More on the issue of bubbles in the stock market. Here is a chart from Google Trends on the worldwide trends for the search of the term "stock market rally". An upward trend but still below the levels in October 2010 or 2011 and much lower than at the height of the financial crisis (2009-2009).
Sunday, May 19, 2013
Thursday, May 16, 2013
The myth of liquidity and bubbles in financial markets
Gillian Tett at the Financial Times wonders today about how long the stock market rally will continue. Her argument is that we see data that are at odds with historical norms: the stock market goes up when unemployment is still rising in Europe, earnings come short of expectations and the rally continues. uncertainty is still high but spreads are low. How can this be? Her explanation:
"It is easy to identify the reason for this: as this data has gone haywire in the past couple of years, western central banks have been unleashing an estimated $7tn worth of quantitative easing. This has lowered interest rates on government bonds, forcing investors to search elsewhere for yield."
So it is the Central Banks and quantitative easing that is supporting the behavior of financial markets and we need to worry about how sustainable it will be. Gillian Tett refers to the 2003-2007 experience when we witnessed something similar and we know how it ended.
This is now a common argument and a concern, that the behavior of central banks and the enormous amount of liquidity that they are introducing in financial markets is simply creating mispricing and bubbles in financial markets.
While it is possible that periods of low interest rate create behavior in financial markets that is associated to bubbles and potential instability, the argument that puts all the burden in central banks and liquidity is simply wrong. In fact, articles like this one reminds me of how disconnected the analysis of prices in financial markets is from the analysis of fundamentals and it is this disconnect and what you read in the article that makes me worry about instability in asset prices. Let me explain.
The first source of confusion is to that rates and returns are low just because central bank actions. As I have argued before, interest rates are low because of a trend that started in the mid 2000s of increased saving in some emerging markets and the effects of the great recession that increased saving in advanced economies and made investment collapse. When no one wants to invest or consume, interest rates are low. And they are unusually low this time because the patterns of investment and saving are driven by a crisis that is very large compared to historical patterns. As a reminder, interest rates are low everywhere not just in countries where quantitative easing is taking place:
The chart above (from the most recent IMF Asia Pacific Regional Outlook) shows that real rates are negative in all countries in the Asia-Pacific region. And, sure, you can still blame Ben Bernanke for all this by arguing that the liquidity that he is creating is crossing oceans and reaching all these countries but that is just nor right. The right explanation is that in a world with fairly well integrated capital markets, returns are similar everywhere.
And this basic fact: that it is the balance between real flows that is mostly behind the abnormal behavior in financial markets is wildly misunderstood. Here is a quote from the Financial Times piece:
"(Quantitative easing) has lowered interest rates on government bonds, forcing investors to search elsewhere for yield. But what has intensified the crunch is that, while central banks have been gobbling up bonds, the supply of assets has declined."
Why is the supply of assets declining? There must be a reason why companies or individuals do not borrow (or borrow less). Equilibrium is about demand and supply. Why is it that companies are not borrowing in what seems to be extremely favorable financial conditions? When asset prices are too high and the cost of capital is below its fundamental value we should observe an excessive amount of (real) investment. But we do not see it. Isn't it more natural to think about an equilibrium where relative high saving and low investment are resulting in low returns and yields across all assets? It is, but it is probably less interesting to write an article about it.
The final confusion is about how low interest rates (or equilibrium returns) should be reflected in asset prices. If markets suddenly learn that the fundamentals of the world economy are pushing the real rate on safe assets down, we expect asset prices to increase to adjust to this new equilibrium. What we should NOT expect is that stock market returns are higher going forward. In fact, stock prices should go up so that equilibrium returns are lower across all asset classes. And this is the biggest source of confusion in the commentary we often read about the stock market rally. The question is always: "How long will the rally last?" as opposed to "Are current stock prices supported by fundamentals?" Bubbles occur when markets think in terms of arrows and not in terms of levels. Some of the rally in the stock market now, as well as in 2003-2007, is associated with the fact that the market is learning that interest rates and equilibrium returns are going to be lower for longer than what they though (this is what some call the search for yield). Asset prices increase to reflect this new equilibrium. But this increase, this "rally", leads to a reading in terms of the high short-term returns that it has generated. And then investors extrapolate and assume that they have finally found a place where yields are high! This is a bubble. When asset prices are not consistent with fundamentals.
The current value of the stock market is consistent with a world where returns are likely to remain low (by historical standards) across all assets, and this is why stock prices are high. But this story is inconsistent with a world where stock prices keep going up and generate an excessive return in the future. If we keep looking at the stock market in terms of arrows we will end up once again in a very unstable world. And it will not be the liquidity of central banks who caused it but the lack of understanding about some basic principles of asset pricing.
