Monday, July 7, 2014

Risk & Valuations, Part 6: At some margin, being short-sighted is rational.

A cornerstone of economic insight has always been the value of specialization.  Abundance depends on it.  We all specialize.  This means we are all optimized to an environment that is stable in relation to our competitive advantage.  If we weren't, we would be reducing our standard of living substantially.  This is the dilemma of the modern world.  Outside of cultural outliers like the Amish, we almost all take the optimized route.  Anyone reading this post certainly has.

At the extreme end of the potential outcome distribution, we have all optimized our human capital to a functioning, civil economy.  If a dystopian hellscape comes, we will all wish we had chosen to be Amish.  And, the choice isn't obvious.  It is reasonable to expect that every society will eventually devolve.  Many places in the world are currently in this position, and every place in the world has been in this position at one time or another.  Our decision to specialize has a non-zero risk.  But, the decision to specialize is almost certainly the right decision to make in the quest for a rich life.

More locally, most of us trade away the manageable portion of our risk for a fixed wage or fixed income.  Note, even here, we can't trade away the most existentially dangerous portion of our personal risk distribution.  Even when we trade the manageable risk, as a laborer, we still retain the risk of being laid off, and as a bondholder, we still retain the risk of default.

We can't trade away the most damaging parts of potential risk, so is this trade irrational?  I say no, because there is a surplus gained from trading this risk.  Utra-stability creates a regime shift in the managed part of our lives that allows a highly optimized decision tree.  If we have a very uneven income stream, it is humanly impossible to plan rationally.  The establishment of a stable plateau of outcomes, then, is very valuable, even if it can't encompass the entire range of risks.  The trading of this risk creates a surplus.  The surplus for the seller of local certainty (eg. the equity holder) is monetary (equity risk premium).  The surplus for the buyer of local certainty (labor or debt sellers holders) is non-monetary, in the form of numerous opportunities for rational planning in a stable economic context.

At a societal level, this must settle at some equilibrium.  The more citizens in a society trade away manageable risk, the fewer sellers of local certainty there are to take the other side of the trade.  We tend to approve of public policy that favors buyers of local certainty.  Most of us identify as certainty buyers.  But, the problem is that policies that make certainty more accessible move the supply/demand equilibrium for risk so that the equilibrium is more likely to be upset by economic dislocations - there are fewer investors to absorb the risk.

Public policy meant to shift risk from laborers to firms increases the value of the imbedded labor risk-trade, and necessarily will lower the compensation level that reflects the risk discount.  Policies that impose other costs on certainty sellers will also increase the premium required by firms in the labor-firm risk trade.

We normally think of risk premiums consisting of a risk free rate with a premium on top of it.  Thinking of this in terms debt holders buying certainty, it might be more clear to think of returns to the firm as the base return, and the risk free rate as a discount from the firm's total returns.  In either case, that difference would be the Equity Risk Premium (ERP).

Currently, we have a demographic situation where an unusually large number of households demand a fixed income, because baby boomers are preparing for a vulnerable time of their lives, when they will be less productive.  The equilibrium price of debt declines, which leads to decreased corporate leverage (see parts 1-5), so that capital is drawn back into equity positions, but the equity positions represent a less volatile portion of ownership, and this leads to a new equilibrium where interest rates are lower, debt levels are low, and leveraged Equity Risk Premiums are reduced due to the deleveraging, even though unlevered ERP remains high. 

The same shifts would occur between labor and equity.  The net level of compensation, after factoring in the discount for local certainty, would decrease.  The decrease in compensation would, counter-intuitively, lead to a "deleveraging" of labor.  Firms would demand less labor in the composition of risks they balance between debt, labor, and equity.  In the end, high risk premiums cause a decline in equity, debt, and labor, but especially debt and labor.  This is because of the ironic relationship between cost and leverage that causes firms to use less of them when their lower cost is the result of relative interest rates and risk premiums.  Of course, returns to equity would be high, in an absolute sense, but the nominal value of the equity would be lower, do to the higher risk premiums.

This is where we are now.  Corporate debt is low, equity prices have been relatively stagnant since 2000, and compensation is low.  Corporate earnings are healthy, which we should expect with low corporate leverage and a high equity premium.  The outlet, then for all that demand coming from buyers of local certainty is real estate.  Real estate provides access to relatively fixed incomes as both debt (mortgages) and equity (the homes themselves, with rent, or implied rent, as the income).  So, we see an inflow of capital into real estate, associated with a low risk free interest rate.

No comments:

Post a Comment