It’s not a bad gig. Buy the stock market and central banks and governments obligingly push it ever northwards. At the slightest hint of trouble panic sets in and they fall over themselves trying to find ways to ensure it resumes its upward trend. Being somewhat old-fashioned we naively thought that the stock market was (or, at least, should be) priced according to investor demand and related to economic and stock-specific performance. Such foolishness.
Of course the same goes for housing and the government bond market. In relation to the former, governments often talk expansively about making housing ‘affordable’ but then shovel money in its direction via a creative range of handouts and subsidies (and restrictive land-use strategies) which do nothing but push prices up. ‘Affordable’ should, in fact, mean lower prices. And as for the government bond market – it is many moons since yields were private sector controlled. In Japan, the central bank now owns more than 50% of its own market.
And so the merry-go-round continues. Government debt piles up whilst interest rates sink well below the prevailing rate of inflation. Real yields? A fading memory.
Central bank balance sheets are now obscenely bloated. In the last six quarters the combined balance sheets of the four main central banks have exploded by around 9 trillion US dollars – whilst world output struggles to return to pre-pandemic levels. Official interest rates remain on the floor by necessity – any rise in the cost of borrowing will devastate the already stressed government accounts.
Even without a rise in interest rates simply rolling over maturing debt and funding the annual budget deficit is straining government finances. In Japan, the leader of the pack in terms of government debt (approximately 220% of GDP), the combination of debt maturities and the budget deficit amount to a forecast 60% of GDP in 2021. In the US the equivalent statistic is 50%.
Japan manages to pull off the 3-card trick because more than 90% of its debt is owned within Japan. The US and other countries have no such luxury. In the US, 30% of Treasuries are held abroad – mainly by China and Japan – whilst similar or greater foreign ownership percentages prevail elsewhere.
So, has the great money infusion worked its wonder on global economic activity?
The stimulus has generated a V-shaped recovery in all the leading economies but amongst developed nations only Australia managed to crank GDP above pre-pandemic levels by the March quarter of this year. In other words, the opportunity cost for most countries of the Covid-induced lockdowns has amounted to at least 5 quarters of potential GDP growth (try telling that to the stock market).
In Australia the magic bullet has been iron ore – rather than ultra-clever footwork by the government. Iron ore currently amounts to almost 35% of Australia’s exports by value (up from 20% at the beginning of 2020) and the price has rocketed from $US90 a metric tonne at the beginning of 2020 to around $US210 at the time of writing. Why? China is the simple answer (together with a serious production issue in Brazil). China has pumped vast sums into its manufacturing capacity – all of which generates increasing demand for raw materials. Australia was ready and willing to step to the plate. For around 100 years it was said that Australia rode on the sheep’s back. Now, more aptly, it can be said to ride on the back of an iron ore excavator.
It would be foolish for Australia to overly bask in the warmth of the iron ore induced economic recovery because there is no guarantee that it will last. China is keen to diversify its import sources and Brazil will undoubtedly return to a competitive export position. Additionally, China and Australia are experiencing serious geo-political spats which will not assist in strengthening the trading relationship. China is, by far, Australia’s dominant export destination (around 40% of the total). It overtook that key position from Japan in 2010 and now dwarfs Japan’s trading importance. In combing through export statistics we cannot find another developed nation that is similarly exposed to China. This does not provide great long-term comfort.
Amidst all the Covid-induced pandemonium and the central bank and government responses the ‘world’ average stock market dividend yield has sunk to just 1.8% – comfortably below its long-term average.
In the US the S&P500 dividend yield has tumbled to a measly 1.4%. At the same time the price earnings ratio has leapt to around 30. The infamous Shiller Cyclically Adjusted PE (CAPE) has now moved above 35 – rarefied atmosphere as it has only touched this level on one other occasion in the last 140 years and that was during the Tech bubble at the end of the 1990s. And let’s not forget – this is happening in a world only now getting back to output levels equivalent to those prevailing in 2019.
The logic running through the market is not hard to discern: if bonds yield next to nothing and money in the bank yields nothing or even less why not buy equities which at least provide some income return. Hard to argue with. The only troublesome bit of nettle rash with this argument is that equities can tumble in value and dividends can be cut. Long-term holders then become panicky short-term holders. Our guess is that no more than one or two out of ten investors are prepared to accept some capital depreciation. The rest find it unacceptable. Having managed pension funds for many years we have encountered so many ‘investors’ who are calm in a rising market but start riding the telephone as soon as the market is spooked. Trying to forecast when the next tumble will occur or what will trigger the decline is not a game worth playing. If you get it right once you are not a genius – just very lucky.
In the meantime FOMO (fear of missing out) seems to be more prevalent than ever. It is standard human nature to be most uncomfortable if others are making money and you are not. The Covid-lockdowns have bred a new phalanx of home-based market traders who are all instant experts. Fundamentals? An anachronism. It is reminiscent of the 1990s Tech bubble – wild speculation fuelled by equally wild stories about immense riches to be made by companies that started in business a week earlier. Almost anything with dot-com attached to its name rode the wave – which, for most, came crashing back to shore.
Is the stock market it in a bubble? Yes. Will it buckle under its own over-valued weight? Undoubtedly, as overvaluation is always corrected. This could start tomorrow or it could take years since the normal rules of valuation have been suspended by the ‘gaming’ of the system by the central banks. Bubbles, of all kinds, are inevitable when interest rates are set at zero.