Economic & Epidemic Models

New economic narratives driven by COVID-19 outbreak are discussed by Professor Robert Shiller.

In this Natixis Access Series video talk, Ken Herold, Head of our Investment Strategies Group, sits down with Nobel Prize-winning economist Robert Shiller. Below are some highlights from the conversation.

Ken Herold: Professor Robert Shiller is an author and Sterling Professor of Economics, Professor of Finance, and Fellow at the International Center for Finance at Yale University. Since 1991, he has, together with Richard Thaler, directed the behavioral finance workshop at the National Bureau of Economic Research. He was jointly responsible for developing the Standard & Poor’s Case-Shiller Home Price Index for metropolitan regions in the United States. He also developed the cyclically adjusted price-earnings ratio, CAPE Ratio, with John Campbell.

How do you see this economic recovery unfolding?

Shiller: Well, of course, it’s very hard to predict the price of equities. It’s easier to predict GDP. But even that is not very easy to predict. Studies have shown that the professional forecasts of gross domestic product out more than a year are practically worthless. And, of course, we are concerned with more than a year. This event is going to last more than a year.

We’ve been hit by a real exogenous shock. This is an unusual market fluctuation. In October 1929 – which is the most famous sharp event – nobody knew what had hit. And even going beyond that, by 1933 when President Roosevelt gave his inaugural address he said, “There is no plague of locusts. There’s nothing affecting the economy.” So he was referring to the biblical story where insects attacked the crop and people were desperate. But we’re now in that sort of situation. There is a plague of locusts that came from a virus – a non-human enemy that puts us in a wartime situation.

And the parameters of this are kind of unprecedented. So I can’t give an outlook. I don’t like to give a forecast because it doesn’t convey the uncertainty of right now. There is a V-shaped scenario, which is possible, I think, for the stock market.

There’s been a massive amount of monetary and fiscal response. Is it enough?

Well, they’re moving forward. We have a Congress that’s not inactive anymore. What I like to see is that they’re not just increasing the money supply. They’re looking at commercial paper, student loans, and other things that are being specially focused on with new facilities at the Fed. And Congress, with the CARES Act, they brought in subsidies for small businesses who will continue to hire. And they didn’t do enough of that, initially, and it didn’t reach every needy company. But there’s a lot of policy response here, which is a good thing for the V-shaped scenario.

Should we worry about the increase in balance sheet of central banks and in sovereign debt that’s been issued?

Yeah. Well, now we are living in a MMT (modern monetary theory) world to some extent. Stephanie Kelton at Stony Brook University has become a leader of a new view that government deficits don’t matter as long as there’s no inflation. And she implied – and many others have picked up on this – that we live in a non-inflationary world. And until then, we can run deficits with abandon. So I think of this attitude as an extreme form of Keynesian economics. John Maynard Keynes, in the 1930s during the Depression, wrote his General Theory of Employment, Interest and Money that advocated deficit spending at a level that would have been considered irresponsible at the time. So the idea is not new that we should run deficits at times of crisis…. And this means there’s a conflict ahead. Somebody is going to have to see their taxes rise to pay off these debt-holders. That’s going to create political tension. Ultimately, maybe creating inflation.

We’ve seen an ESG narrative rise over the last several years. What are your views?

Very interesting phenomenon; if you look on Google Trends you see a strong uptrend in interest in “sustainability” and I’m not sure exactly why it’s happening right now…we have Greta Thunberg, the activist that has just turned 17 …came to the US on a sailboat so as not to pollute the air…but I think it’s partly the environmental disasters that have been hitting, especially forest fires…also an indescribable origin in that somehow this story of environmental change has become contagious…all these narratives have been exploited, and I don’t mean to trivialize this at all, ESG can be a very important thing…it may have been somewhat displaced by COVID-19, but I think it’s a strong narrative that will probably continue.

Regarding CAPE Ratio, where do you see relative value between stocks versus bonds given the low level of interest rates?

Well, one thing that I did in the third edition of my book was do a regression of excess returns between stocks and bonds on the CAPE Ratio and on interest rates – the level of real interest rates. And I find that both of those come in significantly and the R squared, the percent of the variance in the excess return, is close to 0.4. So what does that say now? The problem is that while the CAPE Ratio suggests low returns on stocks – lower, not terribly low because we went out at a record high for the CAPE Ratio – it also is predicting lower returns on bonds. So the excess return is not at such an extreme. That’s why I’m thinking that one shouldn’t exit the market completely. One might want to reflect on the exposure to the market, but I think it does have a chance of doing really well and that shouldn’t be excluded.

What’s your big picture thoughts on emerging markets and how they fare on the other side of this pandemic?

Now here’s where I’m worried that there will be stories of great hardship in countries that are living closer to the edge and countries that have weaker healthcare systems. There might be some real crises.

Any thoughts on growth versus value as we move forward?

Well, I’ve always been a value supporter. But there are good times and bad times for that, obviously. In the United States the last few years have been kind of phenomenal. And it had something to do with our president, who has been a cheerleader for business and an admirer of high tech business. So somehow a spirit has gotten developed that is supportive of growth stocks. And this may be coming to an end. This is particularly affected by the COVID-19 event. I don’t know, I’d have to think of examples of particular companies.

So I maintain a value-investing strategy because it fits in with my narrative economics that stocks that are talked about a lot and appear to have growth prospects can get overpriced. And there are value investors that limit the access to the strategy, but I think there will always be a time for value investing.

How has your real estate outlook changed since COVID-19?

Well, one thing that we have to do as a result of this pandemic is allow social distancing more freely. And that seems to suggest people will work at home. That doesn’t look good for the existing commercial real estate market – I’m thinking of office construction – if people are working more at home. On the other hand, it may be that it will affect the construction industry. Because I think we have to re-outfit and spread out workers in the office more. So that the office has to be redesigned so that you can walk through it without ever coming within six feet.

As for single family homes, we’ve already seen a move toward center city. People – with the internet age and the social media age – don’t feel as strong a need for a beautiful home in the suburbs to invite people over for dinner. You do that now on social media quite easily. Now, with the advent of programs like WebEx that we’re using right now, it suggests a different social life.
The CAPE Ratio is a valuation measure that uses real earnings per share (EPS) over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle. It was developed by Robert Shiller and John Campbell in their Journal of Finance paper "Stock Prices, Earnings and Expected Dividends in 1988."

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