Financial Markets
The financial markets were subject to substantial movements during the past year. Stock prices and long-term yields fell significantly in the USA and Europe. However, the market development had only a minor direct impact on the banking institutions' earnings due to small stock portfolios, hedging and portfolio restructuring. The market impact on the banking institutions’ earnings is more indirect via the business areas that depend on the financial markets such as asset management and investment banking.
No new companies were listed on the Copenhagen Stock Exchange in 2002. Stock exchanges in other countries also saw a significant decline in the number of initial public offerings.
Market trends
During the past year the international financial markets were affected by unrest, with strong fluctuation in stock prices and long-term interest rates. The stock markets in the USA, the euro area and Denmark fell by approximately 20 per cent, 35 per cent and 25 per cent respectively from mid-April 2002 to mid-April 2003, cf. Chart 33.
There was also considerable uncertainty among market participants regarding the future development in prices. This was e.g. reflected in a high level of implied volatility of US stocks. As implied volatility is calculated on the basis of option prices it reflects the cost to stock investors of hedging against fluctuating stock prices.
The falling stock prices should be viewed in the light of the deterioration in the outlook for economic growth in the industrialised countries. In the summer of 2002 this trend was reinforced by doubt among investors as to whether the companies' accounts give a adequate view of their earnings and risks. This doubt arose as a result of accounting scandals involving a few large US companies. Market uncertainty was also underpinned by geopolitical tensions such as a number of terrorist acts and the prospect of a military conflict in Iraq. On the outbreak of war in Iraq the stock markets reacted positively, however, as the coalition forces won ground. Moreover, the uncertainty of the future development in prices diminished, cf. the decrease in implied volatility.
The development in Danish stock prices is driven to a considerable degree by trends in the international markets. The stock markets in Denmark and the USA have thus shown very close co-variation for a number of years, cf. Chart 34. This also applies to the bond markets.
The high degree of co-variation between financial markets across borders means that e.g. Danish investors who spread their investments to financial markets abroad can only reduce their market risk to a limited extent.
Recent years' stronger interest in investing abroad may be motivated by other circumstances such as credit and liquidity risk.
Concurrently with the decline in stock prices in the USA and Europe, long-term yields also continued to decrease, cf. Chart 35. In the USA the 10-year yield fell briefly to below 3.6 per cent in October 2002, and again in March 2003. This is the lowest level for 40 years. The implied volatility in the long-term interest rates was generally at a very high level, which among other factors reflects widespread uncertainty among market participants concerning the future course of interest rates.
The close positive co-variation between stock prices and long-term yields has been observable since the beginning of 2001, and since then has become even more apparent, cf. Chart 36. The co-variation is probably a result of the investors' portfolio shifts from stocks to bonds. As stated in the chapter on the financial sector, the Danish pension companies, for example, considerably reduced their stock portfolios in 2002.
The low level of interest rates in the USA gave rise to a high volume of mortgage conversions among homeowners with callable, fixed-rate loans. In certain periods, investors' expectation that many homeowners would call their housing loans contributed to reinforcing the fluctuations in long-term yields. In Denmark strong fluctuations in long-term yields are also seen when the level of interest rates is low, due to such factors as loan restructuring in connection with conversion of mortgage-credit loans and the returns promised by pension companies[1]. In April 2003, conversions of Danish mortgage-credit bonds amounted to kr. 116 billion, which is the highest amount ever.
Assessment of stock prices
The international stock markets were characterised by strong price increases in the last half of the 1990s. Parallel to this, speculation mounted as to whether the stock prices had reached levels that deviated considerably from the economic fundamentals.
In the industrialised countries stock prices have generally tended to decline since 2000. In mid-April 2003 the benchmark stock indices in the USA and Europe had by and large fallen to half the highest level reached in 2000. Viewed over a longer period, by mid-April 2003 the US S&P500 index was close to its level had the index matched the general economic growth since 1929, cf. Chart 37.
| US stock index and GDP in current prices, 1929-2003 |
Chart 37
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| Note: Logarithmic scale. | |
| Source: US Department of Commerce, Ecowin and own calculations. | |
Equivalently strong stock price drops have been observed previously, e.g. in the period after 1929. In the course of less than three years the S&P500 fell by more than 80 per cent in real terms, cf. Chart 38, and it took 30 years for stock prices to return to their initial level.
In theory, the movements in a company's stock price should in the long term reflect the movements in the expected value of the company's future cash flows. Various methods can be used to assess whether a company's stock price, or a stock index for a group of companies, is in accordance with the economic fundamentals.
