On 12/31/17 the S&P 500 closed at 2674, resulting in a total return of 21.83% for the year. Spanning decades, the expected present value investment return of the S&P 500 is now only 4.74%, rather than our required return of around 8%. Investors should compare this expected stock return with the likely return of the 10 year treasury one or two years from now, around 4%. The actual realized return to short-term speculators will be – whatever.
In our December posting, we noted relatively persistent economic patterns relating unemployment and inflation, patterns that momentum investors or computers could exploit. Is this pattern relevant to value investors? In The Intelligent Investor, Benjamin Graham wrote that investors should consider themselves partners in real businesses; they should analyze their investments as businesses.
“Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes to you a little short of silly….If you are a prudent investor, or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise?”
Consistency is very important for investors in markets, thus the importance of an investment philosophy to guide you through the market’s complexities. But, there is also the issue of ownership. You are the ultimate owner of your portfolio, not Mr. Market.
Some of our readers may have spent decades of their careers amassing their net worth; certainly the investment of that net worth is worth some patience. A value investment philosophy would dictate, “Buy when prices are low, not high,” to preserve wealth. However, if some of our readers are just starting their careers, it is more important to consistently invest in the stock market at their comfort levels, and to invest their efforts in their day jobs, because a major portion of their net worth will accrue in the future. They will then continue to buy stock when the stock market is low and the expected returns of the market are higher. Readers at the midpoints of their careers might find it useful talking to a qualified investment advisor, avoiding complicated investments and being aware of the present historically low return of the U.S. stock market.
This is a website about the stock market, it is also about its political economy context - the organization of society to produce wealth. The present politics of the United States is very worrisome, because it is motivated not by the reasonable consequences of a certain course of action, but by the emotions of fear and anger. Recall school. You are rationally solving an algebra equation. Could you do so if you were overwhelmed by fear and anger? Likewise, we ask whether pandering to the electorate’s fear and anger will achieve anything like the present (albeit unbalanced) economic prosperity brought about by previous years of expert Fed management to recover.
Unfortunately, in a democracy, a way to get political power is to pander to the fear and anger of the voters, always blaming someone else: foreigners, immigrants, fake news, experts, the bureaucratic swamp in Washington, and the “deep state.” (This sounds like the Mideast.) A divisive president can’t govern, can’t convince; the next step is to blame domestic traitors for regime failures. The way to get out of this national nightmare is to realize that people are not powerless; that the 2018 elections do matter very, very much; and that the way to get out of a hole is to stop digging (to mix a metaphor) into a Pandora’s box containing the evils of the world. We would look to real concern * and the power of reason to navigate an increasing complex world created by globalization, demographic, climate and technological changes.
The 12/26/17 Washington Post contains an excellent article, “To beat President Trump, you have to learn to think like his supporters.” The author is a Madrid economist, Andrés Rondón, who grew up in authoritarian and now distressed Venezuela.
“(This is) how populism works. As long as Trump is still swinging back, scandals help him to polarize the country further. The scorn of his adversaries, in the eyes of his supporters, proves that he’s doing exactly what they voted him to do: dismantling a rigged (economic and ethical) system that they believe destroyed their hopes **….what can really win them over is not to prove you are right. It is to show them you care. Only then will they believe what you say….I believe (the solution to Trump) should rest on understanding and emphasizing with their grievances that brought Trump to power ‘(wage stagnation, cultural isolation, a depleted countryside, the opioid crisis)’. Trump’s solutions may be imaginary, but the problems are very real indeed. Populism is and has always been the daughter of political despair. Showing concern (by developing effective programs) is the only way to break the rhetorical (and political) polarization.”
The historian, Donald Kagan (1991), writes about the difficulties of maintaining a system of liberal democracy.
“The paradox inherent in democracy is that it must create and depend on citizens who are free, autonomous and self-reliant. Yet its success – its survival even – requires extraordinary leadership. It grants equal rights of participation of citizens of unequal training, knowledge, and wisdom, and it gives final power to the majority (who concern themselves with leading their lives rather than politics)…It gives free reign to a multiplicity of parties and factions, thereby encouraging division and vacillation rather than unity and steadiness. In antiquity, this led critics to ridicule democracy as ‘acknowledged foolishness’; in the modern world, it has been assailed as inefficient, purposeless, soft, and incompetent. Too often in this century its citizens have lost faith in times of hardship and danger and allowed their democracies to become tyrannies of either the right or the left.”
But why endure hardship and danger when it is easier to slide into the irresponsibility encouraged by a tyranny? The major moral virtue of democracy is responsible freedom, both to oneself and to others. It’s not, “Don’t Tread on Me.” -In Professor Kagan’s words, “(Pericles’) success and that of Athens rested on more than prosperity and rhetoric. He also had a vision for his city that offered…its citizens the opportunity to achieve, through common effort, personal dignity, honor, and the fulfillment of their highest needs.” The Athenian system of democratic self-rule survived for hundreds of years.