Antonio Fatás
"It is easy to identify the reason for this: as this data has gone haywire in the past couple of years, western central banks have been unleashing an estimated $7tn worth of quantitative easing. This has lowered interest rates on government bonds, forcing investors to search elsewhere for yield."
So it is the Central Banks and quantitative easing that is supporting the behavior of financial markets and we need to worry about how sustainable it will be. Gillian Tett refers to the 2003-2007 experience when we witnessed something similar and we know how it ended.
This is now a common argument and a concern, that the behavior of central banks and the enormous amount of liquidity that they are introducing in financial markets is simply creating mispricing and bubbles in financial markets.
While it is possible that periods of low interest rate create behavior in financial markets that is associated to bubbles and potential instability, the argument that puts all the burden in central banks and liquidity is simply wrong. In fact, articles like this one reminds me of how disconnected the analysis of prices in financial markets is from the analysis of fundamentals and it is this disconnect and what you read in the article that makes me worry about instability in asset prices. Let me explain.
The first source of confusion is to that rates and returns are low just because central bank actions. As I have argued before, interest rates are low because of a trend that started in the mid 2000s of increased saving in some emerging markets and the effects of the great recession that increased saving in advanced economies and made investment collapse. When no one wants to invest or consume, interest rates are low. And they are unusually low this time because the patterns of investment and saving are driven by a crisis that is very large compared to historical patterns. As a reminder, interest rates are low everywhere not just in countries where quantitative easing is taking place:
And this basic fact: that it is the balance between real flows that is mostly behind the abnormal behavior in financial markets is wildly misunderstood. Here is a quote from the Financial Times piece:
"(Quantitative easing) has lowered interest rates on government bonds, forcing investors to search elsewhere for yield. But what has intensified the crunch is that, while central banks have been gobbling up bonds, the supply of assets has declined."
Why is the supply of assets declining? There must be a reason why companies or individuals do not borrow (or borrow less). Equilibrium is about demand and supply. Why is it that companies are not borrowing in what seems to be extremely favorable financial conditions? When asset prices are too high and the cost of capital is below its fundamental value we should observe an excessive amount of (real) investment. But we do not see it. Isn't it more natural to think about an equilibrium where relative high saving and low investment are resulting in low returns and yields across all assets? It is, but it is probably less interesting to write an article about it.
The final confusion is about how low interest rates (or equilibrium returns) should be reflected in asset prices. If markets suddenly learn that the fundamentals of the world economy are pushing the real rate on safe assets down, we expect asset prices to increase to adjust to this new equilibrium. What we should NOT expect is that stock market returns are higher going forward. In fact, stock prices should go up so that equilibrium returns are lower across all asset classes. And this is the biggest source of confusion in the commentary we often read about the stock market rally. The question is always: "How long will the rally last?" as opposed to "Are current stock prices supported by fundamentals?" Bubbles occur when markets think in terms of arrows and not in terms of levels. Some of the rally in the stock market now, as well as in 2003-2007, is associated with the fact that the market is learning that interest rates and equilibrium returns are going to be lower for longer than what they though (this is what some call the search for yield). Asset prices increase to reflect this new equilibrium. But this increase, this "rally", leads to a reading in terms of the high short-term returns that it has generated. And then investors extrapolate and assume that they have finally found a place where yields are high! This is a bubble. When asset prices are not consistent with fundamentals.
The current value of the stock market is consistent with a world where returns are likely to remain low (by historical standards) across all assets, and this is why stock prices are high. But this story is inconsistent with a world where stock prices keep going up and generate an excessive return in the future. If we keep looking at the stock market in terms of arrows we will end up once again in a very unstable world. And it will not be the liquidity of central banks who caused it but the lack of understanding about some basic principles of asset pricing.
Antonio Fatás
Monday, May 13, 2013
Time travel in Euroland
Unfortunately, this is not news by now, but the president of the Euro group, Jeroen Dijsselbloem in an interview with CNBC yesterday dismissed the role that fiscal policy and monetary policy can have to address the economic crisis (emphasis is mine):
"Monetary policy can really not help us out of the crisis. It can take away the pressure, it can accommodate new growth, but what we really need in all countries is structural reforms in the first place. I'd just like to stress the point that in the policy mix of fiscal policy, monetary policy and structural reforms — I'd like the order to be exactly the other way around. Structural reforms in the first place, fiscal policy and viable targets in the mid-term for all regions in second place — and monetary policy can only accommodate domestic economic problems in the short-term."
