November 15, 2013
Stock market highs and near-zero interest rates
When stock markets hit new highs, as the S&P 500 and the Dow Jones Industrial Average did repeatedly in recent weeks, business success and a strong economy are generally the cause. This time around too, strong revenues, driven by new products and innovations have driven up the share prices of companies such as Facebook, Twitter and Amazon. Corporate earnings, which are at near record levels as a percentage of GDP in the Untied States, are also doing well.
However the steady climb in North American stock prices during the past five years hasn’t just been driven by economic fundamentals. Much credit also goes to the US Federal Reserve Board, whose zero-interest-rate and money printing policies have driven equity values far higher than they would otherwise have been.
Ultra-low interest rates, which have been likened to giving an economy a “sugar high,” put upwards pressures on stocks in four main ways. First, they drive consumer demand, by making it cheaper for individuals to borrow to buy everything from houses, to durable goods and vacations. Low interest rates also tend to boost exports. They do this indirectly, by driving down the value of a currency, which in turn makes a country’s products cheaper in overseas markets.
Thirdly, low interest rates make bonds, the other major asset class, less attractive and thus almost force investors to buy stocks. For example at the end of October, five-year US Treasuries were yielding just 1.34%, roughly the rate of inflation. That means in real terms, after taxes, investors who bought those bonds, actually lose money. As if that were not enough, lower interest rates also artificially boost business profits, without executives needing to anything, as borrowing costs are often among their biggest expenses.
The good news is that because the Bank of Canada marches pretty much in lockstep with the US Federal Reserve, almost all of these factors are in play here in Canada too, through to a lesser degree (The S&P/TSX rose by 7.46% during the first ten months of the year in local currency terms, before dividends, compared to 23.16% for the US S&P 500).
The challenge is that almost all of the risks of massive central bank money printing are hard to see. For example one of the biggest worries, inflation, has remained totally subdued. Indeed deflation (falling prices) is now a bigger concern to many.
Federal Reserve officials say that its current loose monetary policy will not continue forever. Ben Bernanke, its current chairman has given consistent hints that its bond buying program, which has been keeping down medium and long-term rates, will be “tapered,” as the economy improves.
However Bernanke’s term is expiring in the New Year and Janet Yellen, a former chair of the Council of Economic Advisors in the Clinton administration, who has been nominated to replace him, is thought by some to be an even bigger loose-money advocate. Others are not so sure. Equities investors will be thus watching all her statements closely as she proceeds through the Congressional confirmation process.
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Peter Diekmeyer Communications Inc.