"EconWeekly" - 5 new articles

More deep thoughts about macro models

Jérémie Cohen-Setton at Bruegel does a great job, as usual, rounding up recent blog posts on a specific topic. This time: a critique of modern macro. Can the models built during the Great Moderation explain what happened after the Great Recession?

I would say that "raising the profile" of the financial sector within macro models helps--but I don't know whether a Copernican revolution is necessary. But, ultimately, we will always (literally, always) have to live with model uncertainty. Noah Smith makes this point well.

Global financial stability: the IMF report

Financial stability has been a bubbling topic since 2008--although it never really stopped simmering since the emerging market crises of the 1990s. Over the past year or so, a dominant view seems to be forming that financial instability risks are rising, particularly among some emerging-market countries.

Here's a list of great articles or papers, and one oral presentation, on the topics of financial instability, financial crises, etc. I have perused recently:
Chapter 1 of the IMF's Global Financial Stability Report (pdf), published this week, warns of the main risks to global financial stability. Here's a summary of the report:

1. Financial stability risks have increased since October. Lower growth prospects and disinflation have prompted central banks to respond by loosening policy. The BoJ and the ECB are the most notorious examples, but other central banks have relaxed their monetary policy stances as well.

2. Emerging market financial stability risks have increased. Commodity price declines have hurt commodity exporters, while the corporate sector has increased its foreign currency indebtedness. Lower energy prices have impacted negatively firms in the energy sector.

3. The fall in nominal yields, and flattening of the yield curve, are a threat to the life insurance and pension fund sectors, especially in Europe.

4. Monetary policy divergence has lead to a sharp increase in volatility in foreign exchange markets amid the appreciation of the U.S. dollar. Term premia are narrow in all three main currencies (dollar, euro, and yen). Asset valuations remain elevated, in part because of persistently loose monetary policy. Market volatility in general has increased.

5. Quantitative easing can boost inflation and growth, but it also encourages greater financial risk taking, so monitoring and addressing financial excesses is necessary. Additional policy measures are necessary to enhance the effectiveness of monetary accommodation.

The report also has special boxes for two sub topics:

• The oil price fallout, explaining the channels through which the abrupt fall of oil prices could spawn financial vulnerabilities.
• Russia's financial risks and potential spillovers.

Here are a few charts from the report that caught my attention. Having a good legal system helps a country de-leverage. According to the chart below, an index of the strength of the legal system explains 45% of the cross-sectional dispersion of de-leveraging:

An increasing number of short- and long-term European government bonds have a negative yield:

QE in the eurozone and Japan could lead to significant portfolio outflows. Eurozone investors might allocate up to €1.3 trillion abroad by the end of 2015, a good chunk of which would go to the U.S. Insurance companies and pension funds in Japan could invest as much as \$559 billion, or 12.8% of GDP, in foreign assets by the end of 2017 (that's if announced policies are fully implemented and work to their fullest extent across the three reform arrows):

Non-performing loans and write-offs are frighteningly high in the eurozone and Japan:

European life insurers are in the unsustainable business of writing long-term policies without assets of a correspondingly long duration, which has resulted in negative duration gaps. Moreover, many policies contain high return guarantees, which are unsustainable in a low-interest-rate environment. Insurers in Sweden and Germany have the largest mismatches:

Despite the recent round of monetary policy easing in emerging markets, real rates are expected to rise in 2015 in almost all of them:

Debt of the non-financial (private and government) sector of emerging markets has increased dramatically since 2007:

A significant share of debt is owed by firms with poor interest-coverage ratios:

Global activity: mixed nowcasts

Fulcrum's nowcasting model shows that advanced economies have decelerated so far in 2015:

The slowdown is particularly persistent in the U.S., which is now estimated to be growing at 2% a year, half the pace of last fall:

China is growing at a fairly steady pace, and the eurozone's economy keeps picking up:

According to the Institute of International Finance's EM Coincident Indicator "EM GDP may have grown in 2015Q1 at its weakest pace since early 2009", or 1.8% q/q saar:

That's at odds, however, with the J.P. Morgan global composite output index, which picked up slightly from an average of 53.0 in Q4 (53.0) to 53.9 in Q1:

And, despite a plunge of the J.P. Morgan  U.S. composite in earlier months, output has rebounded of late:

And the HSBC emerging markets composite index looks fairly stable, not falling:

Guest post: Are Australian investors (relatively) conservative?

Naomi Fink, CEO and founder of Europacifica Consulting, is my guest today, writing about the risk preferences of Australian investors.

In one of the preliminary documents leading to Australia’s Financial System Inquiry, authors speculated that the abundance of overseas financing for Australia might owe to a gap in risk preferences between domestic and foreign investors (no supporting evidence or parameter calibration was cited).

Anecdotally, yet consistent with this viewpoint, many players within the domestic financial sector tout about the supposed conservatism of Australian domestic investors.  But is there empirical evidence of such conservatism?

Firstly, following the argument made in passing in the preliminary FSI documents, if divergent risk preferences were the best explanation for Australia’s chronic current account deficits, they would explain Australia’s investment income deficit (the largest component of Australia’s external deficit), given the sensitivity of investment rather than trade to relative risk preferences.

The argument implies, first, that foreign investors should be categorically more risk-tolerant than Australians, who pay higher premiums to compensate for the higher risk of capital they export than what they receive on their lower-risk investments overseas.

The second implication of the argument is less obvious.  Risk preferences in financial economic models are typically parametric rather than variable. Extending this logic, Australia’s investment income deficit is the result of more consistently conservative attitudes among domestic investors in comparison to consistently risk-tolerant overseas counterparts.  This may seem to be splitting hairs, but the distinction is non-trivial.

