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Do Equity Prices Reflect the Ultra-Low Interest Rate Environment?

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Do Equity Prices Reflect the Ultra-Low Interest Rate Environment? 27 FEBRUARY 2020 — N O . 1 Do equity prices reflect the ultra-low interest rate environment? Søren Lejsgaard Autrup Jonas Ladegaard Hensch The viewpoints and conclusions stated are the responsibility Principal Economist Economist of the individual contributors, and do not necessarily reflect ECONOMICS AND ECONOMICS AND the views of Danmarks Nationalbank. MONETARY POLICY MONETARY POLICY [email protected] [email protected] ECONOMIC MEMO — DANMARKS NATIONALBANK 27 FEBRUARY 2020 — N O . 1 Do equity prices reflect the ultra-low interest rate environment? The equity risk premium has Investors face a choice when deciding where to about doubled after the financial invest today: Get a certain return on bonds crisis, amid a sharp decline in offering very low or negative returns, or buy a interest rates and an unchanged risky equity and expect to get around 7 per cent per annum, but with downside and upside required return on equities. risks. Before the financial crisis of 2007-08, the trade-off looked different: The expected return The increase in the premium on equities was at the same level, but the entailed a lower pass-through of alternative looked much more favorable with monetary policy rates to the total bond yields around 4 per cent. In other words, financing costs of corporations. the equity risk premium, defined as the That may help to explain why additional return required as compensation for corporate investments have not investing in equities rather than risk-free assets rebounded faster and stronger (bonds), has about doubled to around 7 per after the financial crisis. cent. Still, bonds are in high demand and no major, global rotation between asset classes has taken place so far. We do not find a major role for a higher underlying earnings risk or a higher price of risk in explaining The increased equity risk premium has the higher premium. Changed exhibited persistency despite a very long and stable, although modest, economic upswing financial structures and behaviour since the aftermath of the financial crisis. A may instead appear potentially higher equity risk premium entails a higher cost relevant. In case of the latter, of equity for corporations. This means that, equity prices may not fully reflect during the years of accommodative monetary the current low level of interest policy by global central banks, firms' overall rates. average financing costs have declined much less than monetary policy interest rates. The lower pass-through of monetary policy interest rates to actual financing conditions for corporations may contribute to shedding light on the fairly sluggish recovery of business investments after the financial crisis. 1 ECONOMIC MEMO — DANMARKS NATIONALBANK 27 FEBRUARY 2020 — N O . 1 The main contribution of this Economic Memo is Federal Reserve's monetary policy after the to analyse the increase in the equity risk financial crisis. premium in light of recent, observed developments in the macro economy and In this memo, we confirm on Danish data that financial markets, and that we assess whether the equity risk premium has increased following or not the increase is explained by economic the financial crisis, using a standard dividend 1 developments, and finally discuss what the discount model. The increase in Denmark is implications for monetary policy are. We are also coincident with a sharp decline in interest not aware of other studies doing that rates such that the sum of the two, the total thoroughly. expected return on equities, is unchanged. We aim to assess if a high premium is an inherent There are strands of literature on topics related feature of low interest rates, or whether the two to ours. For example, there is a very large phenomena are coinciding by coincidence. literature on the so-called equity premium puzzle, termed by Mehra and Prescott (1985), In order to do so, we identify the risks and price showing that equities historically have provided of risk changes that could constitute a much higher realised return than bonds. The fundamental explanations of the increase in the puzzle is that the return difference cannot be equity risk premium. We analyse each explained by realistic risk aversion parameters explanation in turn, where possible using data in standard macroeconomic models, cf., for and including available findings in the 2 example, Jorda, Schularick and Taylor (2019). literature. To identify the relevant equity risks, With this memo, we argue that equity returns we link them with the risk on companies' real going forward may also be significantly larger capital, using the fact that equities are claims on than bond returns. We do so by applying a residual income of companies' real capital. We forward-looking measure of the equity risk show that the increase in the equity risk premium. Companies' investment decisions take premium coincides with a comparable the forward-looking