Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

The Federal Reserve wrapped up its latest Federal Open Market Committee meeting today  and announced that it’s throwing a lifeline to investors -- yet again -- by holding the federal funds rate steady (at least for now).  

That will leave Fed-obsessed investors staring anxiously into their computer screens for any future updates, an unhappy situation because the only predictable thing about the Fed lately is that it's unpredictable.

The market has been notably reluctant to accept the Fed’s efforts to lift rates but clearly the Fed can’t be accommodating forever. Eventually cheap money will cause inflation to spike (and heaven help us if it doesn’t). On the other hand, higher interest rates are likely to take a bite out of asset prices, which does no favors for the real economy.  

Some observers have encouraged the Fed to rip off the band aid. Bill Gross told my Bloomberg News colleagues recently that he wants an aggressive series of hikes: “C’mon let’s raise interest rates by 25 basis points in September and, c’mon, six to nine months from now let’s do it again.” Bloomberg View’s Editorial Board argued this week that low interest rates have “artificially boosted financial-asset prices and distorted normal patterns of risk-taking in financial markets.”

So how did the market’s fortunes come to be so dependent on the Fed? There's a three-word answer: equity risk premium.  

The “equity risk premium” is a simple concept that goes like this: I can leave my money in my bank account or I can invest it in the stock market. My money is safe at the bank, but all bets are off in the stock market. Ergo, because stocks are riskier, I will only put my money in the market if I can expect stocks to pay more than what my bank is offering (in technical jargon, a "risk premium").  

Fortunately the equity risk premium is easy to calculate. You take the earnings yield on stocks -- which is an often-used approximation for expected stock returns -- and subtract the yield on cash. For earnings yield, I use the inverse of the cyclically adjusted price-to-earnings ratio (CAPE), and the federal funds rate is a good proxy for the cash yield.   

According to the CAPE calculated by Nobel laureate Robert Shiller, the earnings yield is currently 3.8 percent. The federal funds rate is currently 0.4 percent. That leaves an equity risk premium of 3.4 percent.

Not too shabby in this starved-for-return environment, right?

Not so fast. The equity risk premium is more worrisome when you look closer. For one thing, the actual risk premium – the difference between what the S&P 500 Index and one-month treasuries have historically returned to investors – has been 6.5 percent annually since 1926 (the longest period for which data is available). By comparison, today’s equity risk premium of 3.4 percent doesn’t seem so great.

Settle for Less
The equity risk premium has steadily declined since the Fed dropped the federal funds rate to the floor.
Sources: Federal Reserve, Homepage of Robert Shiller
Methodology: The equity risk premium is the inverse of cyclically-adjusted P/E ratio minus the federal funds rate.

When the Fed eventually raises rates, investors will either have to accept an ever-smaller equity risk premium or stock prices will have to decline. Neither one is particularly appealing, but there it is.

And it's not just stocks. Investors face the same conundrum with other assets. For example, the FTSE NAREIT Equity REITs Index -- an index of real estate investment trusts -- currently yields 3.7 percent, which translates into a risk premium of 3.3 percent. But the REITs Index has historically delivered a risk premium over one-month treasuries of 7.3 percent annually to investors from January 1972 to August 2016. 

Risk On
Risk assets such as stocks and REITs have enjoyed a good run in the era of loose money.
Source: Bloomberg

As with stocks, the market is currently pricing a risk premium on REITs that is half the risk premium investors actually received for investing in REITs historically. Here too, either the current risk premium will shrink further when the Fed raises rates or REIT prices will take a tumble.  It will be one or the other.

Investors have leaned on loose money for years to justify paying ever-higher prices for stocks and real estate and a host of other assets. That can’t be easily undone. But it’s time for both investors and the Fed to be honest with themselves: The next chapter in this historic monetary policy experiment won’t be pretty for most asset classes.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nir Kaissar in Washington at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Timothy L. O'Brien at tobrien46@bloomberg.net