* This is not an article advocating gimlet-eyed rationality. This 12/29/17 NYT article discusses the importance of positive emotion to sustain your commitments, financial and otherwise.
* *Let these words sink in. More generally, the capitalist system considers labor but a factor of production like natural resources and capital equipment. Of course it isn’t just that. An economic system is supposed to benefit the country and its people at large, not just a deal oligarchy and shareholders, for a short time.
The Washington Post columnist, E.J. Dionne, concludes his new book, One Nation after Trump (2017), “…it is our shared commitment to republican institutions and democratic values that makes us one nation.”
As of 1/19/18 the S&P 500 has increased by 5.11% for the year to 2810, pricing the stock market way beyond its economic fundamentals. A crucial assumption being made is that inflation and interest rates will remain very low, supporting share prices by making fixed-income investments less attractive as an alternative to stock dividends. We make the opposite assumption because:
1) As our 12/1/17 posting suggested, the Philips curve describing a tradeoff between inflation and the low unemployment rate is starting to reappear.
2) The Congressional Budget Office projects that the tax bill just passed will increase the deficit by a 10 year average of $150 billion per year (not including macroeconomic effects; the 2018 baseline projected deficit without this tax bill is $563 billion). During more prosperous times, nations are supposed to increase their savings.
3) International economic growth and oil prices are increasing; the exchange rate of the dollar is decreasing.
We are closely tracking 10 year treasury yields, which we expect to increase.
add: We suggested above that the U.S. economy is primed to generate inflation in the excess of the moderate 2% expected by the Fed and by the market. On 2/14/18 the Labor Department reported that the January consumer price index jumped by 0.5%; excluding food and energy, the core inflation rate jumped by .3%. Whether 0.3% or 0.5%, this doesn’t look good. The yield on the ten year treasury jumped from 2.66% on 1/19/18 to 2.92% on 2/14/18. We think at a level of 3%, long-term interest rates will start to inflict even more pain on the stock market.
To further discuss the effect of monetary creation on the economy: In 2009, at the beginning of quantitative easing, some hedge fund managers expected higher inflation, which did not happen. The reason for this is that the excess bank reserves created remained bottled up in the banking system, held there by a low demand for funds, by the Fed policy of paying interest on these reserves, and by a Congress that had hobbled itself by spending caps and sequestration.
With the Republicans presently in control of all three branches of government, such restraints have disappeared. In the following, the Congressional Budget Office estimates the effect on the deficit of the most recent H.R. 1 Budget Conference Agreement between the House and the Senate; we add New Approved Spending and Infrastructure.
Effect on the Deficit of the H.R. I Budget Agreement & New Approved Spending
(billions of dollars)
2018 2019 2020 2021 2022 …..
Baseline Forecast -563 -689 -775 -879 -1,027
Effect of Tax Cuts -137 -286 -273 -244 - 208
New Spending -243 -153
Infrastructure Spending - 45 -20 - 20 - 20 - 20
Total Deficit -988 -1,148 -1,068 -1,143 -1,255 ….
Rather than starting in 2022, the trillion dollar deficits will essentially start this year, with the economy operating at full capacity, driving up interest rates. The trillion dollar deficits will never end; this analysis does not even take into account economic downturns. At around 5% of GDP, these deficits will add another 25% of GDP to the debt in five years. What does this mean for the future ability of the United States to borrow? Here are OECD comparisons of the 2015 Gross Government Debt /GDP ratios of selected countries:
United States 125% + 25% in 5 years
United Kingdom 112%
These figures show that the large and continuing U.S. deficits will begin to tempt fate very soon.
The $20 billion per year that the administration has allocated to infrastructure will probably be enough to improve all the hiking trails in the United States – we like hiking.
On January 20th, President Trump celebrated his first anniversary with a government shutdown. The major issue of contention was of his making, cancelling an Obama administration executive order that deferred deportation action for the Dreamers, undocumented immigrant children who have grown up in the United States and who are now contributing members to U.S. society. His handling of this issue subsequent to his order illustrates how he does deals. His deal style had resulted in the refusal of all the major banks in New York to do business with him, with the exception of the private banking (not the commercial banking) division of Deutsche Bank.
According to a NPR report, on January 20th, Senate Minority Leader Chuck Schumer related what happened when he spoke with President Trump:
“He’s rejected not one but two viable bipartisan deals...What’s even more frustrating than President Trump’s intransigence (after tasking Republican Graham and Democrat Durbin to reach an agreement, which they did) is the way he seems amenable to these compromises before completely switching positions and backing off (after then considering what his advisors say). Negotiating with President Trump is like negotiating with Jell-O.”
