(James Saft is a Reuters columnist. The opinions expressed are
By James Saft
July 8 The past 15 years of bubbles and busts
notwithstanding, sometimes it may be best to just assume
financial markets have got it right.
The central problem facing investors today is how to
reconcile patchy and uneven growth in the economy with very full
valuations for stocks and other risky assets.
What has been a constant tension over the past five years,
during which U.S. stocks have more than doubled, was highlighted
yet again last week when decent but not outstanding U.S. jobs
figures (wage growth for example was poor) prompted investors to
underwrite yet another stock market run to record territory.
In trying to figure out why financial markets are doing so
well and risk is so well bid, there are two broad competing
The first explanation is that financial markets are ahead of
the curve. In this reading a stronger recovery which will
justify rich valuations is just around the corner. If true,
companies will see revenues jump along with overall economic
growth, and margins with them, prompting a new round of
investment in capacity and allowing for the vast majority of
recently made risky loans to be repaid.
The second theory is that, far from being right, markets are
being manipulated by central banks seeking to goose slow growth.
Markets, therefore, are wrong, as they were in 1999 and 2006,
but may be held aloft so long as policymakers still see a
benefit in keeping the party going.
Bill Gross, the so-called bond king of asset manager Pimco,
has a third theory, closely related to the second but different
in important respects: that markets are right to be priced as
they are, not because policy is going to work, as we with a
pre-crisis mindset would think of it, but because, in effect, it
Under this theory, which Gross calls the New Neutral, and
which he has backed, according to a Bloomberg story, with an
investment of $200 million of his own funds, markets are doing
nothing more than mechanically calculating the value of future
flows of income based on the belief that growth and interest
rates will be capped at levels far lower than we assume.
"In a highly levered world, the real rate of interest has
been and must remain reduced more than growth in order to keep
our financed-based economy functioning," Gross wrote last week
in a note to clients.
LOOKING FOR NEUTRAL
At issue is the 'neutral' policy rate set by the Fed, a
concept denoting the correct federal funds rate to be neither
stimulative nor dampening to growth and inflation.
The very real possibility is that our reliance on adding new
debt as a means of stimulating economic growth has left us with
diminishing returns from both new borrowing and falling interest
rates. That sensitivity to higher rates means that the economy
requires a lower rate of interest than was usual 25 years ago in
order to remain in balance.
Rather than the 1.75 percent fed funds rate which central
bankers assume we will return to when things return to the
status quo, we may only be able to handle something a lot closer
Financial markets attempt to place a value on the future
stream of income represented by a security, such as the interest
rate on a loan or bond or the dividends and capital gains
expected of a stock. That's driven, in part, by current interest
rates and also expectations of where rates will settle in the
future. The higher future rates are expected to be, the lower
the value of those future cash flows, and vice versa.
So, that leaves open the possibility, as argued by Gross,
that current valuations and bond prices make a lot more sense
than those of us with our heads stuck in the 1980s and early
Growth won't accelerate and the Fed won't be able to jump
rates back to historic norms for quite some time. That leaves
current stocks and bonds looking a lot more sensibly priced, if
not with a lot of headroom for future strong appreciation.
Even if you accept the New Normal thesis, there are huge
open questions. For one thing the very highly leveraged nature
of the economy leaves it vulnerable to future shocks from
whatever direction. Stocks priced for low growth and low rates
will look terribly expensive and risky if that turns into
negative growth and low rates.
Financial markets, in other words, may well have it about
right now but still be a good deal riskier than they've usually
been, even taking into account the last 15 crazy years.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at email@example.com and find more columns at blogs.reuters.com/james-saft)
(Editing by James Dalgleish)