US Stock Markets FOTD

From comments on this previous post on US equity values:

If the US wants more foreign inflows into stock, it should reduce the non-resident dividend tax rate from the very high 30% that it is today. Currently, foreign investors are encouraged to invest in US treasuries since the interest is tax-free but not in US stocks. Since my country of residence has no dividend or capital gains taxes, it generally makes more sense for me to invest in British, Brazilian and Indian stocks (0% tax) and to some extent in Chinese stocks (10% dividend tax).

Will US Equity Values Decline Because of Demographics?

The SanFran Fed has published a research note on the value of US equities (with accompanying graph, above) that has attracted a fair bit of attention. Some key bits:

This evidence suggests that U.S. equity values are closely related to the age distribution of the population. Since demographic trends are largely predictable, we can forecast the path that the P/E ratio is likely to follow in the next few decades based on the predicted M/O ratio. ...



Despite theoretical ambiguities, U.S. equity values have been closely related to demographic trends in the past half century. There has been a tight correlation between population dependency ratios, such as the M/O ratio, and the P/E ratio of the U.S. stock market. In the context of the impending retirement of baby boomers over the next two decades, this correlation portends poorly for equity values. Moreover, the demographic changes related to the retirement of the baby boom generation are well known. This suggests that market participants may anticipate that equities will perform poorly in the future, an expectation that can potentially depress current stock prices. In that sense, these demographic shifts may present headwinds today for the stock market’s recovery from the financial crisis.

What this is basically saying is that stock market prices (relative to firm income per share) have tracked US demographics relatively closely over the past few decades. This is bad news for those invested in US equities because the US population is getting older, which means that there is likely to be more people seeking to sell equity investments to fund retirement than people looking to buy. If the supply of equities for sale shifts right, and the number of people with enough wealth to demand equities shifts left, then the price of equities is likely to fall. That's what the "model generated" portion of the graph above is showing.



But I don't buy it. As Ryan Avent notes, demographic trends are no secret, yet if supply is going to outstrip demand when retirees liquidate their equity portfolios the markets don't seem to have internalized the expectation.



More importantly, it's not clear to me that US demographic trends are the most relevant variable going forward. Capital is more internationalized now than at any point in history, and there are many more people in the global middle class than ever before, a trend that is expected to continue over the next 2-3 decades. For many of these people investing in US equities will be attractive, especially if the prices are low. Let's also remember that the US runs a very large current account deficit and is likely to continue doing so for the foreseeable future. That will have to be offset with financial transactions, and equities are one way to do that.



The authors mention the possibility of increased foreign ownership in passing, but it doesn't factor into their methodology. I think it probably should.

Catching Up

Apologies for the light posting. I've had fairly severe computer problems that necessitated the purchase of a new one, then an epic struggle with FedEx to actually get the damn thing in my hands. Obviously the past week has been a bad one for an IPE blogger to go missing, but I'm back in business now. So a few rapid-fire thoughts on the week that was.



1. S&P: This is clearly an attack on the US political system, not the fundamentals in the US economy. (The fact that the GOP hasn't internalized this lesson is bad news for them, methinks.) Nothing changed with the US's debt situation, and the solvency of the US is not under question by anyone in the market (more on this in a later post). For this reason the sloppy math in the initial S&P report doesn't matter... it's not about the math. It's about the legislative process. S&P prefers a cleaner one. I guess it's fine to have that preference, which I share but do not expect, but if this downgrade is about political risk than S&P really should have consulted some political risk experts, legislative affairs experts, or political scientists more generally. They also should have talked to folks who study global political economy, since rapping the US's knuckles can have far-reaching effects if done wrongly.



All said, the actual downgrade wasn't too significant, because the US didn't actually default. US bonds are still investment grade, and yields are at historic lows. The credibility of S&P, not the US, is what was severely damaged with this decision.



2. Europe: How long can this go on? The sovereign debt trouble is spilling over into the banking sector more rapidly. The biggest worries now are about Société Générale, and with good reason: it's the second-largest bank in France and the eighth-largest in the eurozone. It was already helped indirectly by the AIG bailout and directly by the Fed's international activities through TAF, but pressures mount and SocGen is definitely systemically important. Tyler Cowen and others have written about the silent bank run in Greece, and how an exit from the eurozone would affect Greek banks, but it would also affect banks in the Euro core.



The ECB is finally starting to act like a central bank, but either way the game has irrevocably changed. As far as I can tell the ECB's current actions are illegal under Article 123 of the Lisbon Treaty, but I'm no EU legal scholar so I could be wrong about that. In any case it seems to me that the eurozone must change somehow. Either by contracting members, dissolving into a two-track union, or centralizing more authority in a federal system.



3. Fed: It now appears clear to me that Ben Bernanke has been hamstrung by a Board that doesn't understand how or why the Fed should be more active. There were three dissents from the most recent, tepid, statement that interest rates would remain low for two years -- a statement that will be interesting to track, as it has credible commitment issues -- and there is no sign of further action. This is a shame. It's also a shame that Obama has left key Fed spots empty for so long. It seems like he'll be nominating Jeremy Stein and Richard Clarida for two empty Board spots, and Daniel Tarullo to the vice-chair spot that heads the regulatory apparatus of the Fed. I'm familiar with Stein's and Tarullo's academic work, and it is very good in both cases.



But this is not enough. The Fed needs to much more active in changing expectations about the path of the nominal economy. It needs to make much more credible commitments to boosting economic activity. It needs to play a greater role in the international banking system to avoid another panic at a crucial time in the "recovery". It, in short, is the most powerful economic agency in the world, and it needs to start acting like it. It has great capabilities, but also great responsibilities.



4. Equity markets: A lot of people are saying that this is like 2008. This is not like 2008. In 2008 credit markets had frozen up entirely, the whole system lacked liquidity, and every major financial institution was in the process of realizing very large losses. That's not the problem today. The problem today is that economic growth has been weak and will remain so for the foreseeable future, and governments are either unwilling (US) or unable (EU) to do much of anything about it. These are the countries that drive global demand, so if they slip up it hurts production in the developing world as well.

Financial Contagion?

Iceland is near bankruptcy. Credit crisis hits Canada. Belgium, France, Luxembourg intervening to save bank after bank. The Euro falls to 14 month low as credit crisis spreads throughout Europe. Asian equity markets continue their deep slide.

$700 billion bailout. 50 basis point emergency global coordinated rate cut. Banking deposit guarantees. Governments taking equity stakes in banks (yes, including here in the US). 

Is there any further action that can stem the spread? Can the government do anything? Is this too little too late? Is a global recession inevitable?