Are Asset Prices Artificially High Because of Low Rates?

 

    Gavyn Davies wrote in the FT on July 10, 2014 about artificially high asset prices judged by an unknownable Wicksellian natural rate. My opinion is that the answer is that when debt service is too high it acts as a brake on demand and thus lowers the natural real rate (the NR rate) of interest. The NR rate is a form of rationing of resources which goes up when resources are scarce. Thus the current era of low rates are not too low. The verification of this is that one must ask what would happen if a debtor has too much debt and has to default and seek a haircut. The alternative to a cut in principal balance would be to cut the interest rate and make the loan interest-only. But the key here is to understand that debtors are over-indebted and further didn’t have a good reason for the parabolic increase in debt. Thus debtors need a haircut and the Invisible Hand of the marketplace lowering the NR rate (or the Fed) is a natural response. It is a way of saying to the market, go ahead and consume more resources. Deflation is the risk, and it needs to be offset by lowering rates so as to stimulate demand. There are huge labor surpluses for unskilled labor and a huge potential setup to failure as the truth comes out that demand from EM countries such as China was partly inflated by massive unsustainable debt bubbles and will subside. Eventually the world will learn that creating low tech make-work jobs with government sponsored unsound bank loans issued by “policy banks” doesn’t create sustainable, genuine prosperity or demand. Instead future demand will come from people learning new skills and developing new tech as needed by the market. The current global system is actually adding to deflationary pressures to the extent that people are fooled into spending from policy bank loans that ultimately leave people poorer off as these loans encourage a waste of resources that could have been used elsewhere; further such waste may cause the market to be fearful of an eventual pull back once the stimulus is withdrawn. If so then the debt induced stimulus did nothing to stimulate the economy except to encourage speculative bubbles that encourage a few winners to consume a few luxuries. In addition to bogus Keynesian debt stimulus there is bogus Central Bank monetary manipulation where the market sees through it and refuses to respect the Fed’s price setting out of fear that the price will change suddenly; this fear paralyses development, thee result if which is deflationary. Of course there are many inflationary forces at work but it is important to note that deflationary cross currents are at work. The Central Bank stimulus is only accepted by short term overnight speculators who are ruthless traders who are “stopped out” of trading positions at the slightest downtick thus creating a more volatile capital market which ultimately raises the costs of capital and thus defeats any benefit from Central Bank stimulus.
   Low interest rates and the increase in the money supply from Quantitative Easing helped fuel a bubble in asset prices for just about every asset. However part of the reason why assets went up to excessively high prices is because the world’s governments and Central Banks have responded to the great recession of 2007-09 with a Too Big Too Fail attitude (TBTF) which has corrupted investors into thinking there is no downside risk, so why not buy on the dip. This asymmetric viewpoint by investors is supported by the tremendous growth in all types of debt since about 1988 or 1994. Before then U.S. debt was under 190% of GDP, now it has gone parabolic and is twice that level. When a consumer gets a credit card with six months interest free use he may be tempted to buy stocks and then will also buy the stocks on margin. If a consumer sells his house to a buyer who used a large loan the seller may decide to park the money in stocks and then later take a margin loan to buy a house. By offering ever increasing amounts of debt banks have created a situation where some of this new money has leaked into the hands of speculators. Some corporations have used debt to buy back shares to force the price higher so that executives get huge stock option bonuses.  
     The only logical explanation for both what happened to the huge increase in debt and why did stocks go up so much is that these issues are two sides of the same coin.
     Low rates do not justify high asset prices. The proper way to use interest rates to discount the value of future cash flows would be to use a lifetime average forecasted rate, not today’s low rates. What is happening is that wishful thinking by investors makes them assume that they should simply use low rates as part of a discounting valuation formula. The idea that low rates justify high PE ratios was falsely accepted in Japan during their record shattering massive debt bubble of the 1980’s when their rates were very low. The result was a devastating crash in 1990 that hasn’t been fully fixed in 24 years.

   If you buy rental real estate today you need to ask yourself what if you seek to sell it in ten years and the going rate then is 8% for a loan. Then ask yourself how can the future buyer buy your property if he has to pay double what your interest rate is? The proper answer is that the seller would need to cut his price in ten years.

  Even if the Fed could somehow prevent future crashes it seems unlikely that PE ratios can go significantly higher. Thus a new buyer may find the best he could hope for is to own stocks in a stagnant market. But even stagnant markets have the risk of repeating crashes like 2002 and 2009 when stocks went down 50% to 57%.

     Investors need to avoid bubbles and crashes by seeking independent financial advice.
I wrote an article “Why ZIRP doesn’t help the economy”.

 

 

About the author

Don Martin, CFP®

2 Comments

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  • Hello my family member! I want to say that
    this article is awesome, great written and come with approximately all important infos.
    I would like to see more posts like this .

  • The author lacks long term thinking – assuming that demand can go ever higher if we ony keep the rates low. He mentions ” huge labor surpluses for unskilled labor” but assumes that it’s simply something to fix by tweaking the same old economics.

    The rality is that in the next few decades we need to start consuming less and less – we need to wake up to the consequences of lmited resources. And, to be honest, I think a lot of us will be happier if we do that.

    The other main challenge is the huge increase in the automation of industry and the fundamental changes technology can bring .for example, American companies are winning back business from the
    third world by using cutting edge technology such as 3D printing. Good for GDP, good for taxt renenues, largely useless for employment.

    And therein lies the fundamntal problem – an increasing number of people have no useful role, and in fact are an overall drain on society by consuming limited resources. It shows up far more acutely in countries less crowded than the USA – particularly the UK.

    So, while the authors points are not without merit, they assume a steady set set of rules which are likely to be obsolete as the future hits us.

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