It is now more than two decades since Alan Greenspan, then chairman of the US Federal Reserve, coined the term “irrational exuberance”. Yet since then, and despite all the lessons of history, financial markets have repeatedly shown a gleeful willingness to convince themselves that their exuberance isn’t irrational. Look at the highs that were scaled at the turn of the millennium before the dotcom bubble burst. Look, too, at the way that markets exhibited a blithe disregard for risk as they cantered upwards before the financial crisis of 2008-2009 laid them low.
And now? Now, markets appear again to be gripped by exuberance. On both sides of the Atlantic, equity markets have touched new peaks in 2017. Prices of government bonds around the world have been pushed up so high that the yields they offer are vanishingly small or non-existent. As investors scour the financial landscape for something that offers a return of any magnitude, they have been prepared to turn a blind eye to the fragility of large classes of assets. All of this provides indisputable evidence of exuberance. The question is – to reprise Greenspan’s terminology - whether it’s irrational. Will it end in tears? Or, to use a further well-worn phrase, can we say that this time, it really is different?
This time, it is indeed different. But it is not different in the way that many would wish. Look at the monetary backdrop. Never before, have central banks’ interest rates been so low. Never before have those banks shown such readiness to buy financial assets in an attempt to inject cash into the system to stimulate consumption and investment: since the beginning of 2008, the Bank of England’s balance sheet has expanded more than four-fold; the US Federal Reserve’s has trebled in size.
And yet growth rates in developed economies remain anaemic. Despite the central banks’ best efforts, economies in the US, UK and Eurozone have, in recent years, expanded on average by far less than that 2%+ a year – a figure once considered normal. Nevertheless, this lacklustre growth rate has done nothing to dampen the appetite for equities. The rise in US stock market indices has largely been driven by the phenomenal performance of a handful of tech stocks. Amazon’s shares have nudged above US$1,000 (£758) this year, a five-fold increase since 2011. That success, however, is tempered by the near 30% of S&P Index constituents dipping by 20% or more from their highs.
Take Amazon, whose shares have risen by 400% but earnings haven’t moved. How can that be? Shares are bought on the basis that they will produce earnings in the long-term from which dividends are paid. Earnings underpin price; a divergence between the two can’t continue forever. Something has to give.
While equity prices have generally gone up more than 40% in the past four years, reported earnings increased by less than 10% in the same period.
Next, look at the political background. In the US – and other countries including the UK – wealth inequality has become steadily more extreme in the past four decades. The richest 0.1% of the US population is now worth as much as the bottom 90%. Little wonder then that so many people outside the ultra-rich elite feel so disgruntled and willing to vote for the likes of Donald Trump. They are sick of the fact that fiscal and monetary policy helps only those with assets.
It is not just in the US that we have seen evidence of the resentment felt by those who feel that all of the economic gains of recent years have accrued only to a few people at the top of the pile. Britons voted to leave the European Union. France came nerve-janglingly close to electing Marine Le Pen. Germany has seen the rise of Alternative für Deutschland; Spain has Podemos and Italy its Five Star movement. These apparently populist political movements are in essence nationalist. And when nationalism finds expression in protectionism, that poses a profound threat to economic growth.
Elementary economics tell us that trade is one of the key mechanisms by which aggregate wealth can be increased. Any inhibition of trade will constrain global growth.
Yet the election of Trump was greeted with enthusiasm by US equity investors. They were prepared to ignore his threat to institutions such as NAFTA that have helped lubricate the wheels of international trade. Instead, they focused on the new president’s promise to cut taxes, the idea being that lower taxes on both individuals (or at least the better-off ones) and companies would stimulate growth in the US.
That sounds fine in theory, but will it actually happen? One simple and self-evident point is that the Trump administration appears dysfunctional. The president has struggled to fill even a fraction of the posts that require talented and experienced individuals needed to carry out his plans. Trump carries the Republican label, but he is much better described as an independent. He is the quintessential outsider. He entered the White House without the Washington connections required to appoint people swiftly from the established political network.
Furthermore, it’s becoming increasingly clear that both Republicans and Democrats in the Senate and House of Representatives are uneasy about big tax cuts. Their ideological motivations for opposing these cuts are very different: some Republicans don’t want to undermine fiscal rectitude. Some Democrats are against cutting support for the poorest people in order to implement regressive tax changes that favour the rich. Nevertheless, these groups can combine to block Trump’s efforts to introduce tax changes that some equity market players believe would benefit corporate America.
Those who look back to the ‘80s era of Reaganomics, which saw simultaneous tax cuts and higher spending, should be careful about drawing any analogy with what Trump’s attempting now. Back in 1981, US government debt was 152% of GDP; now it’s more than 330%. Base rates were 20% back then and are now 0.5%, while the highest tax rate in 1981 was 70% but is now more than half that. The stock market was very different in the 1980s: the average price to earnings ratio of S&P 500 companies was 8.9 times, a figure that’s since increased to 20 times.
In short, I believe that the Trump mirage is just that – nothing more than a mirage. Ignore the rhetoric; the idea that he will make changes to benefit businesses is ill-founded and simply wrong. Investors betting on a Trump-powered boost to corporate earnings are misguided.
So, if high equity prices are founded on a false assumption about earnings growth and government debt is yielding next-to-nothing, where have investors put their money? Many have piled into emerging markets, which are proving seductive. When a fixed-income investor sees that 10-year German bonds offer just 0.25% and Japanese bonds yield zero, then why not go for something in, say, Brazil, where the yield is closer to 9%? Because of the risk involved. In May this year, the Brazilian Real fell by 6% while bonds dropped by 10%. Any investor who was lured into buying Brazilian government bonds because of their yield would have suffered intense financial pain.
It’s not only Brazil that carries political risk. The picture is similar in places such as Turkey and South Africa. And don’t forget China, the big daddy of emerging markets and the nation that accounts for around one-quarter of all US Treasury bonds held by non-American investors. Five of the seven members of China’s politburo are likely to retire later this year. That brings political uncertainty as China tries to steady its economic ship amid frictions with the US over their trade imbalance.
Even within developed markets, investors appear prepared to ignore risk in their increasingly desperate hunt for yield. Not so long ago high yield lending to companies equated to risky lending. It still does, but investors’ measure of what represents high yield is slowly changing. In Europe, high yield investments may offer a 3% annual return. But is that percentage really high? Of course not. Lending money at 3% of financially fragile companies is foolhardy. In a portfolio of 30 companies, you only need one to go bust to wipe out your returns for the year.
So, taken together, we face a financial landscape where risk and uncertainty abounds; returns on safe assets are negligible and on riskier ones they are not much higher. Equities are changing hands at sky-high prices that can be justified only on the most heroic of assumptions about future earnings. And yet the VIX – the so-called fear index that measures investors’ expectation of future stock market volatility – remains resolutely low.
You could interpret current financial asset prices as a sign of nonchalance or recklessness. You may even say that it reveals exuberance. Whatever terminology you use, the prices appear irrational.
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