What are the ultimate drivers of asset prices? Perhaps no question in investment management is more basic or more disputed. But some rules are reliable, as they depend ultimately only on economic common sense. Five are proposed below, although they are best understood as broadly correct generalisations which need, in particular circumstances, to be interpreted with care. The first rule cannot really be disputed and the next four follow, more or less, as a matter of logic.
1. Nations cannot make themselves rich by printing more money.
This is simply an elaboration of the obvious statement, "there is no such thing as a free lunch". (Investment bank clients may sometimes think their lunches are free, but they are kidding themselves.) A crucial implication is that, however fast the money supply increases, it cannot make people better-off in the long run. The excess monetary expansion is dissipated in higher prices.
A fair generalisation is that, over periods of many decades, the growth of the money supply is related - although not identical - to the growth of nominal gross domestic product.
2. High inflation is associated with high money supply growth.
This is an extension of the first rule. As bonds have to offer a positive real return if they are to attract investors, high money supply growth is also associated with high bond yields. The crucial investment messages are, ‘if money supply growth is high and rising, sell bonds’ and, conversely, ‘if money supply growth is low and falling, buy bonds’.
A good illustration is provided by Britain in 1972 and 1973, when the annual rate of money supply growth soared into the mid-20s ahead of an appalling bear market in gilt-edged bonds (and other asset classes, including equities and commercial property) in 1974.
3. High money supply growth is likely when banks have ample capital and can easily expand their balance sheets by extending new credit.
This is because the money supply consists mostly of banks' deposit liabilities. Further, a well-capitalised and highly profitable (an under-capitalised and unprofitable) banking system is bad (good) for bond yields, because it will try to grow quickly (contract), which will add to (subtract from) both bank credit and the quantity of money.
Japan in the 1990s exemplifies the argument. The banks suffered severe loan losses as the bubble of the late 1980s unravelled in the early 1990s. The result was a crippled banking system, a decade of stagnant bank credit and low money supply growth, and a decline in inflation which eventually became a deflation. Bond yields collapsed to the lowest ever recorded in modern times, with the yield on ten-year government debt hovering a little above 1 per cent for a few years.
4. Although high money supply leads to more inflation in the long run, it may not do so in the short run for all sorts of reasons.
Two common reasons are that the economy has a big margin of spare capacity ahead of the monetary injection or that it enjoys heavy capital inflows which cause exchange rate appreciation.
In these cases high money growth may for several quarters be accompanied by low inflation, encouraging investors to believe that the economy has achieved some sort of ‘miracle’. The bubbles in the Asian stock markets in 1993 and in the USA's NASDAQ stocks in 1999 and early 2000 can be interpreted in these terms.
The rational investor has a difficult problem with bubbles like these. On the one hand, he knows that they must come to an end. (To repeat, there is no such thing as a free lunch.) On the other hand, an investment adviser who misses a big asset bubble may lose all his clients in the short run, while trying to prove to them that he is right in the long run. In monetary economics the short run and the long run are like Punch and Judy, and squabble with each other endlessly.
5. For any given rate of money supply growth, a large budget deficit is likely to do more damage to asset prices than a small budget deficit.
The reason is that the non-monetary financing of large budget deficits requires high short-term interest rates. High interest rates are unhelpful for medium- and long-dated bond yields, and so for other asset classes. The ideal conditions for a stock market boom are a falling budget deficit, low inflation, moderate but rising money supply growth, and a well-capitalised and profitable banking system. That is a fair description of the USA in the five years to 1999, which saw the biggest equity bull market in history. The most serious threat to a bull market of this kind is rising inflation, as indeed has been recorded in 2000 and 2001.