Vikrant Sitani's  Instablog

Martin Feldstein in a recent WSJ Op-ed has written about Fed's QE program. There is a popular notion that there is a direct correlation between QE program and the Stock Market. Increase in QE causes the markets to go up and any signs of stopping or reducing the Fed's QE cause the market to drop.

The Japanese Nikkei is up 50% in the past 4 months ever since the Bank of Japan indicated that it will have their own version of QE. This kind of correlation leads to incorrect conclusion that QE and Stock market growth has 1 to 1 correlation between them. Yen Dollar exchange rate in the past 4 years has gone from 100 Yen to 1 Dollar to 80 Yen to 1 Dollar and now currently back to 100 Yen to 1 Dollar. The financial media has two different versions for the effects of QE. One is that there is a flow of money from outside Japan into Equities therefore the stock market is up. Now what happens to the cash generated by sales by domestic investors is not mentioned. The other effect is on the foreign exchange market, the start of carry trade by Japanese investors is mentioned in the press as cause of drop in exchange rates. The flow of money from Institutions investors from outside Japan in Japanese stock market is excluded in the Yen devaluation against dollar.

Martin in his article has mentioned that Earnings of companies have grown by about 50% since the recession peaked and the PE ratio of stocks has dropped from 21 to 17. The drop in PE ratio is a sign of reduced demand from investors. Increase in QE probably does not encourage investors to dump bonds and buy equities. Had this be true the PE ratio would have increased. Ultimately over longer period what really matters for share prices is underling cash flows represented by earnings. Some of the popular stories mentioned in the press are just stories. It probably drives some investors, to ride into market, which causes momentum and momentum is a very popular driver of the market. It is okay to be part of momentum, but when to get out of the wave is quite tricky and investors should take note of that.

Before you answer this question, take a moment to think how much you save and think what others might be saving. The Bureau of economic analysis publishes every month the estimated Personal Savings rate. The latest number was 2.7%¹. This number has fluctuated in the past few years from 2%-6%. Often this number is quoted in various media publications. If the number increases, media suggest that consumers have become cautious and are not spending or saving more for future.

I think this Personal Saving Rate does not really say what consumers are saving. This number includes the savings by the ultra rich and people who take debt either for college education or medical expenses or any other consumption expenditures. Borrowing for buying a house is excluded as money is not actually spent for consumption, but more for investment. By having an average, it is quite difficult to use this number to determine the consumer's financial health. Knowing consumer's financial health helps investors in predicting the Bank's earnings or designing financial products for consumers.

One data that may help in answering the above question is the survey done by Gallup poll² on US workers. This survey asks the working population how many months they can survive without incurring significant financial hardship if they were to lose jobs today. About 16% said they can survive only for one week, 27% said they can survive up to 1 month, 28% said they can survive up to 4 months and 17% said they can survive up to 1 year and only 11% said they can survive for more than 1 year. There can be sampling error, in any survey or how the question is framed. There can also be issue with what does "Saving" really mean. But to person responding to the survey on how many months they can be survive without a job, it probably means how much liquid cash he has in his bank account to get by. Some people may interpret the data little bit differently. The data does give some insight into wide variation on how people save. About half the population has negligible accumulated savings and 10% of the working population does have a high accumulated savings.

I think financial press gives too much weight to the Personal Savings Rate issued by Bureau of Economic Analysis. People's saving habits vary widely across the spectrum and no one number does justice to how much people do really save. Banks, if they are able to group the people based on savings habit, may have a better credit risk profile on their balance sheet.

Notes

1. http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm

2. http://www.gallup.com/poll/162176/workers-predicting-job-loss-pre-2008.aspx?utm_source=alert&utm_medium=email&utm_campaign=syndication&utm_content=morelink&utm_term=All%20Gallup%20Headlines

Borrowing cost for any borrower in Foreign Currency market is a function of Risk Free (RF) Rate + Spread. For example for any borrowing denominated in US dollars, Interest rate on US Treasury is presumed to be Risk Free (RF). The spread includes the risk of default by borrower's country and its default risk, liquidity risk, collateral etc..

For the past three years ever since the publication of paper by Reinhart and Rogoff (RR) (see link below) the magic number for increase in credit spread for any country is when the country's Debt to GDP approaches 90%. As countries borrow more either during recession or for populist measures, interest rate paid by that country increases as its Debt to GDP approaches 90%. In summary RR stated that country's GDP growth rate becomes negative. Ever since the publication of this research there is constant focus by different countries and Governments to try to reduce the Debt either by higher taxes and or austerity. Even for advanced countries like US, Japan, UK and Europe, there has been constant debate about how to reduce the debt as there is a perception that higher debt levels may affect the interest rates and GDP's growth rate. The decomposition of long term interest rates for these countries is quite complex and is covered in different blog. RR's paper has been discussed at length at virtually all the important Government and Private forums. It has affected the credit spreads of countries, whose Debt to GDP keeps growing. These countries are perceived to be risky and this perception is reflected in its credit spread.

Now in a paper just published by Thomas Herndon, Michael Ash and Robert Pollin, the authors point that calculations done by RR had an error and growth was actually 2.2% and average GDP growth at public debt/GDP ratios over 90% is not dramatically different than what debt/GDP ratios are lower.

The authors are not well known as Rogoff, who was the chief economist at IMF and a professor at Harvard University. Therefore it may take some time for the paper to gain traction. If this paper gains traction, it could affect how people view the Debt to GDP ratio and this could affect not only the various debates about austerity agenda in both Europe and the US but also the interest rates paid by borrowers in foreign currency. The countries with high Debt to GDP ratio may not be perceived as risky as they are currently perceived to be. It will be interesting to see debate over the next few months on this topic and the movement in spreads.

http://www.peri.umass.edu/236/hash/31e2ff374b6377b2ddec04deaa6388b1/publication/566/

www.nber.org/papers/w15639