Another day, another warning of market froth, only this time not from the (widely ignored) Federal Reserve, but from Mikihiro Matsuoka, chief economist at Deutsche Bank who in a note released on Monday says that he believes that "the equity market in developed countries begins to show symptoms of ‘froth’. A simple average of the standard deviation of the stock market capitalization as percentage of GDP of seven major developed countries has been approaching very close to the previous peaks of 2000 and 2008. The reason we believe it is entering a frothy territory is that an eventual turnaround of monetary policy after a long period of post-GFC accommodation is under way in major developed countries, which in our view, raises the returns on safe assets and lowers the valuation of risk assets."
While Matsuoka hardly says anything Janet Yellen did not cover in the past two weeks, here is the summary:
Some factors, such as 1) higher nominal GDP growth above long-term bond yield thanks to massive monetary accommodation, 2) chimera equities in which dividend yields get higher than the long-term bond yield and a resulting rise in P/E thanks to ‘search for yield’, and 3) financial surplus of non-financial businesses in developed countries, might help evade or put off a large and prolonged adjustment in asset prices.
However, the gap between nominal GDP growth and the long-term bond yield has expanded to a historical high under which monetary policy turnaround would naturally shrink the gap. The decline in the potential growth in the post-GFC era eventually restrains the profit growth and a resulting dividend growth over the long run. The price-earnings ratio has been on a slow but persistent rise after the GFC. The monetary policy turnaround could counter this by lowering the valuation of the risk assets. An expanding financial surplus for non-financial businesses reflects disappearance of investment (or profit) opportunities, i.e. an end of capitalism. The fall in the potential growth restrains a rise in the valuation of risk assets over the longrun.
The diminishing marginal returns on economic policy could further reinforce the effect of the monetary policy turnaround on the financial market. The first round of QE had a bigger impact on both the financial market and the real economy than the second and the third shots of QE. It is because the financial market had to dramatically recalibrate its model of the resulting steady state after the introduction of QE. Likewise, the first round of the withdrawal of monetary accommodation could well deliver a bigger negative effect on the financial market and the real economy than the ensuing second and third shots of monetary policy turnaround. The US suffered the 2013 taper tantrum as a result of the first shot of withdrawing monetary accommodation and paid a price of not withdrawing it any time soon. Now, this is the first round for the ECB and the BoE. In addition, the US Federal Reserve appears willing to accelerate the frequency of the rate hikes, which could further amplify the negative shocks. Unlike 2016, the Fed does not appear to have enough patience anymore to postpone the rate hikes.
Equity market in developed countries entering ‘frothy’ territory
Stock market capitalization in the developed countries as a percentage of GDP has already approached levels very close to previous peaks recorded in 2000, 2008 and 2015. We believe that the financial markets seem to have entered frothy territory (even if not being in a bubble). In the first place, we would never know if this is a bubble until it bursts. The reason we believe it is entering frothy territory is that an eventual turnaround of monetary policy after a long period of post-GFC accommodation is under way in major developed countries, which in our view, raises the returns on safe assets and lowers the valuation of risk assets.
Your author covers the Japanese economy, not the global economy or global financial markets. Yet, the economy and the financial market in Japan have often been overwhelmed by the global factors where the analysis of Japan-specific factors becomes almost irrelevant. We begin to feel this is happening again.
So, we decided to write this report despite its global nature and the risk that your author may step out of his lane.
And the details. Stop us if any of this is new:
Stock market capitalization to GDP ratio already near historical peaks
Figure 1 shows stock market capitalization of seven leading countries with relatively large market capitalization for which statistics are available back to 1991 (Australia, Canada, Germany, Japan, Switzerland, UK, US). We calculated the average and standard deviation for each country for 1991-2016, standardized them assuming a standard normal distribution with zero mean and unit variance, then obtained the simple average of the seven countries. According to this, local peaks were 1.45 in August 2000, 1.61 in May 2007, and 1.34 in May 2015, while the figure has risen to as high as 1.30 in May 2017 and 1.29 in June 2017 (preliminary).
Figure 2 shows the stock market capitalization as percentage of GDP in major developed countries (not standardized). The current levels of many countries have been very close to their respective historical peaks.
