London /
We are seeing the beginning of a flexibility cycle of the monetary policy. Many are now wondering how far interest rates can fall and what they may mean for our economies. However, for me the most interesting questions are long-term. To be precise, there are three. Have real interest rates finally made a lasting upward leap, after their decline to extraordinarily low levels? Have stock market valuations stopped mean-reverting, even in the United States, where mean-reverting for a long time seemed the norm? Could the answer to the first question have any bearing on the answer to the second?
To answer the first we have invaluable information, a direct estimate of the real interest rates for United Kingdom provided by 10-year indexed government bonds for just under 40 years. US Treasury inflation-protected bonds provide comparable information for this, but only since 2003. Between 2002 and 2013 these have a good match. Since then real rates have fallen more in the UK than in the US. The explanation is Britain’s regulation of defined benefit pension plans, which forces them to fund the government at absurdly low real interest rates, at great cost to the economy.
Between their peak in September 1992 and their trough in December 2021, UK real rates fell more than eight percentage points. In the US they fell more than four percentage points between their peak in November 2008, at the beginning of the financial crisis, and December 2021, after the pandemic.
Two things happened: a long-term decline in interest rates and a sharp decline triggered by the global financial crisis and Covid. The long-term decline must reflect the impact of globalization, particularly China’s huge savings glut.
However, the real interest rates They are currently 1.5 percent in the US. Estimates from the Federal Reserve Bank of St. Louis (using a different methodology) give rates above 2 percent in the 1990s.
We have some reasons to expect real rates to rise further. After all, they are not that high yet. Fiscal positions are on the limit, especially in the United States. We must also finance the investment needs of the energy transition. Furthermore, we move from societies that are aging to those that are aging. This will lead to a tendency to reduce savings and increase fiscal pressures in high-income countries and China. Global unrest will also increase defense spending. This suggests that further increases in real rates are likely. At the same time, aging societies will be inclined to spend less on consumer durables and housing. This will weaken investment demand. Furthermore, as the OECD’s Interim Economic Outlook points out, global economic growth is generally not expected to pick up.
In general, it is difficult to have a clear view on future real interest rates, in either direction. However, one can still argue that inflation is destined to return, perhaps as a result of growing fiscal deficits and debts. That would be reflected in higher nominal interest rates if (or when) confidence in central banks’ ability to meet inflation targets begins to erode. They were able to contain the recent price increase, but inflationary pressures can very easily return.
Now let’s consider stock prices. What have today’s higher real interest rates meant to them? So far the answer is very little. If we look at the cyclically adjusted price-earnings ratio developed by Nobel Prize winner Robert Shiller, we find that in the US the two ratios he uses are close to historical highs. The implied adjusted earnings yield on the S&P 500 is just 2.8 percent. That’s just one percentage point above the TIPS (Treasury Inflation Protected Bond) rate. It’s also much lower than for any other major stock market.
“Sell it,” he seems to shout. Needless to say, that’s not happening. So why not? After all, today’s earnings performance is nearly 60 percent below its historical average. One answer, proposed by Aswath Damodaran of the Stern School of Business, is that the past is not relevant. You are certainly right that backward-looking valuation ratios have been a poor guide to future returns, at least since the financial crisis. We cannot know if this will continue to be the case; However, it is not difficult to understand why he has discarded the past in favor of forecasts of future profits. But the future is also very uncertain. It is not difficult to imagine crises capable of causing market disruption that are much worse than recent ones.
What we do know is that the margin between the real interest rate and the cyclically adjusted earnings yield is very small. It seems safe to argue that the prospective returns from owning US stocks are unlikely to come largely (if at all) from revaluations, given how highly valued they already are. Even current valuations must depend on a belief in the ability of profits to grow at very high rates into the distant future, perhaps because current (or future) monopolies will remain as profitable as today’s tech giants. (which now includes Nvidia).
In essence, this is a bet on the ability of current American capitalism to generate supernormal profits forever. Weakness in other markets is a bet on the opposite outcome. If investors are right, recent increases in real interest rates are beside the point. In short, they are betting on the proposition that “it’s different this time.” I find it hard to accept, but perhaps network effects and zero marginal costs have made profitability “manna from heaven.” Those who can collect it will enjoy their banquet of profits forever.
Interest rates? Who cares? Rampant inflation may be another issue.