It is not exactly clear what to make out of his statement but it seems that long-term solutions should come first before we implement those that will help us in the short term. It is surprising that even today there is such a great confusion about long-term versus cyclical problems.
This confusion comes from a basic belief that some hold that there is nothing inherently different in the dynamics of an economy when one looks at the short run and the long run. This is part of a never-ending academic debate but when it comes to policy makers and politicians it seems to be more a matter of beliefs.
What it is not always understood is that we are dealing with two separate problems and therefore we need two different set of tools or solutions to deal with them.
It is possible that irresponsible behavior, excessive spending and accumulation of debt (private or public) are the cause of the Great Recession. And if this is true, it will require future adjustments to spending plans, deleveraging, and fiscal discipline to avoid a repetition of this event in the future.
But once the crisis started we are dealing with a second problem: a recession that moves us away from full employment. This is a cyclical phenomenon that is well described in macroeconomic textbooks and to deal with it we use monetary and fiscal policy. The fact that potentially debt and excessive spending were the cause of this cyclical event does not mean that we need to deal with these imbalances now to get out of the crisis. We are dealing with two separate phenomena that are only related because one possibly led to the second one, but the dynamics associated with each of them are very different and the recipe to get out of them can be, in some cases, the opposite.
This is what we write in all macroeconomics textbooks: what works in the short run might not work in the long run. As an example, we emphasize the importance of saving in the long run to drive investment and growth. But when we talk about the short run we emphasize the importance of spending to understand fluctuations in economic activity. Excessive spending hurts growth in the long run but it is spending and demand what drives growth in the short run.
There will be a day when we will have to debate about whether the cyclical phenomenon has already been addressed because we are back to full employment and therefore all our focus should be on the long term, but it is very hard to argue that this is where Europe is today. My point is not to deny that there are many deep structural issues to be addressed among Euro countries, but to recognize that we are dealing with two set of dynamics that require different solutions and until we invent time traveling the short term still comes before the long term.
Antonio Fatás
"Monetary policy can really not help us out of the crisis. It can take away the pressure, it can accommodate new growth, but what we really need in all countries is structural reforms in the first place. I'd just like to stress the point that in the policy mix of fiscal policy, monetary policy and structural reforms — I'd like the order to be exactly the other way around. Structural reforms in the first place, fiscal policy and viable targets in the mid-term for all regions in second place — and monetary policy can only accommodate domestic economic problems in the short-term."
It is not exactly clear what to make out of his statement but it seems that long-term solutions should come first before we implement those that will help us in the short term. It is surprising that even today there is such a great confusion about long-term versus cyclical problems.
This confusion comes from a basic belief that some hold that there is nothing inherently different in the dynamics of an economy when one looks at the short run and the long run. This is part of a never-ending academic debate but when it comes to policy makers and politicians it seems to be more a matter of beliefs.
What it is not always understood is that we are dealing with two separate problems and therefore we need two different set of tools or solutions to deal with them.
It is possible that irresponsible behavior, excessive spending and accumulation of debt (private or public) are the cause of the Great Recession. And if this is true, it will require future adjustments to spending plans, deleveraging, and fiscal discipline to avoid a repetition of this event in the future.
But once the crisis started we are dealing with a second problem: a recession that moves us away from full employment. This is a cyclical phenomenon that is well described in macroeconomic textbooks and to deal with it we use monetary and fiscal policy. The fact that potentially debt and excessive spending were the cause of this cyclical event does not mean that we need to deal with these imbalances now to get out of the crisis. We are dealing with two separate phenomena that are only related because one possibly led to the second one, but the dynamics associated with each of them are very different and the recipe to get out of them can be, in some cases, the opposite.
This is what we write in all macroeconomics textbooks: what works in the short run might not work in the long run. As an example, we emphasize the importance of saving in the long run to drive investment and growth. But when we talk about the short run we emphasize the importance of spending to understand fluctuations in economic activity. Excessive spending hurts growth in the long run but it is spending and demand what drives growth in the short run.
There will be a day when we will have to debate about whether the cyclical phenomenon has already been addressed because we are back to full employment and therefore all our focus should be on the long term, but it is very hard to argue that this is where Europe is today. My point is not to deny that there are many deep structural issues to be addressed among Euro countries, but to recognize that we are dealing with two set of dynamics that require different solutions and until we invent time traveling the short term still comes before the long term.
Antonio Fatás
Tuesday, May 7, 2013
Let's get real about the stock market.
As reported by the financial press, the stock market continues to hit fresh record-high levels in many advanced economies. The Dow Jones passed the 15,000 mark, the Nikkei just went over 14,000, and the DAX just went above its previous record. It seems to be the time to talk about bubbles in asset prices - an important issue given how these bubbles have dominated the last business cycles in these economies.
