After the 2000-2002 recession, the Federal Reserve remained fixed on holding down short-term interest rates in efforts to stimulate demand in interest-sensitive sectors of the economy. Corporations – particularly those with low quality balance sheets – were quick to take advantage of the low interest rates, swapping long-term debt for shorter-term debt. By late-2003 it was already obvious that this process was becoming a threat to longer-term economic stability, prompting me to ask: “the real question is this: why is anybody willing to hold this low interest rate paper if the borrowers issuing it are so vulnerable to default risk? That's the secret. The borrowers don't actually issue it directly. Instead, much of the worst credit risk in the U.S. financial system is actually swapped into instruments that end up being partially backed by the U.S. government. These are held by investors precisely because they piggyback on the good faith and credit of Uncle Sam.” Needless to say, this turned out badly.
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Meanwhile, deprived of a meaningful return on safe investments, investors looked for alternatives that might offer them a higher rate of return. They found that alternative in mortgage securities. Historically, home prices had never experienced a major and sustained decline, and mortgage securities were AAA credits. On that basis, investors chased mortgage securities in search of higher yield, and hedge funds sought to leverage the “spread” by purchasing massive volumes of higher yielding mortgage securities and financing those purchases using debt that was available a lower interest rate.
The key here is that when the demand for securities of a particular type is high, Wall Street and the banking system have the incentive to create more “product” to be sold. So create it they did. In order to satisfy the yield-seeking demand for new mortgage debt that resulted from the Fed’s policy of suppressing the yield of safe alternatives, trillions of dollars of new mortgage securities were created. But how do you create a mortgage security? If you take the money of the investor, you actually have to lend it to someone to buy a home. In order to create enough supply, banks and Wall Street institutions began to lend to anyone with a pulse, creating a housing bubble, an increasing volume of subprime debt, and ultimately, the greatest financial collapse since the Great Depression.
One would think the Federal Reserve would have learned from that catastrophe. Instead, the Fed has spent the past several years intentionally trying to revive the precise dynamic that produced it. As a consequence, speculative yield-seeking has now driven the most historically reliable measures of equity valuation to more than double their pre-bubble norms. Meanwhile, as investors reach for yield in lower-quality but higher-yielding debt securities, leveraged loan volume (loans to already highly indebted borrowers) has reached record highs, with the majority of that debt as “covenant lite” issuance that lacks traditional protections in the event of default. Junk bond issuance is also at a record high. Moreover, all of this issuance is interconnected, as one of the primary uses of new debt issuance is to finance the purchase of equities.
Now, as we observed in periods like 1973-74, 1987, and 2000-2002, severe equity market losses do not necessarily produce credit crises in themselves. The holder of the security takes the loss, and that’s about it. There may be some economic effects from reduced spending and investment, but there is no need for systemic consequences. In contrast, the 2007-2009 episode turned into a profound credit crisis because the owners of the vulnerable securities – banks and Wall Street institutions – had highly leveraged exposure to them, so losing even a moderate percentage of their total assets was enough to wipe out their capital and make those institutions insolvent or nearly-so.
At present, the major risk to economic stability is not that the stock market is strenuously overvalued, but that so much low-quality debt has been issued, and so many of the assets that support that debt are based on either equities, or corporate profits that rely on record profit margins to be sustained permanently. In short, equity losses are just losses, even if prices fall in half. But credit strains can produce a chain of bankruptcies when the holders are each highly leveraged. That risk has not been removed from the economy by recent Fed policies. If anything, it is being amplified by the day as the volume of low quality credit issuance has again spun out of control.
Yes, this is an equity bubble
A few notes on valuation and investment returns. First, as I’ve noted frequently in recent comments, it’s quite reasonable to argue that lower interest rates can “justify” higher valuations, provided that one also recognizes that those higher valuations will still be associated with commensurately lower future equity returns. At present, we estimate zero or negative nominal total returns for the S&P 500 on horizons of 8 years or less, and about 1.9% annual total returns over the next decade. If these prospects seem “fair” given the level of interest rates, that’s fine – one can then say that low interest rates justify current valuations – but that doesn’t change the outcome: the S&P 500 can still be expected to experience zero or negative total returns on horizons shorter than about 8 years (and even that assumes that corporate revenues and nominal GDP grow at their historical norm of about 6% annually in the interim).
Second, one can quantify the impact that zero interest rates should have on valuations with simple arithmetic. Consider a 10-year zero-coupon bond that would be expected to yield, say, 6% in a world where Treasury bills yield 4%. That bond would trade at $55.84 (100/1.06^10). Now suppose Treasury bill yields were expected to be held at zero for 3 years, returning to 4% thereafter. Given the normal 2% yield spread, it would now be competitive for the 10-year bond to return just 2% for the first 3 years, then 6% thereafter. The price today that would produce that outcome is $62.67. So how much of an increase in valuation does 3 years of expected zero short-term interest rates (versus a normal 4%) have on valuation? 12%. Why 12%? 3 years times 4%. The higher valuation today essentially removes that amount of future returns. The same result holds in every scenario, and holds for equity valuations as well.
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