This is a telling comment, for it strikes at the President’s deal making ability, not addressing the separate issue of his intentions. From this comment, it seems that President Trump:
1) Did not exert leadership, pulling a deal together.
2) Doesn’t know what he really wants, being bereft of a political philosophy.
3) Can't govern. Before becoming President, he had run only a family business.
His presidency lacks coherence; its time for checks and balances.
On 2/16/18 Special Counsel Robert Mueller unsealed a detailed criminal indictment against sixteen Russian organizations and individuals, accusing them of having, “…a strategic goal to sow discord in the U.S. political system, including the 2016 U.S. presidential election. Defendants posted derogatory information about a number of candidates, and by early to mid-2016, Defendants’ operations included supporting the presidential campaign of then-candidate Donald J. Trump…and disparaging Hillary Clinton. Defendants made various expenditures (our note) to carry out those activities…and without revealing their Russian identities and ORGANIZATION affiliation, solicited and compensated real US. persons to promote or disparage candidates.
On 9/22/17, Donald Trump had tweeted, “The Russia hoax continues…What about the totally biased and dishonest media coverage in favor of Crooked Hillary?” On 2/16/18 he then tweeted, “Russian started their anti-US campaign in 2014, long before I announced that I would run for President…The Trump campaign did nothing wrong – no collusion.”
These tweets show that the major concern of the President is not securing the United States from future Russian interference. They show his major concern is to be shown to be innocent of Russian involvement in his election. In other words, the presidency is all about him, not about the future of the nation. Time for a rethink about enabling this President to do more damage described in all the above.
Due to the common sense of the American people and our redundant government system of checks and balances, the Republic will (just) survive, even this presidency. But, the economic forces of globalization and the resulting income inequalities are tearing away at the social fabric of liberal democracies around the world: in Britain, France, Italy and (here most notably) Poland.
According to a 1/22/18 WSJ article, “…a battle for Europe’s soul is once more being fought in Poland….(European populist) rebels say control of people’s lives has been given to elites, technocrats and courts, leaving voters with limited choices. They promise to return power to ordinary people. Similar frustrations…(include) the populist wave that helped carry Donald Trump into the White House….’For years we were subject to a kind of indoctrination,’ said Witold Waszczykowski,…Poland’s former foreign minister. ‘Traditional, religious, patriotic family values were not progressive enough, not European, not developed.’”
“The message appealed to socially conservative…Poles in small towns and villages. Many of them didn’t identify with the new, cosmopolitan Warsaw of sushi bars and Gay Pride marches. In the still-poor countryside, many felt the new Europe was more interested in cheap Polish labor than in the traditions that carried them through war and tyranny….The Law and Justice party drew on a broader sense of betrayal among Polish voters. Although the nation’s economy grew during the global downturn, salaries remained low, jobs were insecure and health are and public services were patchy. A cultural divide deepened: half of Poland looked at Europe with hope, the other half with suspicion.”
The world’s economic system is now highly integrated. We do not think it can be fractured without severe consequences. The founder of the Polish democratic revolution, Lech Walesa, says of the ruling party, “They diagnose well, but they cure badly (by acting out).” The socio-economic justification for the free trade system is that the winners compensate the disadvantaged. The failure to do so is the glaring deficiency of the globalized economic system; there is still time to correct.
On Feb. 27, Jerome Powell, Chairman of the Federal Reserve, testified before the House Committee on Financial Services. He expected more years of economic growth:
“The robust job market should continue to support growth in household incomes and consumer spending, solid economic growh should continue to support growth in household incomes and consumer spending, solid economic growth among our trading partners should lead to further gains in U.S. exports and upbeat business sentiment and among our trading partners should to further gains in U.S. exports, and upbeat business sentiment and strong sales growth will likely continue to boost business investment. Moreover, fiscal policy is becoming more stimulative. In this environment, we anticipate that inflation on a 12-month basis will move up this year and stabilize around the FOMC’s 2 percent objective over the medium term.”
But the S&P 500 then dropped 1.27%. Why? If you are invested in short-term money market funds, you will finally be receiving some return on your cash. If you are invested in long-term financial assets, economic growth is beginning to cause losses. In the Keynesian portfolio adjustment process, if the return on cash increases due to a more restrictive monetary policy, so will the return on long-term financial assets and their prices will drop. The discussion now in the financial markets is whether the Fed will hike rates three or four times this year, and then more the year next (causing acute problems). Given the ability of a dysfunctional Republican controlled Congress to generate unending trillion dollar yearly deficits, not at the bottom of an economic cycle but at its likely peak, we consider four ¼% Fed policy rate increases this year to control inflation quite likely. If that does not happen, the bond markets will adjust at the long end to compensate investors for higher inflation. We also note that both the highly leveraged Fed (although it accounts for its assets at historical cost) and world economy, full of low interest rate debt, cannot let inflation get out of control.
