Thursday, 24 October 2019

Balance between financial asset prices and real economic activity

All financial assets derive their value from real economic assets and activity. Time and again we have seen that financial asset prices run ahead of economic activity. Hope is built into human nature - tomorrow will be better than today. One fine example of human expectations is in the price to earnings ratios. We find that prices are running ahead of earnings by many multiples and sometimes these prices get wild and beyond reason. The problem here is that whenever there is a big price correction in financial assets, it paralyses the economic system. Credit which is the lifeline of the economy dries up and there is a panic everywhere. People on the 'Main Street' who are in no way connected to or invested in financial assets are impacted. What does a poor farmer or small business man in some corner of an emerging market have to do with the 30-year mortgage backed security devised by someone in Wall Street? Prof. Damodaran in his lectures states that with the advent of media and technology, there is increased volatility in stock prices. Any market correction or bad news spreads like wildfire and there is no escape. The amount of pain inflicted on the economy is proportional to the number of people invested in the asset in question. There are more people invested in real estate than in stocks, so if there is a price correction in real estate more people suffer than if there is a price correction in stocks.

In order to insulate the economic activity from asset price bubbles, regulatory authorities have identified systemically important organisations, introduced counter-cyclical and liquidity buffers for banks and financial institutions. The effectiveness of these measures will only be known when there is next systemic crisis. (last time the regulators fell short!) To be fair to the regulators, no one can ever predict a crisis on a consistent basis. Some people get lucky sometimes but at least in the longer run, it is not materially possible to predict asset price corrections or economic crises.

To alleviate the pain of asset price corrections on the people of the 'Main Street'  we can devise warning mechanisms. For every asset class, we have asset price multiples and these are available across time. So we can compare the loan to value ratios or debt service coverage ratios for real estate across time. Similarly, for stocks and bonds we can compare price earnings multiples across time. We can device such easy to understand measures for other asset classes as well. We need to calculate such numbers on a broad market basis and disseminate them to the market participants. These numbers can also be compared across asset classes.So if five out of ten asset classes are overheating, perhaps market participants can adjust their portfolios to avoid the risk of a correction.

Dr. Rajan in his book 'Fault lines' remarks that 'Self-interest is the purest form of human emotion'. That is so true -  we are true to ourselves when we act in our own interest. Nobody wants their asset prices to drop. So when all market participants are made aware of overheating on a more prominent basis it is possible to cut down the risk to some extent. Portfolio managers can re-balance their asset allocations. Banks and financial institutions can cut down on big-ticket loans to specific sectors which are over heating. Regulators can more closely look at pockets of economy that are heating up. Small businesses, farmers and families can accumulate additional savings.

We need a concerted (global) effort to maintain the balance between financial asset prices and real economic activity.

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