3/2/21: Monetary Easing and Stock Market Valuation

There has been quite a puzzling development in recent years in the monetary policy universe. A decade plus of ultra low interest rates has been associated with rising, not falling, risk premium in investment markets. In other words, a dramatically lower cost of new and carried debt induced by lower interest rates - a driver for lower risk, is being offset by something else. What?

Laine, Olli-Matti paper "Monetary Policy and Stock Market Valuation" (September 18, 2020, Bank of Finland Research Discussion Paper No. 16/2020: https://ssrn.com/abstract=3764721) tries to explain. 

To start with, some theory - especially for my students in the Investment and Financial Systems courses. Per author, "the value of a stock is the present value of its expected future dividends... Hence, the changes in stock prices must be explained by 

• either changes in dividend expectations or 
• changes in discount rates. 

The discount rate, or (approximately) expected rate of return, can be thought as a sum of a risk-free rate and a risk premium. Theoretically, monetary policy should have an effect on stock prices through the risk-free rates. In addition, monetary policy should affect dividend expectations, for example, through the output or debt interest payments of firms. The effect on the risk premium (not to mention the term structure of risk premia), however, is less clear."

Looking at Eurostoxx50 index components, Laine shows "...that the average expected premium has increased considerably since the global financial crisis. This change is explained by the change in long-horizon expected premia. ... monetary policy easing has had a positive impact on the expected average premium."

Specifically (emphasis added): "a negative shock to the shadow rate is estimated to increase average expected premium persistently. Instead, the results show that monetary policy easing temporarily decreases short-term expected [risk] premia. This means that expansionary monetary policy steepens the slope of the term structure of risk premia."

This is not exactly new, as Bernanke and Kuttner (2005) observed that "expansionary monetary policy generates an immediate rise in equity prices followed by a period of lower-than-normal excess returns. ...However, Bernanke and Kuttner (2005) do not study the effect on the long-run excess returns. My results show that effect on long-horizon expected premia has a different sign. This effect on long-horizon premia seems to more than offset the effect on short-horizon premia."

Interestingly, "Contractionary monetary policy increases the short-term premia temporarily, but decreases long-horizon premia persistently. The effect on average expected premium is negative. Thus, monetary policy tightening actually makes stocks expensive relative to the expected stream of dividends. The results provide no evidence that expansionary monetary policy causes stock market bubbles..."

Here is (annotated by me) a chart showing evolution of implied and actual risk premia:

From theory perspective, therefore, monetary policy "can affect equity prices through the dividend expectations, expected risk-free rates or expected premia":

• "The effect of expansionary monetary policy on the dividend expectations is probably positive, because expansionary monetary policy can be expected to increase output and firms’ earnings.
• "Expansionary policy probably lowers the risk-free rates, but it is also possible that the effect is totally different. Central bank’s rate cut can increase risk-free rates, if people think that the rate cut eventually increases inflation. 
• "As for the expected premium, the sign of the effect is unclear. ... Gust and López-Salido (2014) show theoretically that expansionary monetary policy lowers the premium ... where asset and goods markets are segmented. When it comes to quantitative easing, ... investors who have sold their assets to the central bank rebalance their portfolios into riskier assets, which lowers their expected returns. ... Theoretically, it is also possible to argue that monetary policy easing actually increases the expected premium. If one assumes that there exists mispricing like Galí (2014) and Galí and Gambetti (2015), then the sign of the response is ambiguous. ... This means that monetary policy easing increases the expected premium implied by dividend discount model (see Galí and Gambetti, 2015, p. 250-252)."

So, onto the empirical results by Laine: 

1. "Interest rates have declined considerably since the global financial crisis, yet the expected average stock market return has remained quite stable at around 9 percent. This implies that expected average stock market premium has increased remarkably. This rise is mainly explained by the premia over a discounting horizon of four years.
2. "These results may seem unintuitive as the prices of stocks have risen, and ratios like price-to-earnings have been historically high. However, high price-to-earnings ratios do not necessarily mean that stocks are expensive, because the value of a stock is the present value of its expected future dividends.
3. "When it comes to the role of monetary policy, the results show that monetary policy easing decreases short-horizon required premia, but increases longer-horizon premia. 
4. "The effect on expected average premium is positive, i.e. expansionary monetary policy lowers the prices of stocks in relation to the expected dividend stream."

