On 12/31/19 the S&P 500 closed at a near record of 3231, resulting in a total return of 31.49% for the year, for momentum investors. But projected equity returns for long-term investors declined to 4.77%. For investors who do not plan to actively manage their own portfolios (and who want to eventually invest in an index that tends to outperform), the latter is the relevant return.
The following table illustrates that low future rates of equity return are due to the general decline of interest rates and continued decreased term risk premia for both long-term bonds and stocks:
Normal Conditions Current Conditions
2.5% Policy rate 1.75% Policy rate
2.0% 10 year treasury premium .37% 10 year treasury premium
2.0% Corporate bond premium 1.98% BAA corporate bond premium
2.0% Equity risk premium .67% Equity risk premium
8.5% Normal equity return 4.77% Equity return 12/31/19
Interest rates remain at the lowest levels in 5,000 (sic) years of recorded history and term risk premia remain compressed. The following essay discusses why.
The Causes of Low Rates of Return
The following discusses the causes of currently low interest rates and high asset prices. During the threatened 2008 world-wide collapse of the financial system, a hedge fund manager commented that the rapid monetary creation of the central banks would create an inflationary crisis. That didn’t happen.
If general inflation is too much money chasing too few goods, why didn’t inflation soar as the U.S. government increased the money supply by accommodating the yearly deficit, lending liberally to the banks in return for less liquid (but still sound) collateral and by open market bond purchases?
Stagnation and the Declining Velocity of Money
The main reason it didn’t, was that much of the newly created money remained bottled up in the financial system. The following graph showed that in 2019, excess bank reserves were at $1.388 trillion, potentially funding (at a 10% reserve requirement) $13.88 trillion in additional GDP growth (2019 U.S. GDP will be around $20.5 trillion). But the second graph shows, the velocity of money, defined as v = GDP/M1 (the money supply) - plummeted.
The reasons for this were:
1) At the central bank level, possibly to prevent the banks from making ever riskier loans, the Fed started paying interest on all bank reserves thus keeping limiting the quantity of money that hit the economy; while still being able to lower over-all interest rates.
2) The of-cited factors of globalization and digitization, off-shoring a large amount of U.S. productive capacity and reducing the amount of capital necessary to fund economic growth.
3) Very important, we think, is the ideology of market fundamentalism that limits the role of government, leaving it to the markets to solve major distribution questions, the latter to be solved by the “trickle down” theory that all would benefit by making companies and the upper .01% richer, who would then spend their untaxed money on additional business investment.
The practical effect of this “trickle down” theory was highly mixed. In 1981 the Reagan administration cut the top federal tax rate from 70 percent to 50 percent, among other things. But the subsequent high economic growth is mainly attributable to Paul Volker’s reduction of the Fed funds rate from 19.08% on 1/81 to 8.68% two years later. But the federal debt almost tripled from $997 billion in 1981 to $2,857 billion in 1989. These tax cuts did not pay for themselves. An article by Columbia professor Joseph Stiglitz, “The Starving State” *, in the significant January, 2020 Foreign Affairs magazine discusses the results:
“After the tax cuts in the 1980s, under the Reagan administration, capital taxation collapsed, but rates of savings and investment also declined.
“The 2017 tax cut illustrates this dynamic. Instead of boosting annual wages by $4,000 per family, encouraging corporate investment, and driving a surge of sustained economic growth, as its proponents promised it would, the cut led to miniscule increases in wages, a couple of quarters of increased growth, and, instead of investment, a $1 trillion boom in stock buybacks, which produced only a windfall for the rich shareholders already at the top of the income pyramid. The public, of course is paying for the bonanza: the United States is experiencing its first $1 trillion deficit.” (wait until a recession hits)
This article begins by noting, “For millennia, markets have not flourished without the help of the state…Most economists rightly emphasize the role of the state in providing public goods and correcting market failures, but they often neglect the history of how markets came into being in the first place. The invisible hand of the market depended on the heavier hand of the state.”
