repeated observations that, if share prices returned to normal levels from the high values of the past five or six years, then growth would be affected. Share prices are now much closer to levels that can be regarded as normal. The London market is trading at seventeen times earnings, a rating which could perhaps best be described as the top of a normal range.

With inflation expectations at the Bank of England target of 2 1/2 per cent and long-term interest rates at about 5 per cent per annum, (1) the real interest rate can be estimated at around 2 1/2 per cent. Such a figure is historically low (Scott, 1993). Since share valuations should reflect expected future profits discounted at the real rate of interest, with suitable adjustment for risk, a low real interest rate implies that the expected price/earnings (P/E) ratio should be somewhat above its average. However, doubts about the validity of company earnings figures may make it difficult for current P/E ratios to be sustained. There are also concerns which we do not share that company earnings may grow more slowly than the national economy in the short term. …

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