Except that we are looking at the wrong numbers. It is remarkable that the discussion on the value that these indices are reaching ignores two fundamental issues:
1. These are nominal values and as we were told in the first economics lesson, we need to look at real variables and not nominal ones.
2. Asset prices are not supposed to stay constant (in real terms). In many cases its appreciation will reflect real growth in the economy, earnings and/or the expected return that these assets should provide in equilibrium.
No need to look for data that provides a better benchmark than just nominal indices. Robert Shiller provides all the necessary data in his web site. Adjusting for inflation is easy and below is a chart with the real price of the S&P500 index where the CPI has been used to convert nominal into real variables.
After adjusting for inflation we can see that the index is far from its peak in 2000 and it is even below the peak in 2007. No sign of a record level yet.
Adjusting for inflation is not enough as the fundamentals (earnings) also grow because of real growth. The price-to-earnings ratio takes care of this adjustment (it also takes care of inflation because earnings are measures in nominal terms). Making this adjustment is more difficult but I will reply on Shiller's numbers again (his book and writings provide a lot of detailed analysis on his data).
Once we adjust for nominal as well as real growth, the current levels look even less impressive. Very low compared to the bubble built in the 90s and significantly lower than the ratio observed in most of the years during the 2002-2007 expansion. We are very far from record-high levels if we use this indicator.
Of course, to do a proper analysis we need to bring a lot of other factors: expected earnings growth, interest rates, risk appetite,.... And there will be room there to debate whether the current valuation of the stock market is reasonable, too high or too low. But starting the analysis with a statement of record-high levels when measured in nominal terms and ignoring real growth in earnings is clearly the wrong place to start the debate.
Antonio Fatás
Except that we are looking at the wrong numbers. It is remarkable that the discussion on the value that these indices are reaching ignores two fundamental issues:
1. These are nominal values and as we were told in the first economics lesson, we need to look at real variables and not nominal ones.
2. Asset prices are not supposed to stay constant (in real terms). In many cases its appreciation will reflect real growth in the economy, earnings and/or the expected return that these assets should provide in equilibrium.
No need to look for data that provides a better benchmark than just nominal indices. Robert Shiller provides all the necessary data in his web site. Adjusting for inflation is easy and below is a chart with the real price of the S&P500 index where the CPI has been used to convert nominal into real variables.
After adjusting for inflation we can see that the index is far from its peak in 2000 and it is even below the peak in 2007. No sign of a record level yet.
Adjusting for inflation is not enough as the fundamentals (earnings) also grow because of real growth. The price-to-earnings ratio takes care of this adjustment (it also takes care of inflation because earnings are measures in nominal terms). Making this adjustment is more difficult but I will reply on Shiller's numbers again (his book and writings provide a lot of detailed analysis on his data).
Once we adjust for nominal as well as real growth, the current levels look even less impressive. Very low compared to the bubble built in the 90s and significantly lower than the ratio observed in most of the years during the 2002-2007 expansion. We are very far from record-high levels if we use this indicator.
Of course, to do a proper analysis we need to bring a lot of other factors: expected earnings growth, interest rates, risk appetite,.... And there will be room there to debate whether the current valuation of the stock market is reasonable, too high or too low. But starting the analysis with a statement of record-high levels when measured in nominal terms and ignoring real growth in earnings is clearly the wrong place to start the debate.
Antonio Fatás
Thursday, May 2, 2013
Me not working hard?
Reading a footnote from a blog post written by Noah Smith comparing GDP per capita across countries led me to look back at statistics on how labor markets and effort matters for cross-country comparisons of GDP per capita. The footnote was about one of the most successful Asian economies, Singapore, with GDP per capita clearly above that of the US when adjusted for PPP.
Using data provided by the U.S. Bureau of Labor Statistics, in 2011 Singapore has a GDP per capita which is about 25% higher than that of the US. But a comparison of GDP per hour reveals a very different picture, Singapore has a GDP per hour which is 32% lower than that of the US. Other Asian countries display a similar pattern.
Levels relative to the US. Year 2011. Source: Bureau of Labor Statistics.
In the table above I compare Korea, Japan and Singapore to the US and as we move from the first column to the second and third columns the relative position of these countries worsens relative to the US. Singapore is the most extreme example with GDP per capita of 125% of the US level but GDP per hour as low as 68% of the US level. How can we explain this difference? How hard do the Singaporeans work? There are two things that matter:
1. The ratio of employment to population which is affected by both demographics and labor force participation. This explains the change from the first to the second column.
