Martin Feldstein, the Harvard professor who was one of President Reagan’s top economic advisers, said stock prices will decline as the Federal Reserve raises interest rates and cuts its debt holdings.
“An excessively easy monetary policy has led to overvalued equities and a precarious financial situation,” Feldstein wrote in The Wall Street Journal. “The Fed now faces the difficult challenge of trying simultaneously to contain inflation and reduce the excess asset prices—without pushing the economy into recession.”
Feldstein doesn’t say how much the market may decline in discussing how expensive stocks are in relation to historical norms. The S&P 500 stock index has risen 22 percent in the past 12 months to reach record highs.
“Stock prices rose much faster than profits did,” Feldstein said. “The price/earnings ratio for the S&P 500 is now 26.8, higher than at any time in the 100 years before 1998 and 70 percent above its historical average.”
He said P/E ratios are high even as investors expect the tax reform approved in December by President Donald Trump to boost company profits and the broader U.S. economy. Trump campaigned on a pro-business platform of cutting taxes, reducing regulation and spending $1 trillion on roads, bridges and airports.
Feldstein said the Fed’s policy of raising interest rates and shrinking its debt holdings will pressure asset prices. The central bank had cut rates to record lows of near zero percent, not including the effect of inflation, during the 2008 financial crisis that triggered the worst economic slowdown in 80 years.
“The Fed under then-Chairman Ben Bernanke promised to keep short-term rates close to zero until the economy fully recovered,” Feldstein said. “The Fed also began buying long-term bonds and mortgage-backed securities, more than quintupling its balance sheet from nearly $900 billion in 2008 to $4.4 trillion now.”
Bernanke said that buying that debt would urge investors to shift their holdings out of bonds and into equities and real estate. The “wealth effect” that would result from rising household net worth would make consumers feel better about spending money, which would boost the economy.
As the financial crisis reaches its 10th anniversary this year, Wall Street economists forecast that the central bank will raise interest rates three times as inflation reaches its target level of 2 percent, unemployment stays low and the economy grows.
“Easy monetary policy has produced an overly tight labor market that is beginning to push up inflation,” Feldstein said. “The consumer price index rose 2.1 percent over the past 12 months, and there is an increased risk that at some point inflation will shoot upward. The expectation of rapid inflation will cause long-term rates to rise even before that faster inflation occurs.”
Rates will face additional upward pressure as the Fed reduces its debt holdings and the federal government borrows $700 billion to operate. The Fed’s efforts to normalize monetary policy likely will lure more investors into risk-free Treasurys while selling off stocks, Feldstein said. That will start to reverse the wealth effect.
“If the P/E ratio declines to its historical average, the implied fall in the market would reduce the value of household equities held directly and through mutual funds by $10 trillion,” Feldstein said. “If every dollar of decline in household wealth reduces annual consumer spending by 4 cents, as experience suggests, spending would fall by $400 billion, or more than 2% of gross domestic product. The drop in equity prices would also raise the cost of equity capital, reducing business investment and further depressing GDP.”
Hoisington Investment Management Co. this month published a quarterly report with similar sentiment about monetary policy's effect on the economy.
“The full spectrum of monetary policy is aligned against stronger growth in 2018,” chief investment officer Van Hoisington and economist Lacy Hunt said in a Jan. 11 report. “This monetary environment coupled with a heavily indebted economy, a low-saving consumer and well-known existing conditions of poor demographics suggest 2018 will bring economic disappointments.”
Consumers are bingeing on credit card debt to maintain their lifestyles while wages haven’t grown much compared with inflation, Hoisington said.
“Although the economy may slow due to a poor consumer spending outlook and increases in debt, the real roadblock for economic acceleration in 2018 is past, present and possibly future monetary policy actions,” Hoisington said. “The impact of this tightened Fed policy on money, credit and eventually economic growth is slow but inexorable. The brunt of these past and current policy moves will be felt in 2018.”
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