Interest rates are at long term historical lows and stock pricing is historically high, based on various metrics. Why and what is likely to happen?
Asset prices and “yields” go in opposite directions
It is important to start with the basics: asset prices and “interest rates” go in opposite directions, or more precisely, asset prices and “expected yields” go in opposite directions. Indeed, if you pay the very same asset 100$ instead of 200$, it is a better “deal” at 100$: you pay less for the same future expected value. Hence, when asset prices go UP, expected yields go down on those same assets. That is, buying into stocks are sky-high prices is not the best!
Before we proceed, I will have to make a “rounded corner” to have a reasonable post in terms of length and complexity and I will just say the general and not-totally-accurate statement that ALL interest rates and yields generally go in the same direction in the lomng run. Although “yield spreads” (differences between expected returns on various asset classes) vary both in short run fluctuations and in long run structural evolution, asset returns will not diverge forever for a prolonged period.
Increasing asset prices = falling “interest rates” (yields).
Falling asset prices = increasing “interest rates” (yields).
Returns in any asset class are strongly influenced by returns in all OTHER asset classes, due to the quest for yield: if returns on money market assets become very low (say, zero), then investors search for yields in OTHER asset classes, which boosts asset prices in those other asset classes, which decreases yields in those other asset classes.
Thus, returns in an asset class can theoretically change quickly, depending on the depth of that specific market. If everyone decides to pull out of emerging market debt, asset prices drop and yields increase in those assets, and if everyone sends their savings to stocks, then stock prices increase and expected returns fall (because higher prices = lower expected returns).
In the long run and on the macro scale, average returns can’t completely disconnect from returns on capital stock and innovation. Capital stock suffers from decreasing marginal returns, but research, innovation, and human capital do not. This is one reason knowledge-intensive industries are overperforming relative to other sectors in industrialized countries. Innovate and thrive!
Now that we are clear that asset prices and yields go in opposite direction, we can explore the reasons for low yields and high stock prices…
Asset prices, money, and savings
When all is said and done, asset prices are just prices. They follow the basic forces of supply and demand. Asset prices have had increasing demand and stagnating supply for various reasons. Here are some:
- Falling inflation due to central bank policies and disinflation programs in the 1980s and 1990s, further powered by technology and various innovations that have brought operating costs down. Inflation and interest rates are linked in the long run, hence falling inflation has brought down nominal interest rates.
- Demographics in industrialized countries: aging populations have an increasing proportion of 50–65 and this segment saves a lot. This means more savings looking to buy assets such as stocks and bonds: increasing asset prices, hence falling interest rates.
- Globalization since 1990 and especially since 2000: increasing incomes in emerging markets combined to opening of global markets has brought emerging market savings to rich-country markets, hence increasing asset demand, higher asset prices, and lower yields. This is the famous “global savings glut” explained by Ben Bernanke in the early 2000s.
- Rising income inequality almost everywhere have meant that more of the increasing incomes went to people who save more, because richer people have a higher “marginal propensity to save”, this means that more of the rising incomes have landed on higher-income individuals, who send all that income to… stocks and bonds, hence higher demand, higher asset prices, and lower yields.
- Central bank interventions galore have had a double effect: creating all that new money has sent lots of money into markets and lots of that money has landed in the form of demand for assets of all types, hence higher asset prices, hence lower yields. PLUS, these central bank interventions had an extra effect: central banks effectively BUY assets, hence they remove assets from circulation in the open market! This reduces asset supply, which adds more upward pressure to asset prices and downward pressure to yields.
There are other forces, but these are the main ones, or those other forces somehow generally fall into a sub-category of the above 5.
Now asset SUPPLY could outstrip asset demand, which would put downward pressure on asset prices and upward pressure on interest rates in general, but that has not happened. There has indeed been a huge asset supply by governments on the form of bonds, but this has been dwarfed by the other forces.
Corporate debt has also increased: corporations borrowed heavily by issuing low-yield bonds and used the proceeds for stock buybacks, thus reducing the supply of stock market assets, hence putting upward pressure on prices.
In general, the 5 items listed above have dwarfed all asset supply by a significant margin. I would even dare say that the general “asset class” is not clearing: quantity demanded of assets exceeds available quantity supplied of assets, which is why there is so much upward pressure on all asset classes other than commercial real estate, which has been hit hard by the covid shock.
What about stock prices specifically?
We know that high asset prices can be explained by what I wrote above, but what about stocks specifically?
Faced with super low returns on low-risk assets (fixed return assets), fund managers have turned to other asset classes to get the returns for the savings of their clients, and this means demand for stocks and demand for emerging market assets, as well as riskier corporate debt.
So the combo of those 5-above mentioned forces on asset prices and yields along with a quest for yields in general have pumped up stocks, and it is all quite logical, as strange as it may seem.
USA CAPE ratio: high, but strangely normal:
What could end the party?
There are not many things that could fundamentally change this entire structural backdrop all of a sudden. The reason is that for a major shift of valuations to happen, there would have to be a major “repricing” of all assets, which would come from major structural shocks. None of these seem probable in the foreseeable future:
- Rising inflation in a convincing way. Not a bit of inflation. I mean permanently rising inflation that triggers a break in the long run trend. This would trigger increasing bond returns and since bonds are a barometer for all assets, it would eventually force asset prices down and interest rates up. All the parked capital would flock to the money market and long term bonds as well as stocks would face falling demand, without central bank support. As I have written many many times before, no inflation, no problem!
- Rising taxes on a major scale. I don’t mean a bit more taxes here and there. I mean something really fundamental. A structural shift in governments everywhere that would bring 10 percentage points+ of taxes-income to GDP ratios. This would reprice future growth and profits, hence future asset valuations down and would cause a fall in higher-risk assets, hence lower prices and higher yields.
- Major social unrest on a continued and macro scale. I don’t mean riots here and there. I mean real shit that disrupts all of society. This would cause a spike in risk premia everywhere, hence upward pressure on interest rates and downward pressure on asset prices, especially in stocks.
- Major geopolical tensions. I mean severe and continued tensions between major countries that drive the world closer to chaos, trade disruptions, and military escalation. Same effect as major social unrest.
Since is see all these as essentially zero probability within the next few years, I see little risk in the macro picture, but there could be specific-market risks, obviously. Like, clap and share! Regards.