Wall Street is heading for a different kind of crash
The markets may have taken low inflation into account but Mark Brown and Gareth Williams warn a reduction in growth rates could cause problems
Tuesday 05 August 1997
Judged in isolation the US stock market is now just as fundamentally expensive, and, hence, in just as dangerous territory, as during the two previous mega-bull phases, if not more so. In relation to any form of absolute shareholder value - dividends, earnings, cash flow, book values - share prices are as high or higher than they were just before the October 1987 crash. However, in both 1929 and 1987, the distortion in US and UK equity prices could be seen most clearly in the relationship between long- term interest rates or bond yields and equity valuations. This is not the case this time around.
Superficially, the current bond yield to dividend yield relationship in the US does appear to be in dangerous territory. However, relative valuations appear neutral if account is taken of the decline in the pay- out ratio in the US to a record low. In the UK, too, relative equity- bond valuation measures remain firmly in neutral territory, with a yield ratio of 2 times compared to 3.3 times just before the 1987 crash.
It may be, therefore, that current equity valuations are justified by today's lower interest rates. When rates come down the return on keeping money in the bank falls. In these circumstances investors should value a given level of future earnings more highly.
Bond yields may be thought of as having two components: an element which is necessary to compensate investors for what they think inflation is going to be; and the real interest rate. Arguably, equities should be more concerned with real interest rates because higher prices should partially feed through into higher profits and dividends. Empirical research confirms that this is the case.
This brings us to possibly the main distortion in global financial markets at the present time. Real bond yields have recently fallen below the levels seen in late 1993 to their lowest level since the 1970s. This owes much to the situation in Japan, where real bond yields have tumbled from around 5 per cent at the start of the decade to under 1 per cent currently, although real yields outside Japan have fallen in equally dramatic fashion recently.
Sub-normal rates in Japan reflect its lack of appetite or inability to spend. In effect, Japan's excess savings are financing the rest of the world's financial markets, both bonds and equities. In this way, the current climate resembles that prevalent in the run-up to the bond-market crash of February 1994, when inflation risks were relatively low. A synchronised pick-up in economic activity, or expectations thereof, would soak up excessive liquidity and cause real yields to rise. This would cause problems for equities even if it were not accompanied by a pick-up in inflation.
As for inflation, the process of economic and technological change in the 1990s has been inherently dis-inflationary. Costs have been stripped out of all stages of the production process. Products and services are increasingly manufactured and sold on a world-wide basis, with the result that the competitive pressure to keep prices down has intensified. These changes have come on the back of 1980s measures to weaken the power of workers. The waves of global mergers and alliances currently taking place in the financial services, telecommunications, transport and defence sectors are a response to these trends. New technology too has played its part. Greenspan's Humphrey-Hawkins testimony discussed at length the impact on US productivity caused by computer and telecommunications technology, which may now have matured enough to genuinely add value. In as much as these productivity and margin gains are real and permanent, the rise of the US equity market in response is rational.
The other great sea change in the 1990s has been the change in the conduct of fiscal and monetary policy. Both the US and Europe have tightened fiscal policy. In the US, politicians seem intent on balancing the budget. The single-currency project has had a similar effect in Europe. This has reduced the supply of debt and, hence, both real yields and inflation expectations. The latter effect has been strengthened by the growing influence and independence of central banks.
However, even if markets are right to believe in low inflation and low real yields, it is less clear that they have factored in the concomitant reduction in long-run growth rates. When nominal growth in the economy is only 5-6 per cent it is asking a lot of technology-inspired productivity improvements to produce the 10-15 per cent earnings growth required to satisfy current consensus expectations. This is particularly so when labour- cost pressures are rising, albeit modestly.
It should also be noted that technological change is a negative for those companies whose capital is rendered obsolete as a result. This may be why, despite all the technical progress, there is little evidence of any productivity revolution in the official data. It is also the case that the recent performance in US profits can still be explained by a pretty standard cyclical rise in profit share and margins.
One does not have to rely on airy-fairy theories about productivity miracles. In this respect the current bull case in the US certainly echoes that in the UK in 1987 when share valuations were justified on the basis of a significant improvement in potential economic growth which failed to materialise.
This cautious view on earnings would carry even more weight if standard earnings estimates in the US are not fully capturing the dilutive effect of the growing use of share options in employee remuneration - which is probably the case. In this way US companies are simply storing up problems for the future.
Unlike 1929 and 1987, current US equity ratings may be justified by the current low level of bond yields, particularly in real terms. Nevertheless, while markets may have correctly taken on board the implications of low inflation, it is less clear that they have factored in the concomitant reduction in long-run growth rates. A crash of previous proportions would require the double whammy of a rise in real bond yields from their current historic low together with a knock to growth expectations. A very possible, if not probable, combination.
Mark Brown and Gareth Williams are equity strategists at ABN Amro Hoare Govett.
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