No Sooner Had Volcker Left His Post...: Valuation, Inflation & Greater Fools

Exploring the Drivers of Asset Prices in 2020

One argument for higher equity prices is lower interest rates. It's important to understand why this is. At a high level, it's because asset values are relative: "better" assets are awarded higher values, or premiums. What makes an asset "better"? Theoretically, higher return and lower risk.

[The term asset is used here in the sense of asset class, or income producing investment, i.e. stocks, bonds, investment properties, government bonds, etc.]

Asset values are proportional to returns and inversely proportional to risk. Theoretically (and all else being equal):

1. Company X would be valued at a premium to Company Y if X generates higher earnings.

2. If X and Y generate equivalent earnings, Company X would be valued at a discount if its earnings are riskier, i.e. less certain.

It follows that higher earnings can offset higher risk, therefore in order to justify purchasing a riskier asset, its earnings have to be sufficiently high to attract investment. Note: this is why a lower credit score gets you more expensive debt - the bank needs some reason to take on more risk.

There are risk-free securities on offer to investors: treasuries and GICs. Government bonds like these can pay such low rates of return because their value proposition is not return, it's safety. Almost every other investment bears some amount of risk and therefore must offer higher rates of return to justify the risk.

Equities can be considered far riskier than government bonds and have correspondingly higher return expectations, i.e. if a risk-free government bond was returning 1% and you expected a stock to also return 1%, you would rationally opt for the gov't bond because it was guaranteed while the stock bears the risks of mismanagement, fraud, recession, bankruptcy, etc. The higher the interest rate (or rate of return) on a risk-free investment, the higher the expected return must be on a risk-bearing investment.

[It's important to note that what largely influences the return on a stock is the price paid for it, e.g. if Company X earns $5.00/share and trades at $100/share, it's trading at a 20x multiple and its expected return is 5%.]

With interest rates pushing the zero-lower-bound (and going negative in some places), return expectations for equities have fallen as well, so Company X could now be compelling even at $200 (40x multiple & 2.5% return). Add to this the Fed ex machina (deus ex Fed?) that has seemingly risk proofed the market and return hurdle rates can, and have, dropped even further and resulted in a record stock market contemporaneous with a stagnant economy.

But the problem with the "lower-interest-rates = justified-higher-equity-value" formulation is that it doesn't take growth into consideration. There is a growth assumption built into capitalism and up until recently it was an assumption we could take for granted. But implicit in near-zero interest rates is the expectation of near-zero growth (because if there was meaningful growth, interest rates would have to rise to head off demand-driven inflation). In other words, ultra-low interest rates can be seen to raise asset prices while signalling depressed earnings. This dynamic almost perfectly describes stagflation.

Stagflation can be seen as an aberration of traditional economic theory: it is characterized by rising prices, low growth (depressed earnings), and high unemployment. It's anomalous because high prices (inflation) are usually associated with *low* unemployment. Inflation usually accompanies low unemployment because low unemployment generally means a good economy, higher levels of disposable income and greater demand for goods which allows the supply-side to raise prices. This is demand-driven inflation and is generally healthy (within reason). We don't currently have demand-driven inflation which is why central banks don't need to raise interest rates. What we may have though is supply-driven inflation.

Prices don't *only* rise when the supply-side looks to capitalize on higher demand, it also happens when suppliers are so laden with debt (albeit at low interest rates) and so burdened with taxes (this hasn't happened yet but may in order to pay for recession stimulus) that they have no choice but to raise prices. Moreover, cheap debt encourages greater leverage for home-buying, M&A, student aid, etc. which all carry future debt obligations that need to be serviced. The brrrrrrrrr is what allows this to happen. When prices rise while incomes decline, everyone gets squeezed.

Now we've only begun to see inflation outside of asset values and this is because an increase in the money supply alone is not enough to push up prices - you also need a high volume of transactions, or velocity. The velocity of money is way down because of the shift in consumer behavior since March.

So interest rates are a factor in pushing up asset values but likely do not do so justifiably. What’s more likely is that this is a greater-fool phenomenon. Whether central bank action bridges the gap to the recovery or mires us in stagflation remains to be seen. Volcker missed it by a year.