Equity bears hunting for excess in the stock market might be better off worrying about bond prices, former US Federal Reserve chairman Alan Greenspan said.
“By any measure, real long-term interest rates are much too low and therefore unsustainable,” Greenspan said in an interview. “When they move higher they are likely to move reasonably fast. We are experiencing a bubble, not in stock prices, but in bond prices. This is not discounted in the marketplace.”
While the consensus of Wall Street forecasters is still for low rates to persist, Greenspan is not alone in warning they will break higher quickly as the era of global central bank monetary accommodation ends.
Photo: Bloomberg
Deutsche Bank’s Binky Chadha said that real US Treasury yields sit far below where actual growth levels suggest they should be. RBC Capital Markets chief US economist Tom Porcelli said it is only a matter of time before inflationary pressures hit the bond market.
“The real problem is that when the bond-market bubble collapses, long-term interest rates will rise,” Greenspan said. “We are moving into a different phase of the economy — to a stagflation not seen since the 1970s. That is not good for asset prices.”
Stocks, in particular, will suffer with bonds, as surging real interest rates will challenge one of the few remaining valuation cases that looks more gently upon US equity prices, Greenspan said.
While hardly universally accepted, the theory underpinning his view, known as the Fed Model, holds that as long as bonds are rallying faster than stocks, investors are justified in sticking with the less-inflated asset.
Right now, the model shows US stocks at one of the most compelling levels ever relative to bonds. Using Greenspan’s reference of an inflation-adjusted measure of bond yields, the gap between the S&P 500’s earnings yield of 4.7 percent and the 10-year yield of 0.47 percent is 21 percent higher than the 20-year average. That justifies records in major equity benchmarks and price-earnings ratios near the highest since the financial crisis.
If rates start rising quickly, investors would be advised to abandon stocks apace, Greenspan’s argument holds.
Goldman Sachs Group chief economist David Kostin names the threat of rising inflation as one reason he is not joining Wall Street bulls in upping year-end estimates for the S&P 500.
While persistently low inflation would imply a fair value of 2,650 on the benchmark gauge, the more likely case is a narrowing of the gap between earnings and bond yields, Kostin said.
He is sticking to his estimate that the index would finish the year at 2,400, implying a drop of about 3 percent from current levels.
That is no slam dunk, as stocks have proven resilient to bond routs so far in the eight-year bull market. While the 10-year Treasury yield has peaked above 3 percent just once in the past six years, sudden spikes in yields in 2013 and after last year’s US elections did not slow stocks from their grind higher.
Those shocks to the bond market proved short-lived, though, as tepid US growth combined with low inflation to keep real and nominal long-term yields historically low.
That era could end soon, with the Fed widely expected to announce plans for unwinding its US$4.5 trillion balance sheet and central banks around the world talking about scaling back stimulus.
“The biggest mispricing in our view across asset classes is government bonds,” Chadha said in an interview. “We should start to see inflation move up in the second half of the year.”
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