A key ratio often used to assess the stock price level is price-earnings (P/E), i.e. the stock price (P) as a ratio of the company's profit per share in the last financial period (E). The key ratio thus expresses the cost of purchasing a profit of one unit of currency in a company. In mid-April 2003 the P/E ratio for the US S&P500 was around 30, which is a good deal higher than the historical average, despite the decline in stock prices in recent years, cf. Chart 39. However, the underlying increasing P/E trend since the beginning of the 1980s has been affected by a falling interest-rate level. When interest rates decrease, the present value of the companies' future profits increases, which supports a higher stock price and thereby a higher P/E.
| Price-earnings for US stock index and 10-year US yield, 1960-2003 |
Chart 39
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| Source: Bloomberg and Ecowin. | |
The "Fed model" is a related method for assessment of stock prices. This method considers the correlation between the return on stocks and the return on bonds. The return on stocks is measured by reciprocal price-earnings (E/P), while the return on bonds is measured by the yield to maturity on a long-term bond[2]. The rationale behind this method is that bonds and stocks can be regarded as alternative investment assets, whereby their respective returns should follow the same trend in the long term. The aforementioned argument that a lower level of interest rates supports higher stock prices and thereby a lower E/P also applies. According to this method, stocks are expensive compared to bonds if the level of interest rates is high in relation to E/P. The two measures are compared in Chart 40, which shows that at the end of March 2003 stocks did not seem expensive compared to bonds. In other words, the level of stock prices was supported by the low level of interest rates.
| US 10-year yield less E/P (Fed model), 1980-2003 |
Chart 40
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| Note: E/P is the reciprocal price-earnings for the US stock index S&P500 multiplied by 100. | |
| Source: Bloomberg and Ecowin. | |
A third method for assessing stock prices is Tobin's q, which is the ratio of the market value of capital. A high value of Tobin's q indicates that the market value, and thereby the stock price, is overvalued, while a low value indicates that the stock price is undervalued. In practice, the calculation of Tobin's q presents a number of difficulties. Furthermore, the method is not unequivocal, and may produce varying results. Chart 41 shows an example of Tobin's q for the USA, where it has maintained a high level in recent years.
| Example of Tobin's q for the USA, 1900-2003 |
Chart 41
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| Note: The q value is calculated as the sum of the company's share capital and net debt at market value as a ratio of the booked tangible assets. | |
| Source: www.econ.bbk.ac.uk/faculty/wright/. | |
These methods of assessing stock prices are based on various assumptions, and they also produce different results. The diversity emphasises that in practice determining whether a company's stock price is over- or undervalued is no trivial matter. However, a common characteristic of the various methods is that they illustrate how for long periods actual stock prices can deviate from fundamental values. In a forward-looking perspective, stock prices should therefore also be expected to show movement in some periods that deviates from the economic fundamentals.
Market impacts on the financial institutions
Trends in the financial markets have a direct impact on the banking institutions via their portfolios of bonds and stocks. The declining level of interest rates has led to capital gains on the sector's substantial bond holdings, while the lower stock prices have had a small direct impact on the banking institutions' earnings, since the sector had reduced its already relatively small portfolio of stocks, cf. Table 3. Value adjustment of the banking institutions' securities portfolios was positive in 2002 in overall terms. However, the value adjustment was lower than in 2001.
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Table 3 |
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| Kr. billion |
Banking
institutions |
Pension
companies |
Mortgage-
credit institutes |
| Shares, total |
94.2
|
236.8
|
10.1
|
| Shares in foreign companies |
24.8
|
151.2
|
0.7
|
| Bonds, total |
417.4
|
540.0
|
76.1
|
| Mortgage-credit bonds |
240.3
|
358.4
|
53.31
|
| Foreign bonds |
62.0
|
112.0
|
-0.7
|
| Balance sheet |
2,039.6
|
921.8
|
1,721.8
|
| Note: The portfolios of the banks and mortgage-credit institutes are compiled as of end-2002, apart from the mortgage-credit institutes’ bond portfolios that are compiled as of end-November 2002. The portfolios of pension companies are compiled as of end-2001. All securities are stated at market value. Source: The Danish Financial Supervisory Authority and Danmarks Nationalbank. 1 Only the portfolio of own mortgage-credit bonds. |
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The market impact on the banking institutions' earnings is more indirect via the institutions’ business areas that depend on the financial markets such as asset management and investment banking.
The negative course of the stock markets has reduced earnings from trading activities and led to lower fee income from stock-related management and consulting agreements. Trading of stocks on the Copenhagen Stock Exchange has been declining, cf. Chart 42.
| Trading volume and price development on the Copenhagen Stock Exchange, 2001-03 |
Chart 42
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| Source: The Copenhagen Stock Exchange. | |
The largest banking institutions, which are particularly active in the field of investment banking, have noted a reduction in this area. Issuing activity was at a low level in 2002, and for the first time since 1981 there were no initial public offerings on the Copenhagen Stock Exchange, cf. Chart 43. In an international perspective the number of initial public offerings has also declined, and the level of share issues was lower in 2002 than in 2001.
Furthermore, both the number and value of mergers and acquisitions have declined significantly in recent years both globally and in Denmark, cf. Chart 44.
[1] See Louise Mogensen, Market Dynamics at Low Interest Rates, Danmarks Nationalbank, Monetary Review, 1st Quarter 2002.
[2] The model is based on Lander, J., Orphanides, A. and Douvogiannis, M. Earnings forecasts and the predictability of stock returns: Evidence from trading the S&P. Federal Reserve Board Working Paper, 1997 – 6. The model uses a measure of the companies' expected future earnings, rather than actual historical earnings which are used here.