Thursday, October 30, 2014

The Housing Shortage is Lowering Real Incomes

This is one more follow up to the issue of profits and compensation, and how housing fits into the puzzle.  (Previous posts here and here.)  This issue of Rental Income and Compensation helps to demonstrate how tight monetary policy exacerbates income inequality and reduces real median incomes.  This analysis starts with the understanding that housing markets were, more or less, functional in the 2000's, and the Fed undermined these markets with excessively tight monetary policy that created the financial crisis. (See my Housing label for more extensive discussion of this issue.)  Rent inflation and Rental Income were generally high in the 2000's, which would be very unlikely if homes truly were being overbuilt and overpriced.

The mixture of cyclical, regulatory, and monetary factors keeping households out of mortgage credit markets and limiting housing price appreciation and house construction is causing a housing shortage.  Two signs of this shortage are the sharp rise in net rental income even above the levels of the 2000s (the first graph) and the resurgence of rent inflation (the second graph).

This means that since 2008, Compensation income is being displaced by net Rental income.  For households that rent their residences, this means that real income has been reduced by rent inflation.  For households that own their residences, this means that real income has been reduced by rent inflation, but has been replaced by Rental Income.  So, policies that are keeping home prices down are benefitting households that own their homes at the expense of households that don't.  All households look like they have lower real incomes.  However, real income of home owning households is understated because the high inflation of their imputed rent is being deducted from their compensation income and is being re-constituted as capital income.

The third graph shows relative nominal changes in Compensation and Rental Income since the 4th Quarter of 2008.  Nominal Compensation has increased $1.2 trillion since the end of 2008.  Rental Income has increased by $350 billion.  For home owning households, their experienced real incomes have increased by $350 billion more than what their statistical compensation levels are showing, because this rent inflation generally is not affecting their cash flow.

Non-homeowning households have experienced rent inflation as measured, and the gains from that rent are generally accounted for as reductions in their real incomes, relative to nominal incomes, and as profits to firms in the real estate industry.

The housing shortage is reducing the Compensation share of national income through both mechanisms - home owners and renters.  One path goes to Rental Income and doesn't really affect real household incomes and the other goes to profit and does really affect real household incomes.  Both represent a shift in total income to generally higher income households.

The irony is that so many people seem to agree that rising home prices, by making homes less affordable, are hurting lower income households.  If we don't put the clamps down on the banks, they will just drive us right over another speculative cliff, so the story goes.  Sadly, the tight regulatory and monetary regime that comes out of this flawed reasoning is the thing that is actually hurting low income households.

If returns to capital aren't high, then why is compensation share low? (Hint: It really is monopolistic profits!)

There are only so many places for income to go.  If returns to capital aren't high, then why is compensation low and declining?

Short answer.....Housing

Here is a graph of compensation share of GDI along with net rental income share of GDI.

First, this is a little tricky, because 60% of American households own their homes.  So, in effect, this is a measure of rent we are paying ourselves.  Or, put differently, this is a measure of the income share we capture because home ownership tends to provide excess returns.

The trend in Compensation has dropped from about 57% in 1970 to about 53% - a 4% drop.  But, the trend in Rent + Compensation has dropped from about 59% to 57%.  Rental income explains about half the drop in Compensation Share, and in fact, accounts for more than all of the drop in Compensation Share since the previous low point in 2006.

To the extent that Rental Income supplements Compensation, this income is probably distributed mostly to middle and upper-middle class households.  So, both the level and the distribution of household Compensation Share are probably helped by reducing excess returns to Rental Income.

Returns = Income from Asset / Price of Asset

Rent is generally going to move proportionately to incomes.  A mistake I see committed widely is to model home prices as a proportion of incomes.  Home prices should come from rent and from expected returns.  If rent is stable proportionately to incomes, then home prices should respond to changes in expected returns.  Real estate is usually a relatively low risk investment.  Low-risk rates of return are currently very low, even on very long term investments.  This raises the value of homes.  The only non-disruptive way to reduce this excess net Rental Income is to allow the price of homes to rise.

Estimated Excess Return to Home Ownership
I recently estimated the relative return to home ownership by using mortgage rates, CPI rent inflation, and FHFA home prices, and I found a similar trend to the trend we see in the BEA net Rental Income share - excess returns rise in the 1990's, dip in the late 2000's and rise even higher after the financial crisis.

This is a very difficult concept to accept, but rising home prices would be a positive development for Compensation share and equitable income distribution.  (Please see my Housing label for more extensive discussion of this issue.)