Four more rate hikes this year will lift the Fed funds rate to 2.5%. That should, after some volatility, translate into a 10 year treasury of 4.5%, and a S&P 500 eventually priced to return investors 8% (our target) - 8.5% (including the likely equity risk premium) At a 2/28/18 closing level of 2714, the S&P 500 is priced to return only 4.67%.
Goldman Sachs’ most recent baseline interest rate forecast expects a year-end 10 year treasury rate of 3.25%, saying there is no immediate cause for concern. This is likely the Wall Street consensus. However, this graph series indicates that a low .75% spread between the fed funds rate and the 10 year treasury is unlikely, except in times of extreme financial market turbulence.
This stock market discussion illustrates that stocks can (and should) be priced off their alternatives, which are long-term bonds. This is also the best explanation for our readers.
On 3/1/18 President Trump announced he would impose a 25% tariff on steel imports and a 10% tariff on aluminum imports. The stock market dropped 1.33% to 2678. Now add the effects of tariffs, trade wars to the prospect of an overdriven economy...
This is a political economy website. We have really been trying not to write about the Administration; but then – something happens – illustrating some lack in presidential character and self-control, violating the norms, restraints and expertise that make us free – and therefore inevitably resulting in bad policy. Such a policy is a large tariff on imported steel and aluminum. The 3/2/18 Bloomberg writes:
”…the Trump administration’s focus on metal manufacturing misunderstands the nature of America’s trade with the world, where the (trade) deficit is not in raw materials, but in (more sophisticated) finished products. It’s cheaper for U.S. consumers to buy things abroad, and that’s what they’ve been doing for many years. Little wonder, then, that U.S. steelmakers have been reluctant to invest, showing some of the lowest rates of capital spending and R&D globally.
That refusal to spend now looks to have got its reward in the form of Washington’s new protectionist stance. But the more innovative automotive, machinery and aerospace manufacturers that consume American metal are the ones employing more workers and showing better prospects for the country’s economy. Lifting the materials costs they face by protecting inefficient local mills is only going to exacerbate their problems.”
On 3/22/18 the S&P 500 index dropped by 2.52% to 2,643, bringing to mind the late economist Rudiger Dornbusch’s quote, “The crisis takes a much longer in coming than you think, and then it happens much faster than you would have thought.” Almost ten years ago, on 9/1/08, the S&P 500 closed at 1283. During the Great Recession, it dropped by 46% to a low of 683 on March 5, 2009. In the September posting , we cited three main reasons for the vulnerability of that stock market.
1) A decrease in house prices.
2) Decreasing credit extended by banks.
3) An increasingly complicated financial infrastructure, acting as a vector of contagion that ultimately required the Fed’s rescue of the entire world’s financial system.
In globalized markets the catalysts (positive or negative) can differ widely. We cite the likely catalysts for this large market drop. (We apologize for mentioning Donald Trump again.)
1) An economically optimistic speech given by the new Fed chairman, Jerome Powell, that predicted (in a data dependent way) a series of moderate but indefinite rate hikes, reaching a projected Fed policy rate of 2.9% by the end of 2019. (Needless to say at that normalized interest rate, a 4.67% long-term stock market return is decidedly unattractive.)
2) A data scandal at Facebook calling into question its business model of selling ads, targeted according to the behaviors of their users. Cambridge Analytica produced very misleading political ads and trafficked in disinformation. Steve Bannon was an executive of the company and ran Donald's Trump's political campaign. (Note Facebook's business problem. Commercial ads are ignorable, allowing "puffery." Politics is very serious. Social media facilitates the unchecked spread of rumor and untruths. Does the establishment of truth need the restraint of checks and balances? Who is to judge? How can the social media provide them? These are the classic problems of liberal society.)
3) Donald Trump’s announcement of a plan to slap large tariffs on at least $50 billion in Chinese imports, thus possibly initiating a global trade war. From perusing a summary of “The President’s Trade Policy Agenda,” we sense he means to follow up. What is further disturbing is the announcement of his appointment of John Bolton, a major advocate of the Iraq war, to be his third National Security Adviser. This new appointment, along with many others, signals that after a year of trying to live with the Washington establishment, “Donald is going to be Donald.”
Some things remain the same. We ended that posting with a quote from the Bard, “When sorrows come, they come not single spies but in battalions.” Our portfolio strategy remains risk control.
