Sunday, July 29, 2007

The great normalisation again

The normalisation of the two global asset market anomalies of the period from 2003 to QI 2007 - very low long-term risk-free real interest rates and astonishingly low credit risk spreads across the board - is proceeding apace. Long-term risk-free real rates are no more than about 50 bps from their long-term historical average - certainly if we filter out the transitory flight to quality that has temporarily boosted government bond prices for the past few weeks. Default risk premia on corporate debt, and on the debt of any institution exposed to the US subprime mortgage market are almost back to normal. Credit spreads further removed from the subprime debacle are still low, including emerging market debt of countries that don't have foreign exchange reserves coming out of their ears (there are some!). What is interesting is that global stock markets have gone through a non-trivial, albeit still modest, downward adjustment in the last couple of weeks, and especially at the end of last week. Such a correction is quite consistent with the often-heard view that, compared to debt and credit default risk , that is, given then prevailing long-term interest rates and credit risk spreads, equity was not overpriced during the asset anomaly period. All that statement means, after all, is that the price of equity seemed reasonable, in that it could be explained in terms of the three key fundamentals: projected future earnings, risk-free discount rates and a reasonable guess at the equity risk premium. There was no need to rationalise equity valuations as the result of a bubble in the stock market. However, even if there was no bubble in the stock market, equity could have been the beneficiary of a bubble in the bond markets, and even of the credit risk market anomaly, if the equity risk premium responded to the same force(s) that kept the default risk premium artificially low. A fall in the stock market is, in fact, quite easily rationalised as a result of the fundamental shocks that caused weakening of the two asset market anomalies. Even if the anticipated future path of earnings were unchanged, the bursting of the bond market bubble that, in my view, caused almost of the increase in longer-term risk-free discount rates, would have a negative impact on equity values through an increase in the risk-free component of the equity earnings discount rate. It is true that higher default risk premia caused by a sudden reduction in risk tolerance (an exogenous shift towards fear on the greed - fear spectrum) does not necessarily imply a higher equity risk premium. It is, however, not difficult to come up with quite plausible stories that would have credit risk premia and the equity risk premium going up in tandem; for instance, an increase in risk aversion, holding constant the covariance between consumption growth and the return on equity, would do the job. Finally, expected future earnings growth could have been revised downwards, either independently of the shocks causing the two asset market anomaly corrections or (partly) as a result of these same shocks. There is, however, no evidence, either aggregate or at the level of individual corporate earnings reports, of any unexpected weakness in corporate earnings. Three key global asset market now have flashing amber lights. Does this mean we are about to see the end of the five golden years that saw global real GDP growth never far below 5 percent per annum? Possibly but not likely. The fourth (set of) key global asset price(s), exchange rates, are continuing to play a stabilising role. The US dollar is tanking, as it must. The yen is finally strengthening, as it ought to. The euro and sterling are strong as a DDR body builder on steroids (there is some redundancy in this simile), but there seems to be remarkably little pain. While we may seem some weakening of real economic activity in the remainder of 2007 and in 2008 relative to what was expected earlier (pace the IMF which just revised its forecasts for 2007 and 2008 upward), I believe it more likely that we will continue to see a lot of Sturm und Drang in global financial markets, especially in the overdeveloped world, but rather little noticeable weakening of real economic activity. The financial superstructure appears increasingly to exist in a world of its own, cocooned off from the rest of the world. Fortunes are won and lost, but except for those immediately affected, it really does not impact much on anything real, that is, on anything that matters. This in not what economic theory tells us, since all asset price changes have distributional effects which ought not, in general, to 'wash out' as regards their effect on aggregate demand. In addition, changes in the prices of 'outside' assets (real capital, land etc.) have aggregate wealth effects which should affect the demand for currently produced goods and services, but it is darn hard to see much evidence of this most of the time.

1 comment:

Anonymous said...

Dear Prof. Buiter,

I have written a paper on opportunity cost of holding large reserves which argues that risk premia mean reversion process will be much slower than anticipated. In fact official reserve managers may use risk repricing period to add riskier assets to their holdings to boost long term returns. I would be interested in your view on this, link to my paper is below:

Best regards,
Krzysztof Rybinski
Deputy Governor
National Bank of Poland