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One of the great economic mysteries of 2020 is why common stocks performed so well. The conventional answer: Chalk it up to the Federal Reserve. It set its short-term rates near zero. It coupled this with extensive asset purchases. This buoys up the stock market. Others argue that irrationally exuberant investors are creating a classic asset bubble.
However, be aware of a third possibility: The worldwide supply of savings continues to expand despite, or perhaps because of, the COVID pandemic. Rising middle-class populations in the developing world have a high propensity to save. Increasingly fluid and sophisticated financial markets allow savers to seek out returns anywhere on the planet. A number of recent studies by scholars have documented a long-term decline in real interest rates consistent with this proposition.
To see how this matters, let’s go back to some basic economics. A perpetuity is a promise to pay a fixed dollar amount every year forever. A little math shows that a perpetuity is worth its annual payout (P), divided by its discount rate (r); or P/r, where r is expressed as a decimal.
Of course, the appropriate discount rate (r) depends on the creditworthiness of the issuer of the perpetuity. Nevertheless, we’d expect this discount rate to move in tandem with real interest rates. If the U.S. government were to issue a perpetuity with an annual payment of $10,000 and its discount rate is 4%, the perpetuity would sell for $250,000. If that discount rate were to fall to 2% by virtue of an above-mentioned decline in real interest rates, the perpetuity’s value doubles to $500,000.
Of course, common stocks are not exactly perpetuities. They offer no guarantee of future income and are inherently riskier than government bonds. They nevertheless have the prospect of generating a stream of future dividends that can rise over time and persist for decades or even centuries. Their values will respond to underlying changes in real interest rates in a fashion similar to perpetuities. And this could explain persistently high stock prices in absolute terms and relative to company earnings.
That said, don’t take this observation as a recommendation to buy into the market. We are still baffled why stocks are doing so well, and we continue to suspect Fed action is inflating all asset prices. Yet a long-term decline in real interest rates fueled by increased savings is good news for common stockholders.•
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Bohanon and Curott are professors of economics at Ball State University. Send comments to ibjedit@ibj.com.
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Add to that, the continued increase in corporate profits relative to wages. I wonder if you might explore the reasons this phenomenon in one of your future posts.