In addition to winning wars and dispensing justice, the U.S. government is also partly responsible for economic demand and social advances, the construction of the Interstate highway system and other infrastructure, an environment conducive to life as we know it, medical R&D, and the development of the internet. The same article notes:
“No successful market can survive without the underpinnings of a strong, functioning state. That simple truth is being forgotten today. In the United States, total tax revenues paid to all levels of government shrank by close to four percent of national income over the last two decades, about 32 percent in 1999 to approximately 28 percent today, a decline unique in modern history among wealthy nations. The direct consequences of this shift are clear: crumbling infrastructure, a slowing pace of innovation, a diminishing rate of growth, booming inequality, shorter life expectancy, and a sense of despair among large parts of the population. These consequences add up to something much larger: a threat to the sustainability of democracy and the global market economy.” Many of the problems in the U.S. are self-inflicted.
The stagnation problems engendered by the Reagan/Thatcher supply-side revolution which compromises middle-class purchasing power, are now magnified abroad. A 12/23/19 FT article notes that in Germany, Italy, France and the U.K., the political center has declined due to mandated austerity. “If there was one common policy that accelerated (that decline)…it was austerity. We have come to judge austerity mainly in terms of its political impact. But it is the political fallout from public spending cuts that is most likely to persist….European liberalism has a long history of self-destruction. We are going through another such cycle. In view of the past, extraordinary decade, only a fool would want to predict what comes next. What remains is a sense of dread.”
Low Interest Rates
Modern Keynesian economic policies are concerned with overall demand management. However, there are different effects whether one uses fiscal or monetary policies. Fiscal policy expands the role of government, and monetary policy expands the role of private enterprise. In the absence of fiscal policy, that is appropriate government spending, the only alternative to keeping the economy going is monetary policy that relies on the private sector to generate all economic growth. This overreliance has produced low interest rates, risky high financial asset prices (the present value of an annuity is simply its positive cash flow/the discount rate) and high leverage. Both are risky. High asset prices can easily be brought down by sustained increases in interest rates, and high leverage resulting in financial bubbles that burst.
The following Bank of England graph shows that interest rates remain at the lowest levels in 5,000 years of recorded human history. During the Roman era, interest rates ranged between 4-8%. We think something is amiss, and it isn’t the data.
On 9/19, the business economist David A. Levy published “Bubble or Nothing.” That report discussed in great detail the effects of the low interest rate monetary regime. It notes:
1) From the mid-1980s on – the era of the Big Balance Sheet economy – federal decision makers have had to choose between progressively lower returns…(or) higher risk.
2) Each successive crisis, with more bloated balance sheets to stabilize, was more difficult to resolve and therefore required the government to engineer dramatic new lows in interest rates…
3) The present cycle is almost certain to end badly. Although there are signs that balance sheet ratios are undergoing an extended secular topping process, they remain extreme and will produce extreme financial instability during the next recession.
4) The lives and behaviors of human beings and their societies are just too complicated and too messy…for the economy to maintain machine-like textbook functioning. Furthermore, (our note: especially now with global warming) the future is unpredictable in too many ways to be summed up as a set of determinable probability distributions.
5) Private investors accept so much risk, “(because they see)…no other way to obtain financial returns that are anywhere near their goals and in the case of many institutional investors, anywhere near their explicit targets (of slightly less than 8%).” Thus since stock dividends approximately equal the 1.9% ten year treasury yield, the financial markets believe There Is No Other Alternative, although stocks have an interest rate sensitivity in excess of 36 years and ten year bonds have an interest rate sensitivity of around 8 years.
The following graph charts the ratio of U.S. Private Nonfinancial Sector Debt Outstanding as a percent of GDP. It shows that even with some readjustment since 2008, that ratio is at historic highs. Another implication of this graph is that since debt has grown much faster than GDP, “(there is)…a tendency for more of the new lending to finance purchases of existing assets” rather than new ones that create jobs. In face of low consumer demand, businesses have also been taking capital out of the economy in the form of stock buybacks.
Companies in other developed nations have also drastically increased their leverages and therefore their riskiness. We think the financial system is risky and the financial returns available do not justify taking this risk.
This is our first comment for 2020. We do not like to start this year out with a litany of woe; but the solutions to intensifying problems in the political economy require good leadership, with the conceptual tools and skills to handle these when they come home to roost.
* In Citizens (1989), Simon Schama wrote that a major cause of the French Revolution of 1789 was the “inanition” (starvation - we had to look that one up) of the state that was unable to pay the debts it incurred funding foreign wars, including the American Revolution of 1776. French society at the time was unable to achieve a new equilibrium (consensus) to solve its problems.
On 1/24/20, the S&P 500 closed at 3295, up 1.98% for the year, to yield long-term investors a total return of 4.68%.
