It might not feel like it, but equities have done unusually well in recent years. Since 2010 total returns on the All-Share index have averaged almost 10 per cent per year. This means the gap between returns on equities and on cash has been twice its long-run average, which has been 4.4 percentage points since 1900.
In part, this is simply because we’ve not had a recession in this time, and it is these that usually are terrible for shares.
But it might be because of something else. The fact that returns have been so good during a time of only moderate economic growth suggests that investors might have bought equities not because of a rational assessment of their prospective returns, but simply out of desperation for some sort of return that cash cannot offer. They have, in the jargon, 'reached for yield'. This might have pushed share prices up by more than can be justified by fundamental economic conditions. If so, then there’ll come a point when higher interest rates will force down share prices as investors return to cash: the US Federal Reserve is likely to move us nearer to this point as it may well raise rates next week.
This poses the question: what evidence do we have that a reach for yield has actually happened?
Yes, the ratio of share prices to the money stock in developed economies is unusually high now. In itself, though, this is not proof that investors have reached for yield. It could be instead that they have reasonably judged that prolonged low interest rates will contribute to a long upturn in economic activity and profits. What the expansion lacks in strength it makes up for in longevity. If so, highish share prices are sustainable.
Instead, evidence that there might have been a reach for yield comes from other sources. One is a new study of individual investors in peer-to-peer lending markets by Yongqiang Chu at the University of South Carolina and Xiaoying Deng at Shanghai University. They’ve found that low US interest rates have led investors to make riskier loans with higher default rates. “Lower Fed funds rates encourage individual risk-taking and reaching for yield,” they conclude.
Also, we have experimental evidence. Economists at Harvard University and the Massachusetts Institute of Technology asked subjects to choose between a safe asset and one offering higher average returns but with risk. They found that when they cut rates on the safe asset subjects switched into the riskier one even though the risk premium didn’t change. This is clear evidence of a reach for yield.
A new study, however, questions this. Maren Baars and colleagues at the University of Muenster repeated those experiments. They found that when they cut the safe interest rate from 3 to 1 per cent with a given risk premium (so that expected returns on the risky asset also fell) subjects did not change their asset allocation. They only switched towards the risky asset when interest rates were cut to below zero. Reaching for yield, then, only happens when interest rates are negative.
Perhaps these two studies are not as contradictory as they seem. What matters are investors' reference points. It is only when returns on cash fall below what investors consider reasonable that they reach for yield. In the Harvard experiment, this reference point was somewhere between 1 and 5 per cent, the two returns on the safe asset. In the Muenster experiments, it was zero.
In the eurozone and Japan, this difference might not matter much; interest rates there are negative, although they are not likely to rise for some time so the danger of an unwinding of any reach for yield is not an immediate one.
In the UK and US, however, this inconclusive evidence at least serves as a warning that there might have been a reach for yield, and that higher rates might therefore at some point trigger a fall in shares as investors reverse it. This is one reason why both the Federal Reserve and Bank of England have been saying for months that any rises in rates will be small and slow. They know that a reverse reach for yield is at least a danger.