Risk premiums may wax and wane alongside risk perception, while risk preferences among rational investors are typically more consistent over time.  But if this were so, we would expect to see behavioral evidence of consistently greater risk-aversion among Australian investors than their overseas counterparts.

We took it upon ourselves to perform our own stylised version of the missing calibration; a comparison of risk preferences among OECD countries (using equity market participation, per Vissing-Jorgenson (1997), Guiso (2002), and Guiso et al. (2008)).

This basic examination of parametric measures of relative risk tolerance undermines the hypothesis that Australian investors are relatively risk-averse.

Our results, shown in the chart below, not only argue against the notion that Australia is more risk-averse than the rest of the world: they show that Australia is one of the most risk-loving players in the OECD.  In this light, it is highly doubtful that relative risk preferences somehow structurally rationalize Australia’s income deficit.

 Note: Arguments that Australia pays a higher premium on its debt because Australians are more risk-averse than the rest of the world fail to hold up to our calibration.Source: Europacifica, OECD

Forecasting long-term stock returns: the two-hour recipe (II)

Last week I started writing up a quick (?) methodology to forecast equity returns. Specifically, the question was
Forecast the real total return of U.S. equities over the next ten years. Show your work. Time: two hours.
I wrote down a decomposition of the total return into three components:

$$\frac{R_{t,t+k}}{(1+\widehat{\pi}_{t+1, t+k})^k} = \frac{V_{t+k}}{V_{t}} \frac{(1+g_F)^k} {(1+\widehat{\pi}_{t+1, t+k})^k} (1+\widehat{dy}_{t+1, t+k})^k$$

The three components are:

1) Income, which boils down to the geometric average of the dividend yield:
$$(1+\widehat{dy}_{t+1, t+k})^k$$
2) The 10-year change of a valuation ratio.
$$\frac{V_{t+k}}{V_{t}}$$
3) The real growth of the fundamental used in the construction of the valuation ratio.
$$\frac{(1+g_F)^k} {(1+\widehat{\pi}_{t+1, t+k})^k}$$
Since this is meant to be a quick estimation, I decided that I would use either the historical average or the ten-year rolling average of the relevant data to forecast each of the three components.

Pulling the Shiller long-term data set (xls) on stock prices, earnings, and dividends, I took the geometric average of the dividend yield between 2005 and 2014 as my forecast for the dividend yield over the next ten years: 2.0082%. So my forecast for $$\widehat{dy}_{t+1, t+10}$$ is 0.02.

For the valuation ratio, we can calculate two from the Shiller dataset. The first one is the CAPE ("cyclically-adjusted" P/E ratio, or "Shiller's P/E"). A casual observation of the time series chart since 1880 suggests that the CAPE either experienced a shift sometime after the 1980s, or is experiencing upward drift. Today's CAPE (27.9) is significantly higher than the historical average (16.6) or the ten-year rolling average (22.6). We'll take those two values as alternative forecasts of the CAPE ten years from now. The historical CAPE implies that the ratio of valuation metrics, $$V_{t+k} / V_{t}$$, is 0.595 (16.6 / 27.9). The ten-year rolling average CAPE implies a ratio of 0.81 (22.6 / 27.9).

The second valuation ratio we can compute from the Shiller dataset is the dividend yield (or rather, to fit the total return formula above, the price-to-dividend ratio):
Just like the CAPE, the price/dividend ratio seems to have experience either a shift or drift some time after the 1980s. Today's multiple (55.8) is close to the 10-year rolling average, but much higher than the historical average (27.9). As with the CAPE, we'll consider both to forecast the 10-year-ahead price/dividend ratio. Using the historical P/D, the ratio of valuation metrics, $$V_{t+k} / V_{t}$$, is  0.50 (27.9 / 55.8), whereas using the 10-year rolling average, the ratio is  0.93 (51.9 / 55.8).

Growth of the fundamental

The third component of the total return is the real growth rate of the fundamental:
$$\frac{(1+g_F)^k} {(1+\widehat{\pi}_{t+1, t+k})^k}$$
Which fundamental we use is determined by the valuation ratio we pick. For the CAPE, the fundamental is the 10-year rolling average of earnings. For the price-dividend ratio, the fundamental is dividends.

The real growth rate of (the 10y average) of earnings has been 1.66% per annum. The rolling 10-year counterpart fluctuates quite a bit (even though this is the rolling average growth rate of a rolling average of earnings), and is now at 3.5%.

For real dividends, the historical (10-year rolling average) growth rate is 1.34% (5.1%).

Putting everything together

I have proposed two forecasts for each of two possible valuation ratios and their corresponding fundamentals, for a total of four forecasts (the income component is the same for all four).  The following table combines the forecast components of real returns to produce the total return forecast:

$$V_{t+k} / V_{t}$$ $$g_F$$ $$(1+g_F)^k / (1+\pi)^k$$ $$dy$$ $$(1+dy)^k$$ $$R_{t,t+10} / (1+\pi)^k$$  Annual real return
CAPE (historical avg.)
0.595
0.0166
1.179
0.02
1.219
0.855
-1.55%
CAPE (10y rolling avg.)
0.81
0.035
1.411
0.02
1.219
1.393
3.37%
Dividend yield (historical avg.)
0.50
0.0134
1.142
0.02
1.219
0.696
-3.56%
Dividend yield (10y rolling avg.)
0.93
0.051
1.644
0.02
1.219
1.864
6.43%

The last column shows that the forecast real return, per year, varies from -3.6% to 6.4%.