Take another look at the top graph.  In the 2000's, during the presumed housing bubble, net Rental Income was higher than it had been since the early 1970's.  The reason the housing market was hot in the 2000's was because it provided high returns relative to other investment opportunities.  Speculation in the housing market was not pushing home prices into the unsustainable stratosphere, it was simply capturing gains from sticky prices in the housing market that created a delay in home prices moving up to their intrinsic values.  Rent levels were not unusual.  To justify the housing bubble narrative, one would need to explain why net rent income remained so strong.

Risk Trading

UERP = Unlevered Equity Risk Premium
This leaves a decline of about 2% in Compensation Share from the peak period of 1950s to 1970s.  I have discussed the fluctuations of labor share in a risk trading context.  Just as an increase in risk aversion causes both leverage and the rates paid to creditors to decline, an increase in risk aversion could also cause some decline in the rate paid to and quantity demanded of labor.  This is easily imagined in the form of workers on the margin between labor and owner, and how the costs and benefits of a change would be affected by their attitudes toward risk.

Please read the links if you're interested in this idea, for a slightly more detailed description.

The table below outlines the general trends shown in this graph as they comport with the risk trading framework. (RFR = Risk Free Rate, ERP = Equity Risk Premium)

RFR ERP Compensation Debt Level Equity Value Enterprise Value
1960s Low Med. Med. Low High Med.
1970s High High Med. Med. Low Low
1980s High Low Very High High Med. High
1990s Low Low Med. Med. Very High Very High
2000s Very Low High Very Low Very Low Med. Med.


But, I want the main focus of this post to be the housing element.  A mixture of bank health, bank behavior, regulatory influence, and monetary policy have created an economic context where there are tremendous non-price barriers to entry into home ownership.  The monopolist profits are going to home owners!  Krugman is right.  He's just looking in the wrong place.  And DeLong is right, too.  Investment is low because expected growth is low.  If the housing market were made liquid again, either through inflation-produced deleveraging or through regulatory accommodations, growth and investment would both increase, as we begin to build homes again to reflect demand that isn't dampened by regulatory and monetary policies.  And, lower income shares going to housing would lead to higher income shares going to compenstion - not to mention all the construction jobs that would come along with this development.  (DeLong is looking in the wrong place too.  Clearly the missing investment is in residential fixed investment.)

When QE was adding cash to the economy, all-cash institutional home buyers were flooding into the home market, because excess profits are available for the economic elite who have the means to purchase real estate.  If compensation is going to recover, these barriers to entry need to be removed.  But, for this to happen, many people will need to be disabused of the notion that high home prices must be irrational.  For those not disabused, I think you need to explain why net rental income is higher than it's been since the 1940s.

Follow up:  Housing shortage is causing real income stagnation.

Returns to capital aren't high.

I've been seeing talk regarding returns to capital, corporate share buybacks, profits, etc., including this post by Paul Krugman.  Krugman writes that we are seeing high profits and low investment because corporations are exhibiting monopoly power.  Brad DeLong responds to Krugman here, saying that profits are high because labor compensation is low and that investment is low because we are now permanently below the previous trend in GDP.

Krugman uses this graph, which I think might be causing some confusion:

One bit of confusion is the use of corporate profit as a measure of returns to capital.  From a finance perspective, this would proxy Free Cash Flow to Equity (FCFE), but the more comprehensive measurement is Free Cash Flow to the Firm (FCFF).  Capital comes in the form of debt and equity.  For any firm there is a broad set of factors that might determine the right balance.  But, in terms of measuring the returns on the assets of the firm or the return to capital in general, that balance is fairly arbitrary.  FCFE is a residual, partial measure of returns to capital.  FCFF is the appropriate measure.

Monopoly Doesn't Explain Current High Profits

What if Krugman's assertion was correct, that monopolist tendencies have pushed up the profit margins of American corporations, and that barriers to competitive investments keep investment low while those profits remain high?

In that case, we should expect risk premiums to equity to be low, since profits would be protected by competitive barriers.  Usually, firms within this context are expected to use higher leverage.  Partly, this is because firms with high and stable cash flows tend to have high fixed capital levels.  But, also, from a capital supply standpoint, creditors are more willing to provide a higher portion of the capital base because stable profits create lower default risks.

But, currently, equity risk premiums are very high.  If we had a large amount of capital chasing monopolist corporate profits, equity risk premiums would be bid down, and equities would be trading at much higher valuations.

