The US Fed Funds rate is at 0.25%, which is effectively zero bound. In twelve markets around the world the two-year note is under that level, implying investors believe interest rates are not going up over the next two years. In six of those markets (Switzerland, Denmark, Germany, Finland, Netherlands, Austria) the two-year note yield is actually negative.
Paying governments to earn nothing
Short-term government bonds of highly regarded sovereigns have become like gold: they pay no interest and cost you money for the privilege of owning them.
At various times there have been negative interest rates created by taxation such as the charges imposed on foreign-owned deposits in Switzerland in the 1970s. But recent moves into negative territory have been driven by investors voluntarily paying a premium to own the paper.
Even in Japan, where there has been deflation on and off since 1994, the two-year note has never gone negative. And in the 318-year history of the Bank of England, short-term interest rates have never previously been below 2%.
Capital is misallocated in a world where interest rates are effectively zero. Once you get to zero-bound, as Bernanke famously spoke about in 2002, a central bank then has to start doing the extraordinary. So it buys assets – generally government bonds – to keep interest rates low across the curve.
The hope is that investors will take the money they get from the central bank and go and buy some other asset.
So far, the anecdotal evidence is that investors have indeed gone out and bought corporate bonds. Investment grade non-financial corporate bond yields are at record low levels in the US, UK and core Europe. But in recent months, the inexorable decline in government bond yields has pushed the relative valuation of equity and government debt to levels last seen at the end of the Great Recession bear market in early 2009.
Equity valuations are saying very clearly that investors are not willing to buy them with any conviction.
‘Apparent’ UK recession
Part of the reason for this is that the transmission mechanism from low borrowing costs is struggling to deliver broader economic stimulus because there is little confidence about the future on the part of either corporate managements or consumers. Thus, we have the ongoing apparent recession in the UK and growth rates in the US well below long-term averages.
The Federal Reserve estimates trend growth in the US economy to be 2.3-2.5%. Three years into this recovery, GDP has grown at or above that level less than half the time and the average realised growth rate is just 2.2%. Indeed the ever diminishing yields on offer across financial assets in the non-stressed developed world are indicative of investors trying to avoid taking undue capital risk and paying ever increasing prices for the chance to receive some income. Hence the outperformance of equities that have dividend yields above that of the overall market, and the outperformance of corporate debt.
The problem is that very low bond yields are indicating very low confidence in the outlook for economic growth. Indeed the divergence between the level of nominal bond yields and historic realised nominal GDP growth is now extremely wide. In the US and UK, trend nominal GDP growth has been 5% to 6% over the period 1990-2008. In core Europe it has been 4-5%. These levels are clearly way above current bond yields.
The growth rates of earnings and dividends, which will be proximate to nominal GDP growth, are arguably the critical variables in valuing equities, particularly relative to government bonds. If the market believed that future growth was going to be similar to historic growth, then the opportunity to buy equities that today in many cases have higher dividend yields than government bonds, and that are likely to grow those dividends, would be compelling.
But that is not happening. Hence the equity risk premium is as high as it was in March 2009, meaning it is at a level last seen when the outlook for the world was at its nadir. Indeed, it suggests the same sort of contempt for the asset class that the risk premium on peripheral eurozone debt is suggesting for that asset class. Frankly, relative to highly rated sovereign bonds, equities are a distressed asset.
Expand range of distressed assets
Now, of course, if the highly rated sovereign government bond market is correctly priced today, then nominal growth will be nothing like as strong as we are used to and the Japan experience is in our future. Japanese nominal GDP peaked in 1997 and is 9.4% below that level today. The Japanese stockmarket this year has hit levels not seen since 1983. But the whole purpose of the extraordinary policy we have seen across the Western developed world in the last three years has been to avoid the Japan experience.
So for example, part of the solution to the problem of distressed debt in the eurozone is for the central bank, and/or agencies of the sovereign governments of the eurozone, to buy it. This is deemed sensible, and indeed the realisation that the ECB would not be coming in to do it sooner rather than later has prompted a sell-off in peripheral debt following the 2 August ECB meeting.
What else should policymakers do? I deliberately use the word “should” rather than “will” because while appreciating that we need to be in the business of understanding what policymakers will do, we can occasionally grant ourselves licence to imagine what they should do.
We may well be approaching a point where some lateral thinking is needed. Perhaps it is time to expand the range of distressed assets that governments, and maybe even central banks, purchase.
The Debt Management Office (DMO) will issue £168 billion of gilts this year. There is plenty of demand for these instruments. Indeed, no government can borrow more cheaply relative to its inflation rate than the UK. With CPI at 2.4%, 10-year nominal gilts yield -1% in real terms.
Perhaps the DMO should consider increasing the amount of gilts being sold and use the proceeds to invest in Britain. Perhaps it could show confidence that the future outlook for UK corporate earnings and dividend growth was much higher than the current level of gilt yields implies. Yes, the UK Treasury should buy some equities. It can put them in the public sector pension schemes. For if on a ten-year view equities do not outperform gilts from here then all the efforts of the government and Bank of England to fight the deflationary forces unleashed since 2008 will have failed.
In the 1940s and 1950s, it took George Ross-Goobey and the Imperial Tobacco Pension Fund to show the rest of the investment world the way and insist that equities were a much better investment than gilts. Gilts then yielded about 3%, equities 4%.
In today’s world, where markets have become addicted to central bank stimulus while hanging on the word of policymakers to determine short-term market direction, perhaps it’s time policymakers took the ultimate step in their market interventions and simply did what the Bank of England has made it clear it expected investors to do. Which is to sell gilts and buy equities.
It would signal confidence in the future. And it would be the catalyst that is always needed to make a compelling valuation become a compelling investment.
