negative real interest equities genre

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About this Newsletter

Reflections is a monthly publication

written by John Gilbert, CIO,

GR-NEAM. Each issue focuses on

current capital markets and investment

topics. Our clients find it somewhat

unique from many investment

publications typically received.

For More Information

For more information please contact:

Terry Becker, VP Marketing, via e-mail

address [email protected]; or

Bart Holl, VP Marketing, via e-mail

address [email protected].

General Re-New EnglandAsset Management, Inc.

Pond View Corporate Center

76 Batterson Park Road

Farmington, CT 06032

Tel. 860 676 8722

Fax 860 676 8712

Real Interest Rates and Equity Returns

We return to the question of interest rates, in particular

the yield on inflation-protected bonds, since we have

received some questions on the topic since we discussed

it last in Reflections, Issue 42, December 2003. With the

recent increase in rates, bonds are becoming less

unattractive than they were, but are still not compelling.

Typical coupon-bearing Treasury bonds lose value if

inflation rises, or if the real interest rate embedded in

them is too low, or both. The only advantage to inflation-

protected bonds is that they cannot lose if inflation rises,

but they can lose if the real rate expressed in their prices

turns out to be too low, and it appears that continues to

be the case. We also look at the valuation of the equity

market using this assessment of real interest rates.

July 2004Issue 49

Reflections


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To measure roughly what the real rate should be, consider that households own

the financial assets that finance the real economy (assume this includes foreign

households, who increasingly are doing the job, but that is another topic). The risk

averse households may only buy Treasuries, while the risk takers will own businesses,

either directly or through common stocks. The latter will only do so if the risky assets

return enough of a premium to justify the risk, which is typically referred to as an

equity risk premium. Treasury bonds offer some return in excess of current inflation

to justify the risk of committing for the maturity of the bond, and to compete for

capital with higher return investments, such as businesses. Over time, this real return

should respond to the competition from the other investment alternatives in theeconomy; so if there are many attractive opportunities for investment, the real rate

should be higher than it would be without them. Ultimately the growth of the

economy is the key.

We measure economic growth, relative to population, mainly since it is the traditional

way of doing so. The two components for economic accounting are the number of

people in the economy and the productivity of each one. The real rate of interest

should therefore change with productivity changes over time; changes in the labor

force are slow. In the United States, the labor force grows at modestly in excess of 1%

without much variation in the rate over timeproductivity varies more.

The real rate of interest and the equity risk premium can be regarded as trying to

measure the same thingthe return on financial assets excluding the component of

return that is consumed by inflation. They are in this sense competitors, and themarkets over time arbitrage such competition. It may, however, take considerable

time for imbalances to work out.

Given an observation of one, we can measure what the markets appear to assign the

other. Measuring the equity risk premium is notoriously difficult because it moves

around so much, but then so does the real rate of interest. Inflation-protected bonds

were not issued until the late 1990s, so prior to that we had to guess what the real

rate was, and still do. One way of doing so is to observe the real rate on the market

prices of the inflation-protected bonds since their issuance, compare it to various

implied real rates for prior periods, and pick the best relationship.

The trick in inferring what the real rate was prior to the issuance of inflation-

protected bonds is in establishing what inflation number to subtract from the bond

yield at the time. We could subtract the current inflation rate at the time, but weknow that people may consider other data in forming their expectationsand it

is the expected inflation rate that counts. Of course, we cannot actually measure

the expected inflation rate, so we must guess what the market was thinking.

We tested different inflation rates and the resulting real rates since the issuance of the

inflation-protected bonds against the actual yields at which those bonds traded. The

best fit was a five-year moving average of inflation, as shown in Table 1.

Source: GR-NEAM Analytics

Gen Re Capital2

Table 1. Inflation Implied by Inflation-Protected Bonds: Correlation to Actual Inflation

Observation Periods

Most Recent Moving Average Inflation

(in months)

Most Recent12 24 36 48 60 72 84 96 108 120

Inflation

24% 31% 13% 15% 50% 55% 39% 47% 49% 29% 23%


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Five years may seem arbitrary, but the difference among the time periods is

significant. Furthermore, it appears sensible that people would consider their

experience and would consider a multi-year time period for a multi-year investment.

Thus a five-year average has credentials at least as good as another, and apparently

somewhat better than certain others.

We can use this measure of real interest rates to look at the equity market and its

equity risk premium. To do this we use a simple formula based upon the basic equity

valuation formula, reworked a little to exclude inflation:

Equity risk premium = dividend yield + real growth rate - real rate of interest

Growth is defined for this purpose as labor force growth of about 1% plus

productivity growth. We looked at productivity growth over different observation

periods ranging from one to ten years. In Chart 1 we show the valuation of the

equity market as calculated in the above formula using a moving average of

productivity of five years. That productivity number is now approximately 3.5%,

which produces a growth rate for corporate earnings of 4% to 5%, when labor force

growth is added. Remember that this analysis is in real terms, so adding inflation

would produce reported sustained earnings growth of 6% to 7%, or about in line

with nominal economic growthillustrated in Chart 1.

Chart 1. Equity Risk Premium Using 20 Quarter Productivity

Source: Federal Reserve, GR-NEAM Analytics

This work shows that equities were extraordinarily attractive in the late 1970s, which

in fact was followed by a 20-year rise. Likewise, they were extraordinarily unattractive

in 1987 just prior to the sharp decline in October 1987, and in early 2000, which

clearly also was accurate.

Stocks today look attractive on this measure. However, this is relative to the real rate

of interest available in the bond market, which may itself be unattractive.

Chart 2. Real Interest Rates

Source: GR-NEAM Analytics

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3Reflections, July 2004


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