Politics & Policy - Equity Risk Premium Points to Trouble Ahead.

In our Money and Finance note today, we expressed our skepticism towards the current market bounce in large part due to our overall skepticism regarding a smooth formulation of the proper fiscal policy stemming from Washington.

One should expect a looming battle of the right and left on how best to proceed forward regarding the handling of the national economy with the final solution coming in the eleventh hour. That mounting uncertainty as negotiations roll on will create a level volatility in the market that investors will view negatively.

 That said, the most likely the solution out of Washington will be counterproductive as an economic growth policy and short-term in nature. It will be, in essence another kick the can session.

What is concerning is the state of our fiscal affairs in this country and how it will affect our economy. After reading an article by Robert Jenkins in the Financial Times last week entitled, “It’s time to think the unthinkable on America’s debt”, We wanted to revisit a model that was created many years ago addressing equity risk premium.

Figure 1 compares the twelve-month forward earning yield (this is the inverse of the P/E ratio using forward forecasts) to the ten year U.S. Treasury bond yield. The latest readings are derived from the following figures. Currently Wall Street analysts are projecting S&P 500 earnings to settle in around $111.42 in the coming twelve months indicating an earnings yield of 8.1%. When compared to the 1.6% offered on the ten year, the differential is completely misaligned with where history states it should be. In order to produce a more normalized comparison, stock prices will need to rise dramatically, OR corporate earnings will need to be cut drastically OR treasury yields need to rise aggressively. 

 Perhaps a combination of all three will happen, but given the uniquely easy monetary policy that has been initiated by the Fed, one needs to assume that treasuries are largely over-valued at this point.

Taken further, the Fed has control of monetary decisions for the time being allowing fiscal policy a runway towards restructuring. Let’s hope that politicians in Washington do not squander this window of opportunity while they have it. If the control of the situation transitions from our policy leaders to the bond market, a financial crisis will arise dwarfing the economic meltdown of 2008.

Debt Crisis

The Cato Institute wrote an ominous report about our fiscal dilemma. The report is written by Doug Bandow and is entitled “Heading toward National Insolvency”. A must read for those concerned about our economic future, we wanted to highlight some of the key points from this report. http://www.cato.org/publications/commentary/heading-toward-national-insolvency

Bear in mind that for the past four years, the federal government is running a deficit of over $1 trillion per year, which is the largest budget deficits since 1945 in both dollar terms and as a percent of GDP according to the Congressional Budget Office.

The CBO, under its more optimistic projections warn that debt as a percent of GDP has the ability to decrease to 53% by 2037. Thus under optimistic assumptions, our debt will still be 40% higher than average even after 25 years of restructuring. 

The CBO goes on to state how the growing debt load would increase the probability of a sudden fiscal crisis, during which investors would lose confidence in the government’s ability to borrow at affordable rates.  

Bandow goes on to write, “Unfortunately, rising outlays and debt threaten to create an economic death spiral. Obviously, more borrowing means higher interest payments, that is, more government spending. At the same time, more debt is likely to increase interest rates, since lenders will become ever more worried about Uncle Sam's ability to pay back the loans. Last year Standard & Poors downgraded Washington's credit rating and in early June threatened to do so again if Congress fails to control spending. The result would be even higher interest payments.

Moreover, warned CBO, rising red ink "would reduce national saving, leading to higher interest rates, more borrowing from abroad, and less domestic investment — which in turn would lower the growth of incomes in the United States." That is, because of excessive government outlays Americans will earn less even as they have to pay the government more. And there's no logical stopping point. As expenditures rise, the cycle will accelerate.”

The Fed’s Balance Sheet

Our view holds that Chairman Bernanke has been forced to go above and beyond traditional monetary policy stimulus measures because Washington is in such a funk. Both parties have engaged in ideological sparring and have completely rendered traditional fiscal policy measures inept. The last decade of abusive spending in Washington has drained our resources at a time when we could use them.

Chairman Bernanke and the Federal Reserve have increased the Fed's balance sheet using unorthodox monetary measures such as Quantitative Easing and Operation Twist. The Fed, whose balance sheet was less than $1 trillion prior to the Great Recession now stands at roughly $2.8 trillion. Increasingly worrisome is the “twist” from shorter-term maturities to longer-term instruments that are more sensitive to changes in interest rates. With their latest “QE Infinity” announcement, many economists are projecting an increase of the Fed’s balance sheet to $4 to $6 trillion, or an increase of 40% to 115% by the end of 2013.

At some point, the Federal Reserve would be forced to stop purchasing or risk higher inflation. Should the situation arise requiring the Fed to sell securities, then treasuries will fall and rates will rise.

Rising rates

Given the current level of interest rates and borrowing, some economists are projecting that the nations interest payments servicing outstanding debt will exceed our national defense budget within ten years. This assumes current rates below the two percent level. But if rates were to rise above 5% on the ten year (a concept not that strange) then we could see that time frame shorten dramatically.

Equity Risk Premium

Looking back at figure 1, the model has pointed to financial outliers as coming crises. In September of 1987, the model spiked indicating a breakdown within the normal trend. The market went on to crash two months later. More recently, in January 2000 the model once again went off-kilter inducing me to write a piece entitled “Reality Check.com”. In it we wrote of a coming day of reckoning for the dot.com age. This call proved correct in that the corporate landscape as it related to the internet changed forever.

Completely turned around, this model looks awful for holders of U.S. Treasuries.

 

Joseph S. Kalinowski, CFA

Twitter: @jskalinowski

References

http://www.ft.com/intl/cms/s/0/63ffec6e-2a6a-11e2-a137-00144feabdc0.html#axzz2Cggf33dc

http://www.cato.org/publications/commentary/heading-toward-national-insolvency

http://www.thenewamerican.com/economy/commentary/item/12898-federal-reserve-balance-sheet-set-to-explode

http://www.federalbudget.com/

http://www.investmentu.com/2012/August/treasury-bond-apocalypse.html

http://mobile.reuters.com/article/idUSBRE89H1I020121018?irpc=932

http://www.cbo.gov/publication/43539

http://www.cbo.gov/publication/43288

http://cnsnews.com/news/article/interest-federal-debt-hit-104b-first-half-fy2012-despite-low-interest-rates

 

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