Sent: 18-08-2009 13:43:01
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Growth and Bond Yields
Longer term interest rates need to be sufficiently below growth rates to sustain asset values and encourage investment.
In Australia and in the USA, policymakers will have to decide what an appropriate level of interest rates is going to be once recovery is underway.
While interest rates are generally low so, too, is the rate of growth keeping asset values down and constraining investment.
One way of looking at the connection between growth, interest rates and business values is from the perspective of valuation theory. The simple Gordon growth model, for example, says that the valuation of an equity (P) depends on the upcoming dividend (D) and the difference between the targeted rate of return (k) and the rate of growth (g): P = D/(k-g).
On this view, the higher the rate of growth relative to the target rate of return, the greater the value ascribed to any given firm or dividend stream.
The starting point for the target rate of return is the government bond yield. It is the minimum acceptable return for an investor. Higher bond yields will imply a rising target rate of return. Without a compensating increase in the rate of growth, security prices should fall. For a firm to hold its value in the face of rising bond yields, prospective growth rates must rise.
For reference, the chart at http://www.thebigpicture.com.au/atc/usgdp_yields.htm shows the history of US nominal GDP growth and 10 year bond yields since 1954.
From the mid 1950s to approximately 1980, nominal growth rates generally exceeded bond yields. Due to building inflation pressures, both target returns and growth rates were rising.
In the following 15 years, however, as the second chart illustrates more clearly, the growth-yield differential was at its lowest in the early 1980s and, thereafter, remained on a rising trend until 2005.
The rising trend suggests that, for any given profit level, the markets should also have been rising. Markets were benefiting, therefore, from a double effect: rising profits plus the valuation effects which came from growth closing the gap and eventually exceeding the target rate of return.
A third phase in this history has just begun. Growth has slumped and, while bond yields are somewhat lower than they had been in 2007 prior to the onset of the global credit crisis, the difference has returned to levels last seen at the beginning of the 1990s.
This suggests that, for any level of income, the potential market level will be lower than it would have been fifteen years ago. Another way of saying this is that, under these circumstances, p/e ratios should contract relative to those in the decade or so before the global credit crisis. That has been reflected in markets which have suffered the dual effects of falling profits and contracting market multiples.
Growth is going to recover to some extent but nominal GDP could be increasing at less than 4% per annum if the recovery is a shallow one and inflation remains in check. That would leave it level pegging with bond yields, if they remained where they are, but an improvement nonetheless which would imply some rebuilding of equity market valuations.
However, this would be just a one-off effect. The best circumstances for an ongoing market recovery would be, once again, a combination of rising profits and for growth rates to outstrip bond yields by a rising margin. A potentially difficult bond selling task and constraints on activity due to household balance sheet rebuilding might limit this potential.
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