Financial markets entering frothy territory – Deutsche Bank

Mikihiro Matsuoka, Chief Economist at Deutsche Bank, believes that the equity market in developed countries begins to show symptoms of ‘froth’.

Key Quotes

“A simple average of the standard deviation of the stock market capitalization as percentage of GDP of seven major developed countries has been approaching very close to the previous peaks of 2000 and 2008. The reason we believe it is entering a frothy territory is that an eventual turnaround of monetary policy after a long period of post-GFC accommodation is under way in major developed countries, which in our view, raises the returns on safe assets and lowers the valuation of risk assets.” 

“Some factors, such as 1) higher nominal GDP growth above long-term bond yield thanks to massive monetary accommodation, 2) chimera equities in which dividend yields get higher than the long-term bond yield and a resulting rise in P/E thanks to ‘search for yield’, and 3) financial surplus of non-financial businesses in developed countries, might help evade or put off a large and prolonged adjustment in asset prices. However, the gap between nominal GDP growth and the long-term bond yield has expanded to a historical high under which monetary policy turnaround would naturally shrink the gap.”

“The decline in the potential growth in the post-GFC era eventually restrains the profit growth and a resulting dividend growth over the long run. The price-earnings ratio has been on a slow but persistent rise after the GFC. The monetary policy turnaround could counter this by lowering the valuation of the risk assets. An expanding financial surplus for non-financial businesses reflects disappearance of investment (or profit) opportunities, i.e. an end of capitalism. The fall in the potential growth restrains a rise in the valuation of risk assets over the longrun.”

“The diminishing marginal returns on economic policy could further reinforce the effect of the monetary policy turnaround on the financial market. The first round of QE had a bigger impact on both the financial market and the real economy than the second and the third shots of QE. It is because the financial market had to dramatically recalibrate its model of the resulting steady state after the introduction of QE. Likewise, the first round of the withdrawal of monetary accommodation could well deliver a bigger negative effect on the financial market and the real economy than the ensuing second and third shots of monetary policy turnaround.”

“The US suffered the 2013 taper tantrum as a result of the first shot of withdrawing monetary accommodation and paid a price of not withdrawing it any time soon. Now, this is the first round for the ECB and the BoE. In addition, the US Federal Reserve appears willing to accelerate the frequency of the rate hikes, which could further amplify the negative shocks. Unlike 2016, the Fed does not appear to have enough patience anymore to postpone the rate hikes.”