The New Normal and the New Neutral

The “New Normal” is a phrase coined a few years ago by the Pacific Investment Management Company (PIMCO), or at least that’s what they claim. It referred to a lengthy period of slow economic growth that they expected to persist as people recovered from the financial crisis. In view of the very modest economic growth that has occurred over the past five years (since the recession formally ended in 2009), the PIMCO forecast has worked out pretty well. Of course, my colleagues at the CLU Center for Economic Research and Forecasting (CERF) also have consistently projected modest economic growth over this period, and have been at least as accurate as PIMCO. But, we didn’t attach a clever moniker to our scenario.

Now PIMCO is extending the new normal idea into a view on Federal Reserve policy and asset prices that they call the “New Neutral.” The argument basically is that in a world of modest economic growth, we should expect low real interest rates and elevated asset prices. In particular, PIMCO argues that the real short-term interest rate ought to be around zero, so that the neutral Federal Funds rate should be around 2%, quite a bit lower than the 4% level commonly associated with the Taylor Rule (the Taylor Rule says that the target federal funds rate should be equal to target inflation (2%) plus the short-term real rate (2%) plus premiums if either inflation is running above target or the economy is running above potential). They acknowledge that longer term yields should include a term premium, so their “new neutral” long-term real rates are 1-2%. The implication is that, for example, the 10-year Treasury yield should be in the range 2.5-4.0% over the next several years. This is below the consensus forecast for bond yields.

PIMCO uses the dividend discount model (DDM) to translate assumptions about real rates into projections for asset prices. The DDM says that fair value for equities is equal to the stream of projected future dividends discounted by the required return on equity, which is the sum of expected inflation, the long-term real interest rate and the equity risk premium. Since the real rate of interest is one component of the required return on equity, the effect of a lower real rate is a higher fair value for equities.

On the assumption that the future growth rate of dividends is constant, the DDM reduces to the Gordon Model which says that fair value equals next year’s dividend divided by the difference between the required return on equity and the dividend growth rate. In symbols

Fair Value = Dividend/(R-G)

Where R is the required return on equity and G is the growth rate of dividends (in the aggregate, this is similar to the rate of overall economic growth). Historically, R has been about 10% and G about 5%, so Fair Value for equities has been roughly 20 times next year’s dividend (1 divided by (.10-.05) is 20). PIMCO’s estimates for both R and G are much lower, about 5.5% for R and 3% for G. This implies a Fair Value of 40 times next year’s dividend (1/(.055-.03) is 40).

Let’s apply this model to the S&P500 index, which at current equity prices has a total market value of approximately $20 trillion (i.e., the sum of the market values of the 500 stocks in the index). Consensus estimates for next year’s total dividends on S&P500 stocks is about $50 billion. Based on historical equity returns and growth rates, the S&P index should be trading around 20*$50B=$10 trillion. Based on PIMCO’s assumptions, fair value is more like 40*$50B=$20 trillion. This is very close to the observed market value. Thus, on the PIMCO assumptions the current level of stock prices is fully justified; there is no equity bubble.

The Gordon Model can also be used to estimate future equity returns. Just replace Fair Value by the observed market value and rearrange the equation

Expected Return = Dividend/Market Value + G
= $50B/$20T + 3% = 5.5%

This is significantly below the historical equity return of close to 10% per year. Thus, while equity prices are not massively over-valued, the prospective return from equity investment is modest.

Components of R and G

The new normal and new neutral stories imply declines in both the equity return (R) and economic growth (G). In order for asset valuations to increase, it must be the case that the decline in R is greater than the decline in G. The components of equity return are expected inflation, the long-term real rate of interest and the equity risk premium. The historical equity return of 10% was comprised, roughly, of 3% inflation plus 2% real rate of interest plus 5% equity risk premium. The projected equity return of 5.5% is comprised, roughly, of 2% inflation plus 1% real rate of interest plus 2.5% equity risk premium.

The components of economic growth are inflation and real growth. When you take the difference between R and G, the inflation term drops out and we get R-G=Real rate of interest plus equity risk premium minus real rate of economic growth. The new normal says that economic growth is 1-2% below the historical norm, and the new neutral says that the real rate of interest is 1-2% below the historical norm. These effects net to zero. The real driving force in the PIMCO story is the assumption that the equity risk premium has declined substantially (from 5% to 2.5%).

Why would this be? Perhaps peoples’ degree of risk aversion has declined due in part to the current and prospective extremely low rates of interest. That is, people are willing to invest in stocks at lower returns simply because the alternatives are so bad. Or, maybe the new normal model, while accurate for the past several years, will soon cease to exist. If the rate of real economic growth should soon revert back to historical levels, then current stock prices are consistent with a much more modest decline in the equity risk premium. Finally, a third possibility is simply that stock prices are way too high today. These three explanations have very different implications for the future direction of equity prices.

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