Everything’s expensive – bonds, shares, houses – that’s the conclusion of Deutsche Bank in its latest Long-Term Asset Return Study.
Common sense suggests that asset prices are at record levels because interest rates are at record lows.
But now we might be heading for the first US interest rate rise in a decade.
One of these situations is going to have to give.
I’m betting on the rate rise not happening…
If everything is expensive, what happens if the Fed raises interest rates?
Deutsche Bank analysts Jim Reid, Nick Burns and Seb Barker looked at valuations of bonds, equities and property relative to their histories. They focus on developed markets, because these have the longest records.
We’ll ignore property this morning – it has a shorter record and there’s a wider range of valuations between countries.
But looking at bonds, they are more highly valued than at any point in history (or at least since 1800). As for equities, they are very highly valued, but not quite as highly as they were in May 2007 or in 2000. That’s not exactly comforting, because both of those times, of course, preceded epic crashes.
And when you combine the three of them – property, bonds and equities – then on aggregate, “current 2015 levels are higher on average across the three asset classes than they were back in 2007”.
No valuation measure is perfect. But this is a very respectable study from an official source.
Deutsche then asks the question on everyone’s mind: given that everything is expensive, then what happens when the Fed starts to raise interest rates?
They reckon – by looking at history – that if this was a normal cycle, then “a US rate hike might not have an immediate impact, but could do by the time we get to 2017/18”.
That sounds reassuring. But in any case, as they point out: “if the Fed keeps policy looser than the market expects, we may not witness a typical hiking cycle”. In other words, if rates stay at zero, there’s no reason to expect things to change.
And given that there’s no obvious pressure on the Fed to raise rates, that’s most likely what it’ll do.
Low interest rates are doing the opposite of what central bankers want
That’s not a good thing. I’m increasingly convinced, as is my colleague Merryn, that low interest rates are the problem, not the solution. In short, low rates increase the psychological incentive to save among those who have money, because investors need a bigger cushion to feel safe.
And unfortunately, in the UK at least, they also force those who don’t have much money to go deeper into debt, as the price of property – which is in the miserable position of being both a necessity and an investment asset – soars out of reach.
You’ve got the worst of all worlds. You increase the chances of ‘bad’ deflation (as opposed to ‘good’ deflation, where your TV screen gets both bigger and cheaper) by reining in the ‘animal spirits’ of individuals and companies. But you also render the economy more vulnerable to deflation by forcing people deeper into debt.
That seems silly. And it’s really the opposite of what central bankers would like to happen.
The FT’s Martin Wolf somewhat sums up the economic orthodoxy’s response to arguments like this in his column today, which argues that interest rates should not rise. “Our world is not normal. Get used to it.”
Trouble is, people won’t. That’s the annoying thing about models and systems and economies – they’re made up of people, who all have their own messy internal models that by and large render them incompatible with the wishful thinking of economists and other central planners.
However, the central planners won’t see it that way, because their job depends on not seeing it that way. And that’s why I suspect that the Fed will sit on its hands this month. Because it has no more idea of how to get out of this particular cul-de-sac than anyone else does, and it has plenty of data cover to avoid the tough decision.
So what would that mean for investors? Well, it could well throw a spoke in the wheel of the ‘strong US dollar’ narrative, which is already starting to wobble. That in turn could be good news for the likes of emerging markets and commodities and other assets that have been hit by dollar strength.
Any hint of a move towards easier US monetary policy would also put more pressure on the Japanese and the Europeans to work their printing presses harder. The last thing they want is for their currencies to strengthen against the dollar – which is one reason why I’m keen to keep investing in those markets.
In any case, the direction of the dollar is an issue that will affect all investors, and you should really keep an eye on it. Dr Peter Warburton writes about why he expects the dollar to weaken in the latest issue of MoneyWeek magazine, out tomorrow. If you’re not already a subscriber, sign up now.