Three Questions That Preoccupy the Financial Markets
Investors have three burning questions at the end of the year. What factors will influence the financial markets in 2018? How will the yields on bonds develop? Could debt become a risk? Three key questions and related forecasts.
1. Private debt is back above the level it had reached before the 2007 financial market crisis. Will history repeat itself?
It is true that household debt – as well as corporate and government debt – is once more at the level that preceded the 2007 financial market crisis. However, when assessing debt, the amount is less decisive than the resulting debt service payments. The cost of servicing debt as a fraction of disposable income has fallen over ten years – despite, paradoxically, an increase in debt – to its lowest level in generations (chart below).
Let’s recall: in 2008, global policy rates were slashed by up to five percentage points. Notwithstanding all efforts towards normalization, today’s interest-rate level is not going to change that rapidly. Most borrowers have profited from the slide in interest rates, since it enabled them to refinance old debts at cheaper long-term conditions. Even if key rates were to double next year, it would do little to alter current debt portfolios. Debt servicing is presently at a record low, and for the foreseeable future is more likely to remain a welcome support than become a threat to the economy.
2. Are the capital markets offering anything near adequate risk premiums?
The flip side of low interest on debt is naturally low capital market yields. The resulting dearth of decent investment opportunities has been particularly irritating for yield-oriented investors. How should they resolve this dilemma? Invest in longer maturities? Consider foreign-currency bonds? Buy illiquid or high-yield bonds? Raise the equity allocation, in account of bonds?
These are difficult, but vital questions at the turn of the year. It is important to note that since 1995, compared to equities, bonds have been the strongest performers both in absolute and risk-adjusted terms:
Negative Bond Yields Becoming Normal
As a result of this 22-year rally, bonds have considerably higher valuations than shares today. More than one-third of all segments of government bonds deliver negative yields to investors (chart below). For the generation of millennials who have never experienced a bond-market crisis, this situation is considered normal.
But is it really normal for risk premiums on government bonds to stand at a tiny fraction of equity risk premiums? The price-earnings ratio (P/E) of bonds can be calculated mathematically as the inversion of the yield. This means, for example, that a 15-year Swiss Confederation bond with a yield of 0.17% is trading at an implicit P/E of 590x. This is many times higher than the average P/E on the Swiss stock market. Normal?
3. What is the relation between the size of an economy and stock market capitalization?
The US stock market represents half of global stock market capitalization, more than double the American share of global gross domestic product (GDP) (chart below). The difference between America’s market capitalization and its GDP translates into a premium for its exceptional innovative force or earning power.
The only comparable case was Japan, where companies in the early 1990s made up 40% of global market capitalization, although Japan’s economy never contributed more than 10% to world GDP. All in the past. The inverse of this relation applies for Europe and most emerging markets. Who knows how this will develop in 2018?