Cheap and nasty

A report by Gerard Minack at Morgan Stanley today wrestles with one of this blogger’s favourite topics, the problem that the cost of capital is taking a holiday in developed economies. This is distorting pricing and making the job of getting decent returns unusually difficult. As one chief executive commented at a presentation recently, we are in many respects in a bull market, if not in stocks then certainly in commodities. So money should be expensive. But it is not, because the job of rescuing the financial system is not yet completed, especially in the US. That adds up to dangerous waters for investors looking to get solid returns. Overpaid fund managers are going to find it even harder to justify their fabulous fees. Minack’s report describes the interest rate scene in developed economies. Money is cheap.

The US Treasury market is the most important sovereign market in the world, but this rise-and-fall in yield was not unrepresentative. Five of the G7 nations now have 10-year Treasury yields of 3%-something; Italy is at 4%-something and Japan 1%-something. Forget, for now, the debate about the inflation outlook. The simple point is that a bond yielding 3%-something is very unlikely to generate above-average returns over the medium term. It’s even clearer that returns will be far below those generated through the past 3 decades.

The 10-year Treasury yield is the closest thing the world has (or, perhaps, usedto have) as a risk-free rate. The 30-year trend decline in the developed world’s quasi-risk-free rate dragged down yields on all assets. For debt instruments, this added capital gains to the expected coupon payments. Just as Treasury yields are at the low end of their historical range, so are yields in most other debt markets (Exhibit 2).

I am not arguing that these low yields are unjustified. The point is that declining yields turbo-charge returns. With yields at the bottom of the plausible medium-term range, it seems that returns going forward will be significantly below those seen over the past 30 years. Put another way, none of these assets looks cheap.

It is a pretty treacherous investment environment. Low interest rates are likewise distorting the cost of equity — depending on which interest rate you pick the earnings multiple of stocks should be somewhere between infinity and 27 times. Normal ratios do not apply, in other words. No wonder US stocks look over priced, as Rotten Apple has showed.

The price for the GFC has not been fully paid. There has been no return to “normal” investment conditions. Apart from a few small and unimportant countries, such as Australia and Germany, the cost of capital is taking a  holiday on the Costa del Sol. Don’t expect much relief form the developing world, either. The cost of capital is not a popular concept in Asia; it tends to be seen as something that should be subordinated to national interest.

In Australia, there is a cost of capital, but it is too low because of the bubble in house prices and distortions from the mining boom. If that bubble is pricked, it will fall further. We will join the G7 nations.

Morgan Stanley

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