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The current scenario suggests the start of a monetary policy easing cycle, prompting questions about the potential decrease in interest rates and its implications for economies. However, the focus should be on longer-term perspectives, particularly on three key questions. First, have real interest rates finally begun an upward trend after a prolonged decline to historically low levels? Second, has the stock market valuation stopped reverting to the mean, especially in the US where mean-reversion was common? Third, could the answer to the first question impact the answer to the second?
One crucial piece of data to assess the first question is the direct estimate of real interest rates for the UK provided by 10-year index-linked gilts spanning almost 40 years. A similar source of information for the US is the US Treasury inflation-protected securities starting from 2003. The comparison between the two indicates a divergence since 2013, with UK real rates significantly lower than US rates, likely due to UK pension plan regulations.
The decline in real interest rates over the years, coupled with sharp drops during the financial crisis and the pandemic, can be attributed to global factors such as China’s substantial excess savings. Despite a recent increase, real rates remain relatively low, indicating potential for further rises. Factors like fiscal challenges, energy transition investments, demographic shifts, and geopolitical tensions may influence future rate movements. However, uncertainties in economic growth and inflation levels make it challenging to predict real interest rate trends accurately.
As for equity prices, the impact of rising real interest rates has been minimal so far, with US stock market valuations near record highs. The narrow margin between real interest rates and earnings yields suggests limited potential for significant returns from US stocks. Investors seem to rely heavily on optimistic earnings growth forecasts, particularly in tech sectors, to justify current valuations.
The divergence in global markets reflects contrasting views on the sustainability of high valuations, indicating a belief in exceptional profitability in the US versus expectations of market corrections elsewhere. The essence of the current market sentiment lies in the belief that traditional valuation metrics may not apply in a rapidly evolving economic landscape.
While real interest rates might seem insignificant now, the possibility of surging inflation could alter the investment landscape dramatically. In essence, the balance between economic indicators and market sentiments will shape future investment strategies, making it crucial to monitor evolving trends closely.
martin.wolf@ft.com
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