The price of uncertainty II: Anglo-Irish Bank shares

To continue with my last post's theme:

According to the latest annual results, Anglo-Irish Bank’s loan book carries construction and property sectors exposure of roughly 87% (details in Table 1 below). Given this, the bank is, in effect, a property investment play in the Irish, UK and US markets.
This implies that in the longer-term Anglo’s shares should follow market expectations concerning the ongoing property contraction in Ireland, US & UK. In other words, Anglo’s shares performance should reflect (with a possible lag to account for the differences in timing across the three markets) the fate of the specialty US real estate investors, e.g REITs.

The question is – does it?

Taking weekly closing data for the period of 2006-present for 6 REITs indices:
• SPDR DJ Wilshire REI,
• I-share DJ R EST INX,
• I-share FTSE NRT Residential ID,
• I-share FTSE NRT Industrial/office IDX,
• FTSE UK Industrial REIT and
• MSCI US REIT Index,
normalized at 100% for January 1, 2008, I obtain time-series for changes in weekly prices of these indices and the Anglo’s shares. I then construct Blend 1 & Blend 2 synthetic portfolia with specialty REITs weights in each portfolio reflective of the relative share of these types of properties in the Anglo’s portfolio: 18.4% Residential REIT indices, 77% Commercial REIT Indices and 4.6% I-Wilshire Index (Blend 1) and 4.6% I-Share Index (Blend 2).

Figure 1 compares changes in the valuations of these synthetic portoflia and Anglo-Irish Bank shares.
As shown above, US & UK REITs indices, blended to reflect actual Anglo-Irish Bank’s portfolio allocations of loans across various types of property have significantly outperformed Anglo’s shares since January 2008. While year-to-date decline in Anglo-Irish shares has been a dramatic 98.55%, the same period decline in US and UK REITs with exactly the same property markets and types exposure as Anglo’s was only 44.68%. Even at their lowest point (-63.9%), REITs performance was 54% better than that of the Anglo-Irish shares.

Using synthetic portfolio approach, REITs-based analysis predicts that the Anglo-Irish share prices should trade between €3.21 and €5.66 per share. Synthetic portfolio prices Anglo's shares at €3.75 at their global minimum in the first half of October, rising to €5.70 today.

However, the above does not account for the potential upward bias in Anglo-Irish Bank’s shares valuation prior to January 2008. In other words, we must address the argument that deep discounting in Bank’s shares reflects the fact that its peak valuations were more optimistic than the market average. To do this, I computed blended portfolia discounts from peak to January 1, 2008. Controlling for these, Figure 2 reconstructs the synthetic price share performance for Anglo-Irish Bank based on property markets fundamentals and accounting for the differences in timing in real estate contraction between the UK, US and Ireland.Thus, as shown in Figure 2, Anglo-Irish Bank shares have traded at a sector discount between late June and mid October 2008 and since the beginning of December 2008. Using full-sample simulation, Anglo-Irish shares are fundamentally valued at around €1.09 per share in the current market conditions as opposed to the actual share price of €0.15 today. Note the accuracy of the synthetic portfolio in tracking Anglo's shares since, roughly May 2008.

While the above exercise is not 100% accurate, it does suggest that the markets are currently discounting Anglo’s shares at a rate much greater (ca +13.7%) than warranted by the bank’s exposure to property markets.

There are two possible explanations for this excessive risk premium:
(1) the unexplained risk premium reflects lower quality lending by the bank than the average for REITs; and
(2) the unexplained risk premium accounts for the terms and conditions of re-capitalization scheme announced by the Irish Government.

While the first argument is impossible to assess, given the lack of data on Anglo-Irish Bank’s loans time structure, the second argument can be partially ‘priced’. The re-capitalization scheme will imply a dilution of existent shareholders’ equity to ca 20%. This suggests that the actual price target for the Anglo-Irish Bank shares should be around €0.22-0.25 per share. The associated regulatory risk-premium on the Anglo’s shares is, therefore, in the neighborhood of 69% of the share price.

No coincidence this estimate is so close to the 76% regulatory risk premium for the entire Irish Financials sector estimated in the preceding post…