Fourth, and perhaps most important, the long-term downtrend in nominal and real interest rates was maintained during the decade. Many investors attribute this powerful trend to the actions of the central banks, and they certainly did their best to depress rates by buying unprecedented amounts of government debt in successive doses of quantitative easing.
But the deeper cause of lower rates was the continuing drop in r-star, the equilibrium real interest rate in the global economy.
This rate, which is conceptually that which allows the central bank to hit its inflation target when unemployment is at its sustainable rate, has been falling since the 1980s, and it has dropped by about 2 percentage points since the financial crash.
Central banks were forced by what former US Treasury secretary Lawrence Summers called “secular stagnation” to cut their policy rates by at least that amount in real terms to leave the policy stance unchanged, and this was eventually reflected in long-term bond yields.
The decline in interest rates across the yield curve reduced discount rates on all income earning assets, boosting the fundamental value of assets such as equities and real estate.
Those assets with the longest duration, such as equities in the massive US technology sector, benefited the most. This is because those assets are expected to generate most of their revenues in future years, rather than today, and, in consequence, investors who buy the shares today are sacrificing more immediate returns in anticipation.
If interest rates rise, this increases the immediate returns available to investors from holding cash or government bonds, and so reduces the attractiveness of returns that may be earned from assets in the future.
These macro factors comfortably explain why the past decade has been so rewarding for asset holders.
Pandemic puzzle
However, they do not explain what has happened in the last two years of this period, that is, the years of the pandemic.
Since the end of 2019, the rise in equity prices has skyrocketed, while the fundamentals have been unimpressive. The S&P 500 has risen at an annual rate of 21 per cent, while dividends have grown at only 1.8 per cent, and bond yields have dropped only fractionally.
This supercharged surge so late in the bull market, though extremely rewarding to those investors who have remained exposed to it, is hard to explain in rational terms.
It is certainly true that the dramatic action taken by the finance departments and central banks in the advanced economies to soften the economic blows from the pandemic have been extraordinarily successful. Based on the latest forecasts, US real GDP will expand by 7.7 per cent cumulatively from 2019-22, close to its long-term trend rate.
