This note looks at concerns that share and property markets are only strong because central banks are artificially depressing interest rates. The key points are as follows:
- Shares are vulnerable to a short-term correction, particularly given the risks around the corona virus outbreak.
- But with inflation low, and as long as recession is not imminent, it makes sense that traditional valuations like PEs are higher than their long-term average.
- Similarly, it makes sense that property yields are lower than normal, but the fall in Australian housing yields has been extreme relative to commercial property & shares.
- Key things to watch out for are recession and much higher inflation.
Share markets are at or around record levels despite lots of worries, particularly around the corona virus (Covid-19) outbreak. A common concern is that this is because central banks (like the Fed and the RBA) are distorting market forces and just want higher asset prices. And flowing from this its argued that prices for assets like shares and property are overvalued, record highs are artificial, and a crash is inevitable. Markets are at risk of a short-term correction given the large gains since the last greater than 5% correction into August and given the risks around Covid-19. But beyond this it’s a lot more complicated than the bears would have it.
Central banks really just responding to market forces…
There is some truth to the claim that central banks want higher asset prices. Higher asset prices are part of the transmission mechanism for monetary easing to the economy because they boost wealth and this helps boost spending. As former Fed Chair Alan Greenspan said in 2010 “a stock market rally may be the best economic stimulus”. But it’s not quite that simple:
- First, central banks also fret about that financial instability that flows from higher asset prices as they may lead to overvalued markets that could crash or encourage people to take on too much risk say via excessive debt. Recall Alan Greenspan’s concerns about “irrational exuberance” and don’t forget the credit tightening that occurred from 2017 in Australia that was designed to slow “risky” housing lending.
- Second, more fundamentally central banks are really just responding to market forces. In the post GFC world we have seen lower inflation in response to ongoing spare capacity and competition from online disruptors, offshoring and automation. More fundamentally, reflecting greater caution we have seen desired saving exceed desired investment globally. All of which has driven lower interest rates which central banks have just responded too. To have not cut official interest rates would have defied market forces and caused even weaker growth, higher unemployment and even lower inflation.
- Finally, its rational for asset prices to move up in response to lower inflation and lower interest rates.
…lower inflation equals higher PEs (and lower yields)
The next chart shows the ratio of share prices to consensus expectations for earnings over the next 12 months, which is often referred to as forward PEs. As can be seen, these are now above their long-term averages in the US and Australia, although US and global PEs are still well below tech boom extremes.
Source: Thomson Reuters, AMP Capital