Schwab just finished a wide ranging discussion with former chairman of the Federal Reserve, Ben Bernanke. Chair Bernanke offered a number of great insights, which we summarize below:
Bernanke on Lehman – it could not have been saved. We simply did not have the tools.
Bernanke on Fed Communication– it’s good for investors and Congress who disagree with the Fed to see that there is a diverse set of opinions within the Fed. If you are trying to ascertain the direction of future interest rates, it’s best to simply follow the communication of the Chair, Vice-Chair, and President of the NY Fed.
Bernanke on whether the Fed responds to the stock market: the Fed doesn’t necessarily respond to changes in the stock market, but often the stock market and the Fed are responding to the same phenomenon. For example, in August 2015, equity markets dropped after the Chinese yuan devaluation. The Fed also delayed its interest rate hike, but it was due to concerns as to what was going on in China. The stock market and the Fed were both reacting to China.
Bernanke on the new administration and recent stock price increases: “would advocate a bit of caution.” The stock market is already anticipating big tax cuts and infrastructure spending, but whether or not we’ve overshot is another matter. The policy proposals start with repeal of Obamacare, where you are seeing some disagreement in Congress. The repeal of Obamacare must occur before even getting to tax reform. Believe there will ultimately be tax cuts, but elements of the tax reform package look unlikely, such as the border adjustment tax. Skeptical that an infrastructure bill can pass since Republicans will be anxious to expand budget deficits.
Bernanke on stock valuations: we are not in a 1999, 2007 type situation, but we are in a low return world. When we have low returns, prices are going to be high. P/E ratios will be high when interest rates are low. For example, in a 10% interest rate environment, you may pay $10 for a $1 dividend stream. But in a 5% interest rate world, you would pay $20 for that $1 dividend stream. Looking forward, it is rational to think returns will be low.
Bernanke on the current risks: 1) inflation rises faster than expected and 2) politics. Marine le Pen taking France out of the EU would be very significant. Broad based tariffs in the US would be disruptive.
Bernanke on fiscal stimulus: we could have used some before, but in 2013, we actually had the opposite with tax increases and budget cuts, which hurt the economy. But now, there is less of a need for fiscal spending in order to put people back to work. It may be harder to get controversial things done with 52-48 in Senate vs. what people currently believe.
Our Take: the most interesting comments in our view centered around current stock price valuations and the current policy agenda. It is very interesting to note that Bernanke believes that current stock valuations are justified (supported) by low interest rates, which begs the obvious question – what happens to stock valuations when interest rates rise? If the Fed raises rates 4x this year, shouldn’t stock valuations compress according to this logic?
The second comment which we found interesting was around Bernanke’s cautious view on whether or not Trump’s policy proposals could actually pass. Bernanke pointed out that the stock market is already expecting a number of fiscal policy proposals to pass, but he is expressing skepticism on the border tax as well as infrastructure spending. He points out that the 52-48 Republican margin in the Senate is going to make it harder to pass controversial items relative to what most people currently believe. We have also expressed concern on whether or not the border adjustment tax can pass and have also pointed out that the timeline for approval may take longer than expected.
So putting it all together – what happens to stock prices if interest rates go up at the same time that Trump policy proposals take longer than expected to come to fruition (if at all)? Stay tuned.
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