Global equities have, so far, survived the bout of global deleveraging which followed Ben Bernanke’s remarks about slowing the pace of QE last month, though there have been nasty signs of volatility in Japanese and some emerging markets. Investors have, unsurprisingly, become temporarily obsessed by whether the Fed will taper its asset purchases in September or December. However, in the great scheme of asset valuation, this is nothing more than a passing detail. In the longer term, what matters is real factors, like the forward path for corporate earnings, and the interest rate at which they should be discounted.
The appropriate discount rate is the risk-free (real) bond yield plus the equity risk premium (ERP). The Fed acts on the former, while the market determines the latter. In recent years, the Fed has reduced the bond yield but the market has, simultaneously, required a higher ERP, so the overall discount rate on equities has remained broadly unchanged. As I have argued before, any rise in the bond yield as QE ends may be offset by a fall in the ERP, leaving the valuation of equities protected as bond returns become negative. We have seen a minuscule version of this playing out in recent weeks, for what it is worth.
This, however, does not necessarily mean that equities are fairly valued. A common concern among investors is that the profit share in the US economy is currently abnormally high, which is one reason why US equities have performed so well since 2009. It is frequently argued that the profit share must eventually “mean revert”, and when that happens the market will have to revise downwards its estimates of the sustainable path for corporate earnings. Equities will tumble, not because of a hostile Fed, but because the fundamental earning capacity of corporate America will be found wanting.
This, however, seems to underplay the persistence and global breadth of the rise in the profit share, and the accompanying decline in the wage share, in the last three decades. It is far from clear why this trend should “mean revert” in the foreseeable future. Read more