Fra BNP Paribas:
Big picture: Boiling the frog of risk
Low inflation, decent growth and patient central banks have been a great recipe for rich
asset valuations. But the mood music of central banks is changing: is a correction coming?
It may be, but mean-reversion models don’t explain why asset prices get so stretched and are poor guides to timing. A correction that is in the offing may be a long way off yet.
We believe that markets are too complacent about the eventual effect that QE shifts may
have on markets. As ECB and Fed balance sheet dynamics change, risks will rise.
This may be imperceptible to begin with, but events – either higher inflation or some other development – may eventually prompt markets to reassess the temperature and to jump. QE and low rates are a wonderful recipe for high asset prices. But as central banks look to change gear on the balance sheets – the ECB QE’ing at a slower pace and the Fed moving to QT (quantitative tightening) – what will be the effect on asset prices and will some of today’s “somewhat rich” (Yellen in London in June) valuations that currently look like a boon turn out to be a curse?
Chart 1 looks at Shiller’s cyclically adjusted PE ratio (CAPE). It is clear that on this basis, US stocks are expensive. CAPE is over 30, having reached such levels only twice before: in 1929 and 1997-2002; its average level is under 17. Shiller himself wrote recently, “The US stock market today looks a lot like it did at the peak before all 13 previous price collapses. That doesn’t mean that a bear market is imminent, but it does amount to a stark warning against complacency”.
Clearly, comments by Yellen, Fischer and Williams (“the stock market still seems
to be running very much on fumes”) in June show concern with high stock prices.
One of the key questions is why are stocks expensive? Our colleagues in equity derivatives
believe it is not because the equity risk premium is excessively low, especially in Europe. In
August the ECB opined that “From a historical perspective, the current estimate for the equity risk premium in the euro area is not low, indicating that equities are not particularly highly valued relative to bonds.” (our emphasis).
That’s one of the key issues – to what extent has QE distorted government bond yields and how much will this correct as QE diminishes and QT builds up? Stanley Fischer reckoned that QE in the US had reduced bond yields by about 110bp.
QT will not return the balance sheet to where it was, so the unwind effect might be worth 50bp or so. So far, there is no sign of the market pricing in anything like that. We believe that flows matter and as the Fed’s balance sheet reduction gathers pace, especially with the ECB likely to QE taper next year (to be announced at the October meeting), we believe that bond yields will increasingly suffer. We project the 10-year Treasury to be at 2.75% at the end of 2018