In the process of "self-defeating financial deepening" as the author imagines it, the stock-to-flow ratio (e.g. ratio of financial assets to GDP) attempts to maintain an upward trend along with economic growth. However, an upward trend line cannot be justified and occasionally the ratio undergoes a major correction (decline), after which a new trend upward to the right resumes.
Buffers to ease correction of asset prices
Meanwhile, we are aware there exist some factors preventing (or postponing) a large-scale and prolonged correction in asset prices:
1) higher nominal GDP growth above long-term bond yield thanks to massive monetary accommodation (Figure 3),
2) shorter cycles of capital investment and capital stock in the real economy,
3) chimera equities in which dividend yields get higher than the long-term bond yield and a resulting rise in P/E thanks to ‘search for yield’ (Figure 4), and
4) financial surplus of non-financial businesses in developed countries.
Gap between nominal GDP growth and long-term bond yield already at historical highs
That said, it would be better to assume that these four buffers will weaken over the long run. When economic growth exceeds the interest rate, it supports asset prices. The differential between nominal GDP growth and 10-year government bond yield, measured as a median from 20 major developed countries, has expanded to 3.04%point in Q1 2017, exceeding the previous pre-GFC peak of 2.68%point recorded in Q1 2016 (Figure 3). When central banks' turnaround of monetary policy takes place (except for the Bank of Japan), the differential is likely to narrow.
Declines in the potential growth and the leverage restrain dividend growth
The dividend yield has risen after the GFC (Figure 4) due to new constraints on expanding leverage from tougher financial regulations, which restrains growth in company earnings as well as economic growth where company dividends should be in proportion to these over the long run. The fiat monetary regime that enabled bringing forward future economic growth through leveraging ended and potential growth thus declined. Tougher financial regulations amplify this. These will push both nominal GDP growth and the dividend yield down. Tougher financial regulations have restrained the leverage of financial institutions and raised their capital ratios, which should substantially lower the likelihood of the financial systemic crisis. That said, the lack of expansion in the leverage means a downward revision of profit growth via the decline in the potential growth. It cannot justify stock prices that have become too high.
P/E already on a slow but persistent rising trend after GFC
A financial surplus in the non-financial business sector of developed countries has contributed to stable low interest rates through an increase in the funds for the "search for yield", but it also reflects the loss of investment and profit opportunities (an end to capitalism). These are near-term support factors for asset prices but eventually push valuations on risk assets too high. For example, the 12-month forward P/E, measured by the median of 15 developed countries and that of 19 EM countries, has been on a slow but persistent rising trend following the GFC (Figure 6). The cyclically-adjusted P/E in the US has already started to exceed pre-GFC levels (Figure 7). A further expansion in the differential between nominal GDP growth and the long-term bond yield would be needed to justify these circumstances, but this is unlikely to happen under the monetary policy turnaround.
A rising yield on safe assets suppresses risk asset prices
Major central banks of developed countries (other than the Bank of Japan) appear to be moving to unwind their massive scale of monetary accommodation for the past nine years. This will push down valuations on risk assets through a rise in the yield on safe assets. In 2015 too, predictions spread that the US Federal Reserve would raise rates incessantly in 2016, leading to a correction not only in equity prices but also in asset prices including high-yield bonds. At that time, the Fed turned cautious on their assessment of economic conditions and did not raise rates until December 2016 after their rate hike in December 2015. This left the correction in the prices of risk assets moderate. Unfortunately, the Fed's resolution to raise rates this time seems to be firmer than in 2015 because of their assessment that US economy has almost reached full employment. In addition to this, there are signs that both the ECB and BoE are heading toward a turnaround of their monetary accommodation, although the timing is uncertain.
Monetary policy turnaround as clear force toward asset price corrections
The first sign of the GFC was a suspension of the redemption at a hedge fund. At that time for many people, this did not mean anything substantive. When a bubble bursts, many seemingly idiosyncratic and unrelated events take place one after another, and we finally realize ex-post that they are symptoms originating from a single common cause. This time, such a symptom may include the deterioration of the quality of securitized products of US auto loans, and/or the deterioration of the financing of EM countries following a rise in US interest rates. We all know that financial markets are fickle, in which one event influences investors' psychology and this spreads to many areas to quickly and totally alter the landscape. We believe that a turnaround of monetary policy in major developed countries, or at least its revelation, is a much clearer cause (not a symptom) of downward forces on prices of risk assets through a rise in the return on safe assets, than the suspension of redemption by a hedge fund.