2. The average number of hours worked. This explains the difference between columns 2 and 3.
Here is the labor market data for these three Asian countries in comparison to the US:
Year 2011. Source: Bureau of Labor Statistics.
In Korea and Singapore both ratios point in the same direction: employment to population as well as hours worked are higher than in the US. In the case of Japan number of hours worked is similar but the employment to population ratio is also higher. The differences are very large, more so in Singapore, and they explain the high levels of GDP per capita relative to GDP per hour worked.
Some European countries are on the other side of this comparison, with lower effort than the US as measured by employment or number of hours. The table below shows some of these countries as well as Canada and Australia.
Levels relative to the US. Year 2011. Source: Bureau of Labor Statistics.
The most visible case is France, which has a much lower GDP per capita than the US but a very similar level of GDP per hour (the French are very productive...when they work). Another interesting comparison is Spain and Canada where we can see a slightly higher number for GDP per hour in Spain even if there is a significant difference in favor of Canada when it comes to GDP per capita. Northern European countries (like Sweden) look very close to the US when it comes to labor markets so when you move from one column to another you see very little change in their relative position.
All of these numbers make clear that looking at GDP per capita to assess growth and convergence can be misleading in the presence of significant differences in labor markets.
A final caveat: GDP per hour is not a perfect measure of productivity either. It is ignoring the productivity of other factors and it might give a distorted picture of productivity when there are large variations in the sectoral composition of GDP -- a sector-by-sector comparison would be a much better way to assess true differences in technology.
Antonio Fatás
Using data provided by the U.S. Bureau of Labor Statistics, in 2011 Singapore has a GDP per capita which is about 25% higher than that of the US. But a comparison of GDP per hour reveals a very different picture, Singapore has a GDP per hour which is 32% lower than that of the US. Other Asian countries display a similar pattern.
|
GDP
Per
capita
|
GDP
Per
worker
|
GDP
Per
hour
|
|
|
Korea
|
63
|
58
|
45
|
|
Japan
|
71
|
64
|
66
|
|
Singapore
|
126
|
93
|
68
|
|
United States
|
100
|
100
|
100
|
In the table above I compare Korea, Japan and Singapore to the US and as we move from the first column to the second and third columns the relative position of these countries worsens relative to the US. Singapore is the most extreme example with GDP per capita of 125% of the US level but GDP per hour as low as 68% of the US level. How can we explain this difference? How hard do the Singaporeans work? There are two things that matter:
1. The ratio of employment to population which is affected by both demographics and labor force participation. This explains the change from the first to the second column.
2. The average number of hours worked. This explains the difference between columns 2 and 3.
Here is the labor market data for these three Asian countries in comparison to the US:
|
Employment
to Population
|
Average
Annual Hours
|
|
|
Korea
|
49%
|
2289
|
|
Japan
|
50%
|
1726
|
|
Singapore
|
61%
|
2409
|
|
United States
|
45%
|
1758
|
In Korea and Singapore both ratios point in the same direction: employment to population as well as hours worked are higher than in the US. In the case of Japan number of hours worked is similar but the employment to population ratio is also higher. The differences are very large, more so in Singapore, and they explain the high levels of GDP per capita relative to GDP per hour worked.
Some European countries are on the other side of this comparison, with lower effort than the US as measured by employment or number of hours. The table below shows some of these countries as well as Canada and Australia.
|
GDP
Per
capita
|
GDP
Per
worker
|
GDP
Per
hour
|
|
|
Germany
|
81
|
73
|
91
|
|
Italy
|
66
|
74
|
73
|
|
Australia
|
86
|
75
|
77
|
|
Canada
|
84
|
75
|
77
|
|
Spain
|
67
|
76
|
79
|
|
Sweden
|
86
|
80
|
85
|
|
France
|
73
|
80
|
95
|
|
United States
|
100
|
100
|
100
|
The most visible case is France, which has a much lower GDP per capita than the US but a very similar level of GDP per hour (the French are very productive...when they work). Another interesting comparison is Spain and Canada where we can see a slightly higher number for GDP per hour in Spain even if there is a significant difference in favor of Canada when it comes to GDP per capita. Northern European countries (like Sweden) look very close to the US when it comes to labor markets so when you move from one column to another you see very little change in their relative position.
All of these numbers make clear that looking at GDP per capita to assess growth and convergence can be misleading in the presence of significant differences in labor markets.
A final caveat: GDP per hour is not a perfect measure of productivity either. It is ignoring the productivity of other factors and it might give a distorted picture of productivity when there are large variations in the sectoral composition of GDP -- a sector-by-sector comparison would be a much better way to assess true differences in technology.
Antonio Fatás
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