At times, it is said the stock market discounts the hereafter. We model the “hereafter” by assuming that current S&P 500 annual operating earnings to the 1st quarter ($160.46) will increase constantly at a non-cyclical growth rate of 2% real and 2% inflation/year, in perpetuity. The total return of such an investment would be only 6.48%. *
However, the 1/23/20 FT notes the following economic contingencies:
1) China’s share of global GDP will hardly change, “… largely because increasingly centralized government will stifle reform and make the allocation of resources less efficient.” This means that China’s slowing economic growth will begin to approximate low real global economic growth of around 2%+.
2) Changes in fossil-fuel dynamics may happen “quicker than we think” and will affect first the Emerging Market currencies. At Davos, a major oil company executive finally mentioned global climate change as a factor to consider. A 1/24/20 Washington Post article headlines, “Davos elite want to plant 1 trillion trees to help the planet, but many still fight a carbon tax.”
3) We add, to remedy global warming, energy must become more expensive, cutting somewhat into economic growth. In 2017, U.S. energy consumption was 5.8% of GDP. More expensive energy would cause less use. Appropriate and broad political action would result in a less impactful use of energy.
These contingencies overlay a highly leveraged world economy and an overvalued stock market. We would be especially careful because there are many people (and computers) in Wall Street that have never seen a bear market.
* A columnist in the 1/27/20 Barron’s makes exactly the same “perpetual growth” assumption with his rule of thumb for calculating S&P return. He writes: 1) Start with (this year’s consensus projected earnings growth of 10%, divide in half for estimate cuts. 2) Add two points for dividends (should be 1.77%) 3) Take off a point because of elevated p/e ratios. 4) Add back a point because reversion to the mean is on disability leave. This totals to a 6.77% S&P 500 return. The Street assumes that growth will be perpetual.
In the U.S,, impeachment is charge of misconduct made against the holder of a public office, that will result in removal from office. Article II, sec. 4 of the Constitution is the basis for the House impeachment of President Trump. The constitutional reasons for impeachment is “high crimes and (high) misdemeanors.” A misdemeanor is “bad conduct.” In Federalist No. 65, Hamilton wrote that impeachment is a political act, but “political” (not in a partisan sense) but “political” because the offenses “…relate chiefly to injuries done immediately to society itself.” That is, a president’s impeachment by the House and removal by the Senate should occur because he has acutely injured the political order.
The “political order” along with “rights” are abstractions on how the citizens of a Republic should view things. On January 23, 2016 President Trump said, “I could stand in the middle of 5th Avenue and shoot someone and I wouldn’t lose voters.” Most immediately, he did not understand the government system of which he is now President, and greatly disrespects the American voter.
More generally, the U.S. political order derives from ancient Greece and Rome, Greek democracy and Roman law. In “The Origins of Greek Thought,” Vernant wrote that (in the 6th century B.C.) due to changes in social structure brought about by the orientation of a whole sector of the Greek economy toward overseas trade, “What was peculiar to Greece was the reaction those changes produced in society: the refusal to accept a situation that was felt and denounced as anomia (lawlessness)…” In particular legislation concerning homicide marks the moment when murder ceased to be a private affair, a settling of accounts between (relatives, as still occurs in the Mideast). “Blood revenge, which had been limited to a narrow circle but had been obligatory for the relatives of the dead man, and thus could set in motion a disastrous cycle of murder and reprisal, was supplanted by repression organized by the city…involving the community as a whole. Now the murderer defiled not only the victim’s relatives, but the entire community.” * Thus originated the rule of law (which was the Greek philosophical temperament anyway, to look for order in the cosmos. About which more later).
Both the President and Senator Mitch McConnell view politics solely through the lens of political partisanship; they propose a rigged Senate trial without documents and witnesses. This endangers our rule-based political order, whose capabilities will be greatly challenged in the future by climate change and increasing economic inequality.
* Vernant (1984), p.p. 74-75.
A Senate impeachment trial without documents and witnesses is not a fair trial. It would drastically change our shared power system of government. To preserve our freedoms, the founders balanced that power among the executive, legislative and judicial branches. If the Senate permits this President, who has refused all House subpoenas for information, to defy Congress, it will have failed to exercise its oversight responsibility at a crucial time. It would then become an accomplice in placing the U.S. on the road to dictatorship, the President putting his own interests above that of the nation’s.
There is a lot at stake.