Stimulus And Stocks: Beware The Unintended Consequences

The link between equity prices and monetary and fiscal policy is often misunderstood, with investors currently focusing only on the direct positive effects and ignoring the indirect negative effects. The direct positive effects of easy monetary and fiscal policy on stocks are well known. All else equal, reduced interest and tax payments and higher inflation tend to lift nominal earnings while the former provides support to valuation multiples.

However, all else is rarely equal, and such policies tend to have offsetting negative effects. Specifically, easy monetary and fiscal policies undermine real GDP growth and raise the potential for financial crises. Furthermore, shifts from low to high inflation rates also tend to raise the required rate of return on equities, causing a countervailing compression in valuations. These factors help explain why deeply negative interest rates have failed to support equity valuations in the past (see “Faith In The Fed’s Ability To Support Stocks Is Unfounded“)

Impact Of Monetary And Fiscal Stimulus On Equity Performance

Source: Stuart Allsopp

We believe the response of equity markets over the past six months reflects the direct positive impact of aggressive policy measures, with the indirect negative consequence still ahead of us. We expect to see policymakers embark on increasingly loose monetary and fiscal policies, which may well provide some support to nominal corporate earnings. However, contracting valuation multiples are likely to more than offset any positive impact of rising inflation on nominal equity performance.

Direct Positive Impact On Fundamentals

Low Interest And Tax Payments: Low real interest rates benefit corporate earnings by reducing interest costs which benefits indebted companies. Meanwhile, low taxes benefit corporate earnings by reducing tax expenditures. The chart below shows the impact that declining interest costs and tax costs have had on the S&P 500 earnings over the past 20 years.

Source: Bloomberg

Rising Inflation: Low real interest rates and high government bond issuance are also positive for nominal earnings to the extent that they lift the general price level. Fiscal deficits in particular tend to be highly inflationary, regardless of whether they result from low individual or corporate taxes or high levels of spending as they result in an increase in government bond issuance which has a similar effect as increased money supply.

Source: Bloomberg

Direct Positive Impact On Valuations

Increased Present Value Of Future Cash Flows: Lower interest rates raise the present value of future cash flows. This is the mechanism which investors tend to cite most frequently when they talk about the positive impact of monetary policy on stocks. For instance, a 1 percentage point decline in the discount rate from 2% to 1% would raise the present value of $100 in 10 years’ time by $8.50 or just over 10%.

Declining Real Yields Have Helped Depress SPX Dividend Yields

Source: Bloomberg

Indirect Negative Impact On Fundamentals

Weaker Real GDP Growth: When real interest rates are set below the rate of real GDP growth, there is a tendency for it to drag down productivity growth. For instance, assume that real GDP growth is 5%, reflecting the annual increase in the productivity of labour. If real interest rates were set by the free market, they would be between zero and 5%. It could not be below zero because human time preferences are positive as people prefer stuff now to in the future so they would not lend out money for a negative real return.

If real rates are set by the central bank at a rate below zero, this would enable companies to borrow at a rate that no one would be willing to lend at under free market conditions. As a result, companies with low levels of productivity and profit growth are able to have access to capital that they would not have under free market conditions. As companies with low levels of productivity growth compete for real resources, there is a tendency for overall productivity to decline, dragging down real GDP growth.

Fiscal deficits also undermine real GDP growth. Regardless of whether the deficits are caused by high levels of spending or low taxes, they tend to undermine national savings rates (see “The U.S. Has A Savings Problem The Fed Can’t Fix“), which, all else equal, reduces the potential for investment and growth. Furthermore, if deficits are caused by excessive spending, productivity is likely to be undermined.

Increased Risk Of Financial Crises: In addition, low real rates and fiscal deficits tend to result in a build-up of private and public debt. High levels of private sector debt raise the prospect of a credit crunch which can lead to collapsing earnings as we saw during the global financial crisis. Meanwhile, high levels of government debt raised the risk of unforeseen and destabilizing fiscal austerity measures.

Indirect Negative Impact On Valuations

Increased Required Risk Premium: While shifts from deflation to inflation are associated with rising equity valuation multiples, shifts from low levels of inflation to high levels of inflation have shown a strong tendency to result in declining valuation multiples. Our sense is that this decline reflects the increased risk premium that investors require to compensate for the increased uncertainty of future cash flows and the rising threat of a potential spike in interest rates and fiscal austerity measures to prevent inflation spiraling out of control.

Source: Robert Shiller

The Best And Worst Times To Invest

Data going back over 100 years clearly shows that over a multi-year time horizon, the best times to invest have been when valuations are low and inflation rates are high. During such periods, the combination of high nominal earnings growth and multiple expansion have resulted in strong equity returns in both nominal and real terms. In contrast, the worst times to invest have been when valuations have been high and inflation has been low as is the case today.

SPX Performance Under Various Conditions

Source: Stuart Allsopp. Valuations measured using the Cyclically-Adjusted PE ratio

Disclosure: I am/we are short SPX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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