The conditions for a new financial crisis are firmly in place. Mispricing of assets has now reached epidemic proportions.
Since 2009, global equities prices have increased strongly. Banks argue that the falls of August 2015 and early 2016 represent a healthy correction and present good buying opportunities. Volatility –the fear and greed index, at least – remains low.
But equity markets are underpinned by financial engineering and liquidity. US stock buybacks have reached 2007 levels and are running at around $500bn annually. When dividends are included, companies are returning around $1n per annum to shareholders – close to 90 per cent of earnings.
The major driver is liquidity, in the form of zero interest rates and quantitative easing (QE). According to one estimate, over 80 per cent of equity prices are supported in some way by QE.
Stock prices have risen as the rate at which future earnings and dividends are discounted back to the present has fallen dramatically. The equity risk premium has increased as result of lower interest rates.
Citibank analysts argue that the equity risk premium is now over 5 per cent, well above the historical average of 3 per cent. As equity becomes more expensive relative to debt, companies ‘de-equitise’, substituting debt for equity, reducing the quantum of available shares boosting prices.
Recent rises in equity markets have been helped by the fact that globally central bank purchases of government bonds is above new issuance. This implies further falls in term rates and increases the equity risk premium, which will boost share prices. Over time, if the equity risk premium reverts to its long term average, then share prices may move higher with each 0.5 per cent equating to a rise of 20-30 per cent.
Higher stock prices are supported by improved earnings. But on average 70-80 per cent of the improvement has come from cost cutting, rather than revenue growth. Since mid 2014, profit margins have stagnated and may be falling.
A key factor is currency volatility. The higher US dollar is pressuring American corporate earnings. A 10 per cent rise in the value of the dollar equates to a 4-5 per cent decline in earnings.
Rallies in European and Japanese stocks have been driven, in part, by the fall in the value of the Euro and Yen respectively. Lower commodity – especially energy prices – will affect resource firm earnings. In the US, wage rises may also erode profit margins. The major concern is weak global demand, with lack-lustre growth in Europe and Japan and deterioration in emerging markets.
The S&P500 now trades at around 17-18 times forward earning – a level which is historically expensive and only exceeded during the 1999-2000 tech bubble. Other markets are also priced above historical levels.
As in the lead-up to the dot.com crash, investors chasing revenue and earnings growth have pushed up sectors such as technology and bio-technology, which has been the best performing sector for a number of years. More than 80 per cent of new initial public offerings are for companies with no earnings.
Other asset classes show similar stresses. Government bonds globally, unless distressed like Greece, Ukraine or Venezuela, trade at artificially low rates. Over $7tn of sovereign debt globally now trades at negative yields.
The overvaluation is driven by central banks. US Fed Vice Chairman Stanley Fischer observed that staff calculations indicated that current programs had reduced 10 year Treasury yields by about 1.1 per cent. But with central banks globally likely to continue or even expand liquidity support programs, it is possible that rates may stay low for an extended period or even fall further.
The perverse environment caused David Rosenberg, chief economist and market strategist at Gluskin Sheff, to muse about the strange phenomenon of investors buying low or zero yielding bonds for capital gains and purchasing shares for income. With risk on government bonds increasing, equity analysts argued that investment in shares was preferable to bonds as they offered better protection from a rise in risk free rates.
The lack of returns in government bonds has driven overvaluation in credit markets. Investors have taken on additional risk, moving into corporate bonds. In the US alone, the estimated net inflow into bond funds has been $1.2tn. The investment-grade corporate bond market, as measured by a Bank of America Merrill Lynch index, has increased to $4.8tn. The increased investment has driven rates ever lower, with the average falling to a low of under 2.9 per cent in early 2015.
The risk return relationship has deteriorated with investors no longer being compensated for the true default risk.
Real estate prices have risen globally with investors purchasing rental income streams to diversify away from low income financial assets. Markets as disparate as the US, Canada, UK, Germany, France, Scandinavia, Australia, New Zealand, China, India and many other emerging countries have become overheated.
Only one asset class, commodities, has corrected. The combination of increased supply, slowing demand especially from China, a stronger US dollar and geo-political factors has seen most commodity prices fall.
Charles McKay was correct in his observation that people lose their sanity collectively but regain it one by one.
Satyajit Das is a former banker and author. His latest book is ‘A Banquet of Consequences’
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