This year, equity investors have been shouting “three cheers” for central banks. When Jay Powell, Federal Reserve chairman, dramatically loosened monetary policy in March, he halted a market rout.
However, if the boffins at the Bank for International Settlements are correct, the precise quantity of cheers that Mr Powell and his ilk actually deserve is closer to one and a half out of a possible three, for American assets, and a half cheer out of three for Europe.
As part of its latest quarterly assessment on the financial system, the BIS attempted to quantify how much of this year’s equity rally since March has been driven by low rates; the calculation suggests that loose monetary policy accounts for “close to a half and a fifth of the rebound in the US and euro area equity prices, respectively”.
This number-crunching deserves attention given the Fed’s promise not to raise rates until inflation has been above 2 per cent “for some time” and the fact that central banking groups rarely publish such sums. Remember that the BIS is often dubbed the central bank to the central banks.
Let’s put these numbers in perspective. Central bankers all acknowledge in private that low rates are like rocket fuel for asset prices; indeed, this is considered a key transmission channel for monetary policy. But few will admit in public that they are responsible for this summer’s stock market surge, either because they do not want to create a “put” for the markets, or get blamed for increasing wealth inequality or become scapegoats if a bubble pops. Or all three.
The BIS, unlike national central banks, does not answer to a specific government. Thus it can be more outspoken about the flaws of modern monetary policy. And this week’s report reveals deep unease at the Basel-based institution about the fact that today’s sky-high asset prices seem at odds with underlying economic data.
Stock market bulls might retort that recent equity price records reflect a secular shift. Indeed one reason US stock markets have surged is that investors have dashed into Big Tech as the Covid-19 pandemic amplified the power of digital platforms. Indeed, Big Tech mania is now so extreme that the sector’s weight in the S&P 500 index has risen to 45 per cent.
The combined weighting for the tech and communications sector plus Amazon represents “the greatest concentration issue that either equity or credit markets have faced in 50 years,” calculates JPMorgan in a recent note. Even during the craziest moments of last decade’s credit bubble, finance was “only” a little more than 20 per cent.
But that lopsided pattern does not fully explain the entire equity market surge. Nor does the dismal growth outlook. “[Market] levels contrast sharply with the continuing dire state of the economy,” Matt King, analyst at Citi, noted last week.
Hence the BIS interest in calculating the role played by low rates.
The number-crunching exercise was not easy — that’s partly why such efforts are unusual. The BIS team started by assuming that the value of a share price should represent the sum of the present value of the stream of all expected future dividend payments. It also assumed that short- and long-term dividend expectations could be extrapolated from prices in the futures market. Then it presumed that short-term expectations expressed investors’ views about an economic future that is close enough to imagine. Meanwhile, long-term expectations (anything beyond five years) were shaped by the “time value” of cash, which they took to mean the rate of return on risk-free assets such as US Treasuries.
The BIS economists then calculated the short-term dividend outlook for the S&P 500 and Euro Stoxx 50 indices and then extrapolated the long-term element by comparing short-term components to the full prices of the indices.
This exercise revealed three things. First, implied short-term dividend projections collapsed in the spring, when the pandemic shattered growth projections. Second, the long-term element increased because the risk-free rate fell too.
Third — and most important — when the BIS team calculated what would have happened if rates had remained at February levels, they found that “the long-term components of US and European stock prices would have been roughly 18% and 6% lower than they were on 4 September, respectively”. The short-term component of stock prices would also have declined but only slightly.
This in turn implies that low rates fuelled half of this year’s US rebound and one-fifth of that for Europe.
This methodology is not perfect. But it should make investors ponder what might happen if rates rise. That seems unlikely in the short term because the Fed’s new view suggests that interest rates will stay at rock bottom until at least 2023.
But therein lies the rub. “The more central banks drive real yields down and valuations in risk assets up, the more they will need to keep buying just to keep them there,” Mr King observes.
That could set a nasty trap for central banks and investors alike. And it is a good reason to keep watching those BIS boffins.