The year has begun well in markets. Stock markets in 2012 are generally up, and European sovereigns have experienced less difficulty borrowing than many expected. And economic data, particularly in the United States, has come in ahead of expectations. So as President Obama prepares to give his State of the Union address, and as a large group of policymakers and corporate chiefs come together in Davos this week, there is if not a sense of relief at least some diminution in the sense of high alarm that has gripped the global community for much of the last few years. Yet anxiety about the future remains a major driver of economic performance.
The news coming from financial markets is in important ways paradoxical. On the one hand, interest rates remain very low throughout the industrial world. While this is partially a result of very low expected inflation, the inflation-indexed bond market suggests that remarkably low levels of real interest rates will prevail for a long time. In the United States, for example, the yield on 10-year indexed bonds has fluctuated around -15 basis points. That is to say: On an inflation-adjusted basis, investors are paying the government to store their money for 10 years! In Britain, inflation-linked yields are negative going out 30 years.
One might expect that with low real interest rates, assets would sell at unusually high multiples to projected earnings. If anything, the opposite is the case, with the S&P 500 selling at only about 13 times earnings. Stocks also appear cheap to earnings in historical perspective through much of the industrial world. And similar patterns are observed with respect to most forms of real estate.
The combination of low real interest rates and low ratios of asset values to cash flows suggests as a matter of logic an abnormally high degree of fear about the future. This could reflect expectations that earnings or other cash flows will rise more slowly than anticipated, or simply result from a higher discount associated with future earnings because of abnormally high uncertainty.
This idea that future uncertainties are driving financial markets is supported by the observation that in the recent period there has been a much stronger tendency than normal for higher interest rates to be associated with a stronger stock market and vice versa. This is exactly what one would expect in an economic environment like the present one — on days when people become more optimistic, both interest rates and stock prices rise as the expectation is of more profits and demand for funds.