In a steep market sell-off, the S&P 500 closed at 2,582, down 2.23%. This decline was likely motivated by Donald Trump’s growing trade war with China and by his graduation from going after people to going after Amazon on Twitter. An unremitting hostility to everyone, excluding his political base, is not good for business. A trade war could have a short-term effect of driving up inflation, as domestic producers become free to raise prices; but a long-term effect of depressing business, as the international economy ceases to grow. How the crosscurrents of these affect interest rates, already biased upwards by increased deficits, or corporate earnings we cannot specify; but an increase in the former (and, or) a decrease in the latter are not good for stock prices.
For an unrelated reason we sold two of our three remaining stocks at the opening of the market, and took a slight profit. The reason we did so is related to a loss in our one remaining equity investment in Buckeye Partners (BPL). With the reduction of the interest sensitivity of our portfolio, what happens to the price of BPL (especially in this general market environment) is much less of a concern. In 2017, the company completed an acquisition that increased its risk. A long-term investor would say, "Let's see how things turn out." The U.S. tax code also discourages the sale of limited partnership investments.
This leads to the issue of short-term losses. We will likely increase our equity investments during a period of high market turmoil. The market may hit our rate-of-return buy point. At that time, we will have no assurance that we will have bought at the bottom.
In last month’s posting, we identified three major events that were likely catalysts for a steep market drop:
1) The Fed’s interest rate hikes.
2) A data scandal at Facebook, calling into question its business model.
3) An U.S.-China trade war.
The consequences of the last two, while still potentially problematic, will play out over time. The market promptly ceased to factor them into prices. But the first will continue to be a major concern to markets in the future. Some discussion of all the sources of long-term stock returns is therefore warranted.
A present value formula for calculating the rate of stock market return has a time horizon of more than twenty years – appropriate for a pension fund or an individual with a very long investment time horizon. Over a shorter time horizon, investors will experience returns that are either greater or lesser – depending upon their investment philosophies or trading luck. The Gordon model simply states that the equilibrium stock market return is equal to the sum of the present dividend yield, real economic growth and inflation. Thus:
Equilibrium Return of the S&P 500 = D0/P + real economic growth + inflation
= 1.87% + 2% +2% (the current Fed target) = 5.87%, say 6%
At long-term equilibrium, the sources of future stock market returns are roughly balanced among current dividends, real economic growth and inflation.
In 2017, John Williams, now president of the New York Fed, published an excellent study that explained why interest rates and investment rates of return have declined in developed countries. In this study, the Philadelphia Fed’s Survey of Professional Forecasters estimated an average 6% 10 year stock market return figure, including 2% inflation, since 2012 (that tracks the longer term Gordon model), see the following figure 4. The following graph from the Williams study also shows the markups of financial assets over the natural rate of interest, the real interest rate in the economy prevailing at full employment and non-accelerating inflation. The following graph implies a low 0% natural rate of interest, a near 0% short-term Tbill rate, a 10 year treasury bond markup to yield a 2% real rate of return equal to the growth of the economy, and an additional 2% equity markup to account for risk. The total estimated equity return is 4%. Then add 2% for inflation; totalling 6%.
But our 12/31/17 present value estimate of equity return was 4.74%, in line with the estimates of a number of pension fund managers. Why the discrepancy? We utilize Robert Schiller’s 10 year earnings average (here operating earnings assumed equivalent to distributable cash), to account for economic cycles. The Forecasters are apparently assuming the present dividend yield (at what is likely near the peak of the economy) which does not take into account dividend decreases and the extreme market behaviors described in Charles Kindleberger’s “Manias, Panics, and Crashes (2000)”, that can take 40% off the stock market’s value. We think a 4% markup of equities over the 10 year treasury is appropriate, requiring a S&P 500 investment return of 8.
A 5/1/18 Washingon Post article noted that in 466 days, President Trump has made 3,001 false or misleading claims. We value truth; we assume most of U.S. society does. Why does he do this? In a 4/28/18 NY Times, former CIA director Michael Hayden writes:
“It was no accident that the Oxford Dictionaries’ word of the year in 2016 was “post-truth,” a condition where facts are less influential in shaping opinion than emotion and personal belief. To adopt post-truth thinking is to depart from Enlightenment ideas, dominant in the West since the 17th century, that value experience and expertise, the centrality of fact, humility in the face of complexity, the need for study and a respect for ideas.” The value of truth is woven into this society (and economic growth cannot continue without it).
It is an idea from the classical world that the search for truth requires reason, reason to see into the factual nature of things and to inform a judgment which properly evaluates the likely consequences of our decisions. This results in liberation from the tyranny of circumstances. Mr. Hayden continues, “The historian Timothy Snyder stresses the importance of objective reality and truth in his cautionary pamphlet, ‘On Tyranny.’ ‘To abandon facts,’ he writes, ‘is to abandon freedom. If nothing is true, then no one can criticize power because there is no basis upon which to do so.’ He then chillingly observes, ‘Post-truth is (n.b.) pre-fascism.’”
In a 4/16/18 talk, Columbia journalism professor, Bill Grueskin also crucially noted that the goal of “fake news” in authoritarian societies is not to convince people on issues of government policy. Its purpose is to make it impossible for people to believe what is true. They then turn passive, close off and say its all too confusing. They can’t believe anything.
Mr. Hayden asks, “…was Mr. Trump actually able to draw a distinction between the past that had really happened and the past that he needed at that moment?”
Timothy Snyder is a professor of Modern European history at Yale. He believes that the degeneration of our democracy into the willed chaos of fascism is now quite close. Complacency would be a bad mistake. In “On Tyranny,” he suggests a number of steps we could take, among them:
· Do not obey in advance Most of the power of authoritarianism is freely given.
· Defend institutions. Choose an institution you care about, and take its side.
· Take responsibility for the future of the world. Life is political, not because the world cares about how you feel, but because the world reacts to what you do.
This pamphlet concisely (and brilliantly) details how totalitarianism works. It is available from amazon.com as a $3.99 Kindle download. Its value exceeds its price.
On 5/3/18 a CNN anchor said an all-time. “We know less today than we did yesterday.”
On 5/21/18, the S&P 500 closed at 2733, yielding a long-term investor a return of only 4.65%. What should that return be in a normal market? In the U.S., the yield to maturity on bonds and loans is measured by a markup from the Fed funds policy rate. Although this concept is not usually applied to equities, we treat the S&P 500 likewise to describe what is happening to risk assets in the financial markets.
Debt and Equity Investment Yields 5/21/18
Theoretical Actual Difference
Current Fed Policy Rate 1.75% 1.75% 0
10 Year Treasury 3.75%* 3.06% -.69%
S&P 500 7.75%** 4.65% -3.10%
*This is the 2% Fed rule of thumb, which calculates 10 year treasury yields above the policy rate. **This assumes a 4% risk premium over the 10 year treasury, add: about which more next month.
The table above indicates that the yield curve of risk assets is extremely flat, due to the Great Recession of 2008, the integration of China into the world-wide product supply chain and demographics. The first two factors are likely to change as the economy is at full labor capacity utilization, as energy prices increase and as the Fed contemplates four or more .25% policy rate hikes from now to 2019. Would anyone want to invest in a 4.65% stock market compared with a 4% plus ten year treasury?
There is an ancient military strategy, ”Divide and Conquer.” This is the exact strategy that the divisive President Trump uses to gain leverage over American society: its voters, its institutions and its allies – by trying to diminish (in any way possible) larger and sometimes balancing concentrations of power, so he can exert his will. But as playwright Robert Bolt wrote, “ …do you really think you could stand upright in the winds that would blow then?” American society is a commercial civilization where economic growth and therefore social trust matter.
On 5/15/18 PBS aired an episode of, “First Civilizations,” that examined the crucial role of trust in commercial societies. We will let the narrators speak, who provide some things to think about:
“Trust and trade may work in this...feedback loop. For trade to start, any civilization needs trust and the more trade you have the more trust you have, and so the loop continues and the benefits are really exponential. In high trust societies they don’t just thrive economically, you actually see individuals in society thrive because they have more freedoms, they have more empowerment, you see more entrepreneurship, you see more human empathy…
“The collapse of any civilization is never a simple story. (This episode looks back to the archaeological record showing increased interpersonal violence; AK-47s anyone?) It sort of paints a picture of the experience of that loss of social control.
“You can look back over history and look at the collapse of civilizations and they follow this similar pattern. Most recently, we’ve seen this in the financial crash, in that you have a system that people have confidence in, and then something goes wrong. Someone behaves badly, someone becomes greedy and the first thing to go is the confidence, and then quickly its like a house of cards.
“Trade has always been a trigger of change. It encourages us to come together, to exchange things, to share ideas, to create societies built on cooperation, trust, peace. This was true for the first civilizations and it is still true today. Trade, the driving force of civilization.”
On 5/21/18 Federal Reserve Governor, Lael Brainard, gave a speech, “Sustaining Full Employment and Inflation around Target,” where she asked how the Fed would be able to sustain an economy at full employment, currently around 3.8%, and inflation around 2%. To do so, the Fed expects a policy path for fed funds that, “…moves gradually from modestly accommodative today…and (then) modestly beyond neutral-against the backdrop of a longer-run neutral rate that is likely to remain low by historical standards.”
The causes for this policy of gradual (but of course conditions determined) rate hikes will be:
1) The tightening resource utilization of a cyclical economy (as we expected).
2) Rising fiscal stimulus that “…reinforces above-trend growth” (which we did not expect). According to OMB projections, beginning in F.Y. 2019, the U.S. will run trillion dollar deficits – at what is likely a cyclical peak, for as far as the eye can see.
3) The Fed’s bond sales from its $4 trillion dollar balance sheet (as we expected).
Given the above, at least another 4 quarter percent rate hikes until the end of 2019 is very realistic. Such a series of rate hikes will result in a Fed funds rate increase of 1% to a level of 3%. A parallel shift in the yield curve will then result in a ten year treasury of 4%+, a yield considered reasonable by many financial executives. Stocks, however, are not long-term treasuries. Using a measure that can be applied to almost all non-derivative financial assets, the current duration (analogous to a payback period) for the S&P 500 is likely more than 36 years, whereas the duration of a 10 year treasury is only 8.7 years. Therefore to compensate for the additional risk, an equity markup of 4% over the 10 year treasury is appropriate – especially considering the current systems risks in Washington.
As appropriate, we will discuss the S&P 500 in greater detail.
If you think that those with opposing political opinions are wrong, but trust that they are at least well-intentioned for the United States; then there is the basis upon which to craft real solutions to the challenges of globalization and automation. As our economics discussion in, “The Limitations of Very Limited Government, “ illustrates, practical solutions have elements of both the free-market right and the government-regulated left. But, by themselves, the impersonal economic forces of globalization and automation, both pull in the direction of increasingly rapid change and increasing inequalities, thus making broad democratic societies ultimately impossible. It is to the discussion of these forces and their effects on the country that we now turn.
To start with the main problem. In the social sciences, the most numerous median is often used to characterize data, because it is a measure of what affects most people. The following St. Louis Fed graph illustrates that in the 36 years since 1981, the real weekly median earnings of U.S. workers has grown by only .34%/yr.
The typical American worker has not benefited from the 2.72% real annual growth of the economy during that period. In an excellent article, “The Age of Insecurity,” * Professor Ronald Inglehart, of Michigan’s Institute of Social Research, notes that the top ten percent in the U.S. now take home almost half of the national income. Political democracy requires a rough economic equality among citizens; not disparities like this. What are the causes of these disparities? The article crucially notes that between 2000 and 2010, “…over 85 percent of U.S. manufacturing jobs were eliminated by technological advances, whereas only 13% were lost to trade.” Many U.S. jobs are now highly integrated into the world economy, and great care has to be taken not to compromise them in favor of preserving a few. An effective government jobs policy should address the root causes of their loss.
Trade Policy (responsible for 13% of manufacturing job loss since 2000)
Economic competition from China had a large effect on U.S. manufacturing employment in the years beginning in 1990, Autor (2016). At that time, American workers were not re-employed by the trade theory of comparative advantage which held that trade could only be beneficial – the theory crucially assumes no capital flows (Gray,1998). With the assumption of free capital flows, trade theory becomes regional economics, where the jobs simply flow to the lowest cost region.
Professor Inglehart notes, “Fifty years ago, the largest employer in the United States was General Motors, where workers earned an average of around $30 an hour in 2016 dollars. Today, the country’s largest employer is Walmart, which in 2016 paid around $8 per hour. Less educated people now have precarious job prospects and are shut out from the benefits of growth…”
But a nostalgic effort to try to recreate the industrial conditions of the past by scapegoating trading partners and imposing high tariffs will fail; because the structure of the productive economy is now international. High tariff barriers will disrupt intricate supply chains, to the detriment of all. The trade deficit no longer has a large direct effect upon U.S. employment. But the continued trade deficit in manufactured goods impedes the development of the producing U.S. economy. Something has to be done to reassert national control over trade and its spill-over effects. Harvard political economist, Dani Rodrik (2011), argues for institutional diversity based of national priorities because, “Trade is a means to an end, not an end in itself.” He further writes, “…a new global financial order must be constructed on the back of a minimal set of international guidelines and with limited international coordination….the rules would explicitly recognize governments’ right to limit cross border financial transactions, in so far as the intent and effect are to prevent foreign competition from less strict jurisdictions from undermining domestic regulatory standards…” For most countries, and we believe somewhat the U.S., the goal should be a rough trade balance, to be effected by a combination of fiscal and capital flow policies; also catalyzing the industries of the future. **
Automation (responsible for 85% of manufacturing job loss since 2000)
Automation has been and will be the largest reason for U.S. job loss. The American Enterprise Institute notes on 3/17/18, “The main reason for the loss of US steel jobs is a huge increase in worker productivity, not imports, and the jobs aren’t coming back. In the 1980s, American steelmakers needed 10.1 man-hours to produce a ton of steel; now they need 1.5 man-hours….Increased productivity means today’s steel mills don’t need as many workers. Steel industry employment peaked at 650,000 in 1953. By the start of the year, U.S. steelmakers employed just 143,000….The policy point is that Mr. Trump’s tariffs are trying to revive a world of steel production that no longer exists. He is taxing steel-consuming industries that employ 6.5 million and have the potential to grow more jobs to help a declining industry that employs only 140,000.”
To get even more specific, a 6/1/18 WSJ article quotes economist Douglas Irwin, “…we’re producing the same amount of steel, or even more, we use many, many fewer workers to produce that steel.…The old newsreel image of workers mixing metals next to furnaces is far from today’s reality, which consists of “one or two (highly paid) engineers who are adjusting dials in a highly mechanized place.”
It is a platitude that the advance in automation will create more, high quality jobs; because people will dream of new things to do. Professor Inglehart disagrees. The problem is the zero marginal cost of quality products. “The problems of cultural change and inequality in rich democracies are being compounded by the rise of automation, which threatens to create an economy in which almost all the gains go to the very top. Because most goods in a knowledge economy, such as software, cost almost nothing to replicate and distribute, high-quality products can sell for the same price as lower-quality products. As a result, there is no need to buy anything but the top product, which can take over the entire market, producing enormous rewards for those making the top product, but nothing for anyone else.”
Platforms such as Amazon, artificial intelligence programs and driverless navigation will all be subject to the above.
Increased employee productivity (roughly Revenues/Wages) is the key to a higher standard of living provided everyone is well employed. A society where productivity is infinite, because wages are zero, will simply not work; yet this is where things are heading. The Inglehart article reiterates, “The rise of automation is making societies richer, but governments must intervene and reallocate some of the new resources to create meaningful jobs…”
The economic problems we have noted, caused by trade and automation, are large-scale; requiring the intervention of well thought out government policies. Nationally beneficial trade policies, wage subsidies for the present and regional economic development for the future could be useful.
*This article is worth the time to register on the Foreign Affairs website.
In the May/June issue of the magazine there is also an article called “The Big Shift,” by the historian Walter Russell Mead. He writes that the U.S. made a big economic transition before, in the years (1865-1901), when the country industrialized; and people migrated from farm to factory. The Republic survived. However, this time:
“The full consequences of the information revolution will only gradually come into view, and the ideas and institutions suitable to it will emerge as the rising generations learn to use the resources and wealth that an information society creates to address the problems it also brings. It is likely that before the adjustment is finished, every institution – from the state to the family to the corporation – will have changed in fundamental ways. In the meantime, people must learn to live in a world of forces that they do not always understand, much less control…(luckily) Americans are the heirs to system of mixed government and popular power that has allowed “them to manage great upheavals in the past. (Because this diverse system allows creative responses - when its not gridlocked.) The good news and the bad news are perhaps the same: the American people in common with others around the world, have the opportunity to reach unimaginable levels of affluence and freedom, but to realize that opportunity, they must overcome some of the hardest challenges humanity has ever known.”
** In a prescient book, “One Economics, Many Recipes, (2007), p. 200” Professor Rodrik notes the open-economy trilemma of international trade: it is necessary to choose among only two out of these three following economic policies: capital mobility, fixed exchange rates and monetary autonomy. The last two place priority on the well-being of the nation-state. He then discusses an augmented trilemma (which to us seemed theoretical at the time). International economic policies have to choose among economies thoroughly integrated into the international system, the nation-state and political institutions that are responsive to mobilized groups. The last two place priority on the welfare of citizens where they live.
The Trump Administration’s policy of imposing tariffs on imports from other nations will not win friends and influence people. The first's indirect policies have been much more effective.
But here’s the problem. The economic systems involving domestic jobs and foreign trade are complicated. When things go wrong, the natural and simplest human reaction is to look for scapegoats – “Who did this to us?” The Trumpean answer is always foreigners, immigrants, personal adversaries and the U.S. government itself - standing in the way of restoring a nostalgic “American Greatness.” In this he is no different from Mideast radicals blaming “infidels,” seeking to restore the past glories of the Caliphate. As the NYT notes on 6/12/18, "...in the complicated, nuanced world of economics and security, (Trump) has achieved nothing except the destruction of previous agreements, of institutions..." We won’t even try to enumerate the specifics. About his high risk strategy in North Korea, see what can really be implemented.
A business executive once said that it is important to, “Tell the Truth and Give Hope.” The system requires reform for the next cyclical downturn. Perhaps the best way is to treat voters as intelligent, to suggest real solutions: a more nationally responsive rule-based trading system abroad and a better social safety net at home.