As I have pointed out in several previous posts, total real returns to capital, implied by the Federal Reserve's Z.1 report, currently are pretty close to the surprisingly stable long term average of about 8%.  If we use something like Damodaran's estimates of risk premiums for the S&P500, the required return runs a little lower, understandably, but, they are still pretty stable over time, especially when adjusted for leverage.  Here is my rough estimate of real total required returns implied from the Z.1 report over time.  Total required returns to non-financial corporate capital here are Real Risk Free Rates (RRFR) + Unlevered Equity Risk Premium (UERP).  Nominal returns include inflation (GDP deflator used here).

It is common, and understandable, to assume that firms have high profits because low interest rates allow them to leverage up on cheap debt, keeping more of the returns for equity holders.  If this was the case, we would expect to see firm leverage increasing when rates are low and equity values would soar.  However, what we find instead is that firms deleverage when interest rates are low.  Here is a comparison of the 10 year nominal treasury rate and debt/Enterprise Value from the Z.1 report.  The next graph is from JP Morgan, showing Debt to Equity levels among the S&P 500.

So, the high profit levels aren't due to low rates in the way we normally think of it.  High profits simply reflect the current balance of capital - debt vs. equity.  Firms are using more equity to fund operations, so more of the operating profits are flowing to the bottom line, simply as a matter of accounting.  This is, indeed, the opposite of what we would see in an economy of monopolists.

High ERP suggests risk aversion.  In fact, equity risk premiums and risk free interest rates tend to move inversely.  The fact that rates are low and risk premiums are high could suggest that, as Krugman puts it, "business are holding back because Obama is looking at them funny".  While that is a more plausible explanation of interest rates and risk premiums than Krugman's monopolist conjecture, it is hard to say how much.  Regulatory and tax threats and uncertainties generally affect potential competitors at least as strongly as existing firms.  A common way to become one of Krugman's monopolists would, in fact, be to have the government look at your potential competitors "funny".  So, it's not clear that the monopolist context and the unfriendly regime context create distinctly different signatures in required returns.

Current risk premiums are probably mostly the product of capital supply.  Well known demographic trends mean that millions of households are preparing for decades where they will be unproductive, and thus don't have the stomache for potential financial losses.  I have also argued that the exchange of high risk and low risk capital between the developed world and the developing world is highly beneficial to both sides of the trade.  Low risk free rates also reflect this influx of developing world capital that lacks avenues for local low-risk returns.*

Low interest rates and low corporate leverage both reflect this demand for low risk.  Here is Krugman's original graph, with additional information regarding returns to capital.

We start with Profit (the blue line at the bottom).  I have extended the time frame further back.  The green line represents all returns to corporate capital, both to debt and equity.  The debt portion peaked in the early 1980's when corporate leverage was at its highest.  When we make this correction, we find that corporate returns to capital have been flat for 40 or 50 years.  If we add in proprietors' income, we find that returns to capital have been flat or declining for a century.  From 1929 to about 1985, there was a trend of profit claims moving from proprietors to creditors.  From 1985 to the present, there was a trend of profit claims moving from creditors to equity owners.  But, there is no trend of increasing total returns to capital over the past 30 years.

And, when we take the longer view, there really isn't so much of a trend in private fixed investment either, especially considering that investment continues to recover from the recent recession.  Investment is well above the levels of the 1950s.  Investment as a share of GDP ranged from 10-12% until the 1970s.  Since then, the range has moved up to 11-14% and is currently 12.3%.

There is nothing to see here.  Which casts doubt on DeLong's reply, also.

But, if that is the case, then what is causing compensation to decline as a share of GDI?  I'll tackle that in the next post.


* I would put this in the "We are the 100%" file.  Developing world laborers may have a depressing effect on unskilled wages in the developed world.  Developing world capital may have a depressing effect on risk-free returns in the developed world.  This creates higher relative returns to skill for laborers in the developed world and higher relative returns to risk for capital in the developed world.  The context we see in labor and in capital is parallel.

This is a product of the opportunities global capitalism presents to developing economies.  Without these opportunities, developing world laborers would have lower wages or would simply live outside the wage-based economy, and developing world capital that lacked foreign low-risk outlets might seek local low-risk returns through limited-access land ownership and governance.  Access to global financial markets allows for both labor and capital in developing economies to jump up to a much more productive and universally applied economic system.

Wednesday, October 29, 2014

Quick Update on Forward Rates

Here is a chart of recent yield curve fluctuations.  The changes are more straightforward than I would have thought just from recollecting the month's news.

From mid-September to mid-October, the long end of the curve moved down about 