By James H. Nolt
Stocks (equity) and bonds (debt) are the two major long-term financial assets that investors typically hold. It is common knowledge among investors that the prices of these assets, on average, tend to vary in opposite directions. There are two recurring exceptions to this normal trade-off: Boom and bust “culminating points” (as Keynes called them) are periods when stock and bond prices are broadly correlated rather than moving in opposite directions. During a general financial crisis both stocks and bonds may fall in value, wiping out considerable fortunes. As I argued in my last blog, there are recent indications that both may fall during the coming months—that is, we may be primed for a more general financial crisis sooner rather than later.
The easiest way to grasp the stock-bond trade-off is to consider them as two alternative or substitute assets purchased out of the same pool of investable funds. If investors wish to sell stocks because of concerns about falling corporate earnings or rising bankruptcy risk, they ordinarily switch their funds into bonds. On the other hand, if bond prices are likely to fall because of rising fears of inflation or excessive debt in relation to the income of borrowers (the issuers of bonds), thereby increasing the default risk, investors tend to sell bonds and buy stocks. Of course, by the laws of supply and demand, increased selling pressure tends to lower prices and increased buying pressure tends to increase prices. Consider it this way: If many want to sell and few want to buy at existing prices, then prices must fall until more potential buyers believe the asset is now a good buy at the discounted price.
During a bullish boom, most capitalists are optimistic about the future, so many expand credit in the expectation that most uses of credit will earn profit. This creates a self-fulfilling prophecy, at least for some time, because credit expands faster than real output. New net credit increases purchasing power, whether for real goods or investment assets like stocks and bonds. The pool of investable funds is thus expanding as credit expands. With more funds available for purchasing goods and assets, prices tend to rise. Rising asset prices fulfill the prophecy, justifying with capital gains the credit used to purchase them. Credit expansion occurs in diverse forms, including bank loans, lines of credit (including consumer credit cards), issuance of bills, increasing accounts payable (sellers give their customers more time to pay), and new bond issuance (bond IPOs). As a boom takes off, stock and bond prices may both rise, reflecting the spending power of this exuberant expansion of credit.
However, the correlation of stock and bond prices begins to break down as the boom evolves into a normal expansion. With so many capitalists anticipating growth, many new projects are initiated, expanding infrastructure and factory capacity. These new projects are financed three ways: 1) stock IPOs, 2) bond IPOs, and 3) investors (including firms themselves) selling some of their existing financial securities (stocks and bonds) to create equity in companies that are using that new equity to buy new productive machines and equipment, expanding employment and output capacity. The first two methods increase the supply of financial assets while the diversion of investable funds to owners’ equity reduces the demand for securities. If these trends are not counteracted by new credit expanding fast enough, this increasing supply of securities and decreasing demand leads to their prices declining, or their rise slowing.
Thus, as the boom matures, asset inflation tends to be superseded by price inflation of real goods as demand for adding capacity pushes up prices of machinery and equipment, along with wages. Rising wages and employment also tend to increase consumer prices until new output can catch up with expanded demand.
During most expansions, bond prices tend to soften before stock prices. This represents the trend of investors rushing into shares of real assets (either stocks or owners’ equity in productive firms) to profit from real output growth. The falling value of bonds is the inverse of the rising interest rate, or the yield on bonds. The rapid expansion of debt (which is credit viewed from the other side of the contract) tends to make investors more wary of owning debt assets relative to the soaring value of equity. Product price inflation also tends to weaken investor interest in bonds. The typical stock-bond inverse price relationship thus appears. The 1920s were a classic equity boom (and debt bubble) of this kind, also coming at a time when debt securities were abundant because of vast quantities of government bonds issued to finance World War I, plus new corporate bonds issued to finance booming corporations in new industries like automobiles and electronics.
Many expansions continue for years, punctuated by fluctuations reflecting alternating shivers in the context of broad bullishness. Most peter out within a decade or so. The irony that kills every expansion is that the accumulation of debt and perhaps growing inflation means that debt assets become less attractive stores of wealth at the same time that continued expansion requires an ever-increasing expansion of credit. But credit cannot continue to expand if potential creditors expect falling bond prices. They demand higher and higher interest to hold debt rather than equity assets. Rising interest rates mean that indebted firms and real estate investors must pay more and more to roll over their debts, leaving them less capital to spend on real investment in factories, productive equipment, and construction. Demand for new output starts to sag. Demand for investment tends to be more volatile than consumer spending, since consumers are more oblivious than capitalists about economic trends. When capitalists see slowing growth, there is less need to invest in expanded productive capacity. Meanwhile, as long as they have jobs, consumers just keep spending as usual.
Now comes the most controversial part of my story. I first had this idea during my PhD dissertation research when I stumbled on the dynamics of the Japanese financial crisis of 1927. During my decades of reading and research since, I have found the pattern I saw then to be rather common.
Major creditors, by definition, hold most of their wealth in the form of debt assets, including bonds, bills, and loans. Yet as creditors they reserve the power to lend or not. On the one hand, they profit by the interest they earn issuing credit. On the other hand, if they issue so much credit that inflation begins to erode the value of their assets (nearly all debt assets are denominated in a fixed currency value), they can choose to curtail credit, forcing prices down, which is to say, making currency more valuable and therefore making their entire debt portfolio more valuable, too, in relation to the goods and assets it can purchase.
Textbook economics claims to be a science of choice. But it focuses first and foremost on consumer choice, as if the inertial behavior of consumers drives the system. In fact, the most strategic choices in a capitalist system are those of major creditors, often big banks, to extend or withdraw credit. This highly centralized strategic choice is ignored in textbook economics and finance by the absurd assumptions of perfect and efficient markets, meaning that no buyers or sellers of anything are big enough or organized enough to act strategically to influence prices. I will explore this more next week as we delve deeper into the anatomy of a market crash.
James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.
[Photo courtesy of Banco Carregosa]