Which is why Greece is defaulting and the UK and US will have more QE to offset the impact of fiscal tightening.
One of the causes of the weakness of an economy after a financial crisis is that the financial sector needs to be repaired. One way this happens is when policymakers create a steep yield curve, thus allowing banks to make money without doing anything risky like lending to anyone. Although commercial and industrial loan growth is in positive territory, aggregate loan growth is in negative territory. The housing market remains moribund and commercial property is also a “no” from loan officers.
Financial sector
The financial sector is unlikely to be in either the mood or the position to lend freely for some considerable time. Minimal credit creation will make it hard to achieve the sort of economic growth that the western world has become accustomed to in recent decades. The government bond market may well ‘get’ this. Nominal growth in an economy and the level of long-term nominal interest rates need to be broadly the same because when they are apart, an arbitrage exists between the return on government debt and investment instead in the real economy.
US ten-year Treasuries have been in a range of roughly 2% to 4% since the end of 2007. Over those three-and-a-half years the average yield has been 3.35%. Although there is much discussion about the alleged distortion to price discovery in the bond market because of QE, there may well be a very simple message coming from it. That nominal growth will be 3-4% going forward.
At what point do we have to accept that message? It’s certainly not clear that even bond market investors want to accept the message, given the consensus view that government bonds around the world are a sell. Economists and equity investors certainly do not seem to have digested the implications of slower growth in a post-crisis world, let alone the idea that growth could be 3% to 4% nominal.
Nominal GDP
Yet perhaps they should, given that the realised level of growth in the developed world in the past decade was pretty consistent with bond yields being in a range of 3% to 4% (and 1% in Japan). From 2000 to 2009 nominal GDP growth averaged 4.4% in the US, 3.6% in the UK, 3.5% in the eurozone and 0.4% in Japan.
There is a tendency at the moment for regional equity strategists to proclaim that their market is cheap or at least fairly valued on a cross-asset view. Our UK equity risk premium is based on a presumed 5% growth rate in dividends. We add the actual dividend yield and deduct the gilt yield. It’s not very fancy, and there are all sorts of issues around real and nominal variables, but intuitively it makes sense. It shows an ERP that is lower than at the height of the crisis but still high by any recent historic standard. Equities look cheap.
But in any model of equity valuation the assumption about the growth rate is critical. If in fact the growth rate of dividends (or earnings) in the future is going to be lower than it has been in the past then equities don’t look so cheap. Indeed, if we use a 3% growth rate going forward rather than the 5% long-run historic average, then equities are as expensive as they were in the late 1990s.
QE to return
All this has implications for expected equity returns. Forecasts of future equity returns using earnings (e.g. Shiller PE), or those comparing the market value and the replacement value of assets (e.g. Tobin’s Q), have made equities look expensive for some time. According to Smithers and Co, US equities are 65% overvalued on the former and 57% on the latter measure.
If the ERP really is low then government bonds are attractive, at least on a relative basis. Could the search for yield today be looking in the wrong place? Could any sell-off in government bonds (say to 3.5% in the US or 3.75% in the UK) be a buying opportunity? One suspects so. This is a challenge to conventional investor thinking today.
Labour markets are the dominant influence on consumer confidence. QE2 may not have been politically popular but if we still have a weak labour market in September one suspects QE3 will look pretty good to Obama and to most members of Congress (i.e. those seeking re-election in 2012).
And here in the UK, QE2 will look pretty good to the government and increasingly to the MPC after UK inflation peaks in October 2011 (when it is forecast to) and a few more strikes.
