Are bonds and equities a bubble? Wrong question…

Domainfax has a piece today debating whether equities and bonds are a bubble:

One of the big questions being tossed around global markets at the moment is if shares and bonds are overvalued.

One side says clearly yes, pointing to historical averages, while the other side argues it’s different this time, pointing to record-low interest rates that – despite some noise – are unlikely to rise significantly anytime soon.

Capital Economics belongs to the latter camp, conceding that valuations of both bonds and equities are higher than their long-run averages, but saying sharp falls in their prices are unlikely.

“This is because we believe their equilibrium valuations have risen,”says chief markets economist John Higgins.

The reason for higher equilibrium asset valuations has been a decline in equilibrium real interest rates (ie ‘the new normal’ in rates), stemming from slower potential economic growth, an increase in the desire to save and a decrease in the desire to invest, he explains in a note to clients.

A key piece of evidence that supports the idea that equilibrium real interest rates have fallen is a lack of inflation, despite the fact that central banks have been setting real policy rates at lower and lower levels, Higgins says.

“Real policy rates affect real interest rates in the economy. If these real interest rates are permanently below their equilibrium levels, demand will eventually exceed potential supply, leading to higher prices.”

Higgins admits that there is asset price inflation, but challenges the view this has contributed to slower growth in the real economy.

“Some claim that central banks are responsible for a bubble in these prices, which has actually contributed to slower potential economic growth by, for example, facilitating the misallocation of capital and increasing inequality.

“In our opinion, though, higher asset prices are mainly the consequence rather than the cause of a decline in equilibrium real interest rates.”

 

Rather obviously it is both. The equilibrium interest rate falls as economies become debt-saturated. Once you add a shock and some deleveraging it gets worse again. As central banks try to boost flagging demand through monetary easing, they unwittingly prevent creative destruction and we end up with oversupply as well as poor demand and inflation falls even further.

Naturally, as the risk free rate falls the price of yield rises.

When applied to today’s emerging volatility, then the reverse is also true. As the risk-free rate rises then the price of yield falls. Thus any bond back-up will today choke equities. But given the underlying circumstances of debt-saturation, lacking demand plus artificially supported over-supply, just how far do you think that yields can back up before the pain caused by crashing asset prices hurts demand and drops inflation even further?

Rinse and repeat. So I wouldn’t call it a bubble so much as it is the death throes of an entire monetary system.

The only way out is get rid of the debt. That can be done through productivity gains via reform, through a jubilee, or through printing money for government’s to invest to grow incomes and the economy. Only one of these is politically easy so that’s the one we’ll choose. But not before further exhaustion of the present system.

The question before investors today is not whether or not assets are a bubble, it is who will own the right to create money in future and what does that do asset prices?

David Llewellyn-Smith
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Comments

  1. “decline in equilibrium real interest rates (ie ‘the new normal’ in rates), stemming from slower potential economic growth, an increase in the desire to save and a decrease in the desire to invest

    Real interest rates have been falling for 30 years and this secular trend has held regardless of whether there has been growth or not. I doubt that the desire to save or invest has changed much over this period, though the ability to may have (surplus disposable income plus cheap and easy credit).

      • Demographics might be disinflationary, but central banks have been cutting real rates, not just nominal, even when economic growth is evident. Its like a doctor trying to cure an incurable patient by giving them an overdose of medicine.

    • Dan,
      They refer to *potential* growth – you respond about ‘growth’ per se.
      Interest rates are an identity function of savings and investment, in macro-economic theory/models … the fact that they have fallen ipso facto means that desire has fallen – you respond that ‘you doubt …. ‘
      Trust this helps.

  2. The question before investors today is not whether or not assets are a bubble, it is who will own the right to create money in future and what does that do asset prices?

    That’s the real $50 trillion question.

    Thomas Piketty would argue that low inflation, low growth, and hence low interest rates combined with high asset prices as defined by their inverse earnings yield (how he calculates the value of ‘capital’) are actually ‘normal’ from a historical perspective and that the high rates of growth and interest rates experienced between the end of WWII and the dawn of the internet economy (pre-bubble) was abnormal.

    I wouldn’t be waiting around for P/E ratios to return to their roaring 80s/90s values. Especially given the rising activism of central banks.

  3. “The equilibrium interest rate falls as economies become debt-saturated. Once you add a shock and some deleveraging it gets worse again. As central banks try to boost flagging demand through monetary easing, they unwittingly prevent creative destruction and we end up with oversupply as well as poor demand and inflation falls even further. Naturally, as the risk free rate falls the price of yield rises.”

    The post GFC environment in four sentences. Absolutely nailed it.

  4. There are four things which likely mean that interest rates will stay very low for a very long time:
    1. Demographics. There are going to be a smaller proportion of workers, maybe even a smaller number of workers.
    2. Offshoring. The continuing loss of jobs to overseas and a moderate unemployment level means not much if any real growth in wages for most people in the workforce and therefore no real demand growth.
    3. A tendency to austerity by government. Even though there might still be some stimulus, all the talk means that savings ratios stay higher than they might if the outlook was for unbridled growth
    4. Nothing left to goose GDP. There is virtually no one who can be added to the workforce without major government expenditure. Most of the single income families have converted to dual incomes. Pension ages have already been increased to help keep the older generation working longer. The only fat in worker availability is immigration and reduced opportunity for tertiary education..

  5. I think I understand this material at a very modest 50% level. I think I might just have the capacity to understand it at a high eighties percent level. If you took time to cut the jargon and the in-group speed lingo, I might learn HnH. By contrast, UE is very easy to understand and accessible.
    This comment is not a shitty compare and divide ploy, HnH. Comparisons are indeed odious. And, without doubt, you both know your stuff. Rather, it is tough but honest feedback. Hope it is received as such. The goal is accessibility, even for slower people like me.

  6. Grrrr jubilee is an abhorrent concept given bankruptcy is perfectly fair & legal. I wouldn’t object to those who over borrowed being a life long asset on a banks balance sheet until they pay off their commitment (which has prevented others purchasing a home for a fair affordable price).