costs into account. development in the excess return on real Therefore, our measure is more relevant for capital. Therefore, we analyse whether the financing conditions in the economy and the higher return on real capital is a compensation transmission of monetary policy than measures for higher risk. We do not find evidence that the based on realised returns. earnings risk for corporations has been increasing sufficiently to account for the Duarte and Rosa (2015) analyse several models developments in the excess return on real to derive forward-looking estimates of the capital. equity risk premium for the US. They observe an increase after the financial crisis and conclude We then turn to developments in the price of that the equity risk premium rose because risk. Perceptions of equity risk may have interest rates declined. In a comprehensive changed as a result of the financial crisis. review of equity risk premia and their Nonetheless, it is difficult to reconcile that a behaviour, Damodaran (2019) notes that equity large increase in the price of risk has caused the risk premia until 2008 were positively correlated higher equity risk premium with the more with the level of interest rates, but vice versa benign developments in risk compensations in 1 afterwards. Without analysing it in greater This memo uses Danish data where it is available, because the aim is to detail, Damodaran comments that this change analyse the financing conditions for companies in Denmark. However, our findings generally apply to the euro area. 2 may have had negative implications for the It is out of the scope of this memo to formally test and prove whether each of the potential risk or price of risk explanations – alone or in combination with others – can explain the higher equity risk premium. 2 ECONOMIC MEMO — DANMARKS NATIONALBANK 27 FEBRUARY 2020 — N O . 1 corporate bond markets and equity options markets. Equity valuation after the financial crisis We argue that there is no strong evidence that Equity prices globally have increased strongly the proposed fundamental explanations of risk since the trough in March 2009 after the and price of risk have the power to explain the financial crisis. As a result, investors relying on increase in the risk premium. Therefore, we also simple valuation metrics, e.g. price/earnings, review explanations grounded in financial price/book or price/sales ratios, may easily frictions and financial behaviour that can reach the conclusion that equity valuation today potentially explain the higher equity risk is high and stretched. premium. Among the explanations proposed are excess global savings in a world with In Denmark, the price-to-earnings ratio is, for financial segmentations, stickiness in investors' example, more or less on the same level as right way of deciding on their required returns and before the financial crisis, and higher than the hesitation to evaluate the profitability of historical average, cf. Chart 1. investments relative to the low interest rates currently prevailing in bond markets. Discussions with market participants and use of Price-to-earnings ratio above the Chart 1 survey results tentatively support a role for historical average these alternative explanations. Cyclically adjusted price-to-earnings ratio 50 The role of risk premia in monetary policy and The dot-com bubble macroeconomics is a very important topic and 40 The financial crisis still understudied. Many unanswered questions 30 remain. There are a number of issues to look Denmark into, both in Denmark and internationally. One 20 avenue of further research would be to US supplement the analysis by a more formal 10 Euro area survey of corporations and investors regarding 0 83 86 89 92 95 98 01 04 07 10 13 16 19 their view on required returns on capital and equity investments, respectively. Note: Equities in Denmark, the euro area and the US are based on companies included in broad Datastream country indices. The price-to-earnings ratio is cyclically adjusted (also known as the CAPE ratio) and is defined as current prices divided by a 10-year moving average of inflation- adjusted earnings. The advantage of using CAPE ratios instead of standard price-to-earnings ratios is that the measure smooths potential differences in earnings over a business cycle. Source: Refinitiv Datastream and own calculations. Price-to-sales and price-to-book ratios have broadly evolved in the same manner and are close to the highest levels since the mid-2000s, cf. Chart 2. 3 ECONOMIC MEMO — DANMARKS NATIONALBANK 27 FEBRUARY 2020 — N O . 1 Key valuation metrics at high levels Chart 2 The concept and derivation of required Box 1 returns and the equity risk premium Right axis 4,0 40 = Current levels Our measure of the required return on equities is a 3,5 35 3,0 30 forward-looking implied measure of the expected 2,5 25 average return over an infinite time horizon. It is implied 2,0 20 because it is the return that justifies the equity price 1,5 15 today for a given future earnings path for the companies 1,0 10 in the Danish stock index.
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