Bailout

Is the stock market pricing in U.S. fiscal tightening?

By Felix Salmon

Why are stocks yielding more than bonds? The expected 2011 earnings of U.S. stocks are more than 8% of their current price, while bonds yield much less than that. Rob Dugger has an interesting explanation: the market is looking at fiscal deficits as far as the eye can see, and trusts the US government to close the fiscal gap over the medium to long term. And doing so will inevitably mean hitting corporate profits:

The higher taxes and spending cuts needed to reach fiscal sustainability will echo throughout the economy in millions of ways. Companies that are dependent on the current structure of spending and taxes will be hurt. Their earnings and balance sheets will be weakened. In a sense, fiscal adjustment costs are off-balance sheet liabilities of every US company.

This might also help explain why companies have been so conservative about raising their debt issuance, even as the cost of debt has plunged: they don’t want to add to their on-balance-sheet liabilities even as their off-balance-sheet liabilities, in the form of fiscal adjustment costs, are rising sharply.

The book value of the stock market — the value of its assets minus the value of its liabilities — has, on this view, been declining steadily of late, as the size of America’s liabilities has steadily risen. This is why people lump Spain in with Greece: while Spain’s liabilities are largely in the private sector and Greece’s liabilities are largely in the public sector, ultimately it’s the economy as a whole which is responsible for them.

Of course, we have no idea whether or how future governments might seek to achieve fiscal balance by reducing corporate profitability. But that very uncertainty is something all investors hate: it’s impossible to price in, or to hedge against. Which is why bonds seem — are — so much safer, and yield so much less than stocks.

Full post as published by Macroprudential on August 23, 2010 (boomark / email).