Equities can outstrip bonds in a liquidity trap

Until recently, Keynes’ notion of a liquidity trap was of great interest to macroeconomists, but was viewed by investors as a rare aberration which, outside Japan, could be safely ignored. In the aftermath of the 2008 credit crunch, all that has changed. Many developed economies seem to be falling into a liquidity trap, and may stay there for several years. What does this imply about asset returns?

The term “liquidity trap” means slightly different things to different economists. To Keynes himself, it implied that bond yields had fallen to a lower limit, at which the risk of future capital loss outweighed the prospective return from the coupon. Consequently, cash dominated bonds as an investment vehicle, and interest rates could be reduced no further. To Paul Krugman, the re-inventor of the liquidity trap in the 1990s, it means that short rates have fallen to zero, with inflation expectations so low that the real rate of interest is too high to permit the full utilisation of resources.

I would suggest that a full liquidity trap has three crucial characteristics:

First, short rates should be (in effect) at zero. Second, bond yields should be at their lower limit in the Keynesian risk/return sense. Third, the real economy should be operating below capacity because real interest rates, though very low, are stuck at levels that are too high to produce enough aggregate demand. Underlying inflation rates should, therefore, be declining.

Japan is probably still in a liquidity trap based on these criteria. The rest of the developed world fits the criteria to varying degrees, but it seems clear that the direction of travel for Europe and the US is only in one direction, and that is towards a deeper liquidity trap.

Since a liquidity trap is such a distinctive economic condition, we might expect that relative asset market returns might also be very clear cut. For government bonds, that should indeed be the case. Bond yields should drop to the lower limit implied by Keynes, and then remain there. This may need some help from central bank bond purchases, or it might happen because expectations of low inflation and permanently low short rates become deeply embedded in the yield curve.

That is exactly what happened in Japan in the 1990s, and it now seems to be happening elsewhere. In the Japanese case, the sustainable downside limit on bond yields turned out to be around 1.3 per cent, with occasional spikes below that level not proving durable. If that proves to be the case in other developed economies, then the risk/return in bond markets already looks unattractive.

Even if we make the extreme assumption that yields decline from current levels all the way to the 1.3 per cent lower limit in the next 12 months, then total bond returns would be limited to a maximum of 7 to 8 per cent in the US, Germany, and the UK. On the other hand, if economies escape from the liquidity trap and yields begin to rise to a more normal historic level, capital losses could be very large. Although the most likely case is that bonds continue to provide low positive returns, the risk/return trade off does not seem attractive from here.

What about equities? A natural assumption would be that in the disinflationary environment of a liquidity trap, equity returns should also be very low. That may be true in nominal terms but, in inflation adjusted terms, there may still be a good case for holding equities. Investors who suffered through two decades of negative real equity returns in Japan may be sceptical about this, but the valuation of equities relative to bonds in the US and Europe is currently much more attractive than it ever reached in Japan’s lost decades.

The comparable point to the present day in the Japanese experience was probably around 1997, when short rates were hitting 0.5 per cent for the first time. At that stage, the long term underlying earnings yield on the equity market was hovering around 2-2.5 per cent, roughly the same as the government bond yield. The nominal risk premium on equities relative to bonds was therefore zero.

This contrasts sharply with the present situation in the US and Europe. In the US, the equivalent earnings yield on the S&P 500 is 4.7 per cent, which produces an equity risk premium of almost 3 per cent. In Germany and the UK, the risk premium is more than 4 per cent, while in the peripheral eurozone it is around 5-6 per cent.

In other words, liquidity trap conditions have left bonds looking extremely expensive relative to equities in the developed economies. Nominal equity returns may be held back by low inflation but in real terms they should outperform government bonds, even if the liquidity trap deepens further.

Source: http://www.ft.com/intl/cms/s/0/343c763e-45a8-11e1-acc9-00144feabdc0.html#axzz1kg6hL8t9