On 12/31/18 the S&P 500 closed at 2507, resulting in a total return of -4.38% for the year. According to the November, 2018 Fed Open Market Committee, “…the labor market has continued to strengthen and that economic activity has been rising at a strong rate.” This observation correlates with the fact that, while bank lending was stagnating prior to the Great Recession of 2008, lending is now growing strongly.
But in the month of December, the S&P 500 declined by 9.1%, a worse December performance than the 6.0% December drop in 2002, giving investors a lump of coal in their stocking. The 12/24/18 NYT notes, “…the biggest worry for 2019 is not so much that…disruptions (are) so large to cause a recession. The real fear is that shaky policy allows small shocks to create a broader crisis of confidence.” For both the real and financial economies, confidence matters.
In The General Theory (1954) Keynes wrote, “The state of confidence…is a matter to which practical men always pay the closest and most anxious attention. But economists have not analyzed it carefully and have been content, as a rule, to discuss it in general terms….There is, however, not much to be said about the state of confidence a priori. Our conclusions must be mainly depend upon the actual observation of markets and business psychology. This is the reason why the ensuing digression is on a different level of abstraction from most of this book.”
The practical reasons for having confidence are surely the elements of intention, competence and reliability. What does it mean to have confidence in government, particularly the competence and reliability of Fed policy? In a 12/21/18 CNBC interview, John Williams, president of the New York Fed, crucially remarked:
1) The Fed seeks the best policy, to achieve its dual mandate of high employment and low inflation.
2) In developing this policy, it looks at the incoming data and, most crucially, talks to many others.
3) As a result, the Fed “judges” rather than “expects.”
The underlined words are the crucial elements of rationality under the condition of uncertainty. (Hopefully) with our readers, we now discuss what rationality is.
The most general definition of rationality is to do things for reasons, to obtain a given result. A more specific definition of rationality depends upon the conditions under which it occurs. Ref. (Russell and Norvig, 2010). For instance, when driving to a destination, a fog might roll in. Depending upon the degree of fog, one can look at different things to reach one’s goal.
1) On a clear day, there are no other vehicles, the environment’s landmarks are clearly visible; and one can drive along the best route with almost no other feedback. This is navigating under certainty.
2) The fog begins to roll in, there are no other
vehicles, the environment’s landmarks are visible only in blurry outline; the
prudent thing to do is to slow down and to verify that the landmarks are the
actual ones. This is navigating under risk, when the alternatives are known but
the probabilities of their realizations can be
identified estimated * by
numbers ranging from 0 to 1. The action to take is to proceed along the best expected
3) The fog becomes pea-soup thick, there are no other vehicles, the landmarks appear sporadically, the smart thing to do is to slow down more and to ask the expert passengers to help identify the landmarks. This is navigating under uncertainty, where the alternatives must be identified anew in a complex world. Under these conditions, taking the best route requires good judgment, consultation with other experts and continued communication in a “multi-agent environment.”
This discussion shows that Reason can be a very powerful tool – when reasonably used after considering conditions.
* This is a very crucial distinction. In the practical world, good judgment is really important. Russell and Norvig (2010) write, “The connection between toothaches and cavities is just not a logical consequence in either direction. This is typical of the medical domain as well as most other judgmental domains: law, business, design, automobile repair, gardening…” The title of their definitive book is, “Artificial Intelligence.” It discusses A.I. algorithms and design considerations, also philosophy from Aristotle to Gödel, in 1132 quite difficult pages.
What is useful to us is that computer programming forces clarity upon some questions that originate in the humanities; A.I. is likely to have a very large impact on society. However, this is not at all to reduce one field to another.
At the 1/4/19 annual American Economic Association meeting in Atlanta, Fed Chair Powell and former Fed Chairs Yellen and Bernanke placed the implementation of Fed policy in the perspectives of the U.S. and world economies.
1. Powell: The Fed will be patient and flexible in its implementation of monetary policy. The U.S. economy is growing moderately and well. In December jobs increased by 312,000 (our note: about 170,000 is normal), unemployment has been less than 4% for four months, wages are moving up along with labor participation.
The financial markets, however, foresee the opposite. With China pulling back, copper down. The financial markets are pricing in downside risk to global growth. We don’t have a fixed monetary policy. In the 2016 (international) taper tantrum, Chair Yellen nimbly adjusted rates and normalization resumed. We will be prepared to adjust policy quickly and flexibly.
We need the concept of the natural rate of unemployment, to give us an idea of whether interest rates are too high, too low or just right. The exact level of the natural rate is uncertain, but it is possible to go too fast in relation to resource constraints.
Future research ought to integrate macroeconomics (our note: assumes equilibrium) and markets (our note: assumes disequilibrium on the path to equilibrium ).
2. Yellen: We have a strong economy with consumer spending comprising 2/3 of it. The Philips curve (linking unemployment and inflation) is relatively flat, giving the Fed the opportunity to move carefully in a data dependent manner, managing risk. The growth rate of the economy is consistent with potential and may warrant some tightening.
When giving rate guidance, it will be important for the Fed to co-ordinate across asset classes.
3. Bernanke: It was very important for the Fed to anchor inflation expectations at 2%. As a result the Philips curve is flat, allowing the Fed to experiment with policy. Unanchored inflationary expectations mean that it is more difficult to stabilize the economy.
(This is really important because it provides an order that enables a rational and more deliberate management of the economy.)
On 1/18/19, the S&P 500 closed at 2671, providing a long-term investment return of only 5.3%.
The pricing of assets in the financial markets is based upon a risk markup from the short-term Fed policy rate, currently at 2.5%. Under normal spread conditions, the rates of return available from major financial investments are as follows:
Normal Conditions Current Conditions
2.5% Policy rate 2.5% Policy rate
2.0% 10 year treasury premium .4% 10 year treasury premium
2.0% Corporate bond premium 2.4% BAA corporate bond premium
2.0% Equity risk premium 0% Equity risk premium
8.5% Normal equity return * 5.3% Equity return 1/18/19**
* With the exception of the policy rate, these are returns available under normal conditions. For the ten year bond, a rule of thumb is 2% above the policy rate.
** The present ten year treasury premium of only .4% signals a flat yield curve and a low demand for capital either due to low growth (and the increased digitization of the economy) and/or an impending recession. The high BAA minimum investment quality bond spread signals a recession. The equity return of 5.3% assumes a cyclically adjusted 10 year S&P 500 operating earnings average. Growing this year’s earnings estimates in perpetuity would result in a much higher equity return.
But why is the equity risk premium zero (which is another way of saying the stock market is overvalued)? *** In theory, equities are supposed to be more risky than corporate bonds; but financial history is what actually happens. During the last ten years, the economy has been slowly recovering from the Great Recession, when rates were at the zero bound, overvaluing equities, which do not default the way bonds do. At a zero required rate of investment return, the price of an infinite stream of $1 payments is infinity. With rates low since the Great Recession of 2008, and just beginning to normalize, equities have been overvalued.
If this economic recovery continues, the Fed will very likely raise interest rates slowly, in a conditions dependent manner, to stabilize inflationary expectations and keep the real economy’s expansion going. If the economy slips into a recession due to a combination of factors affecting business confidence such as the shutdown of the Federal government and/or financial crises abroad, with a trillion dollar government deficit right now, future monetary policy is less likely to be effective. There will also be balance sheet (stock) problems that go beyond the decreased (flow) of exports. Equities will unlikely remain at a “permanently high plateau.”
*** Jagannathan, McGrattan and Scherbina (2000) from the Kellogg School and the Minneapolis Fed found that the equity premium relative to 20 year U.S. long-term government bonds in 1999 was -0.27%. Our calculation yields a present equity premium of 2.4% against 10 year government bonds.
The spreads above obviously vary according to financial conditions. It is possible to read the story of the markets from these spreads, and to ask whether the spreads justify the individual asset risks.
With U.S. economic growth still continuing, this is the time to seek reforms, to begin to solve many problems that only government can remedy. In his epic chronicle of the French Revolution of 1789, Citizens, Simon Schama writes that the ancien regime, distracted by modernization and unable to effect financial reform, frittered away its social order in discord – often incited by members of the aristocracy. The result was prolonged chaos. Writing On The Origins of War, the classicist Donald Kagan noted that the next generation of European statesmen then constructed an international treaty system that resulted in decades of peace and stability, a stability that vaunting national ambitions increasingly undermined prior to W.W. I.
The rest, as they say, is history. The 1/22/19 NYT reports that a major investor now warns against, “global social tension, rising debt levels and receding American leadership.” Social stability should not be taken for granted. U.S. social cohesion is quite challenged by a “whatever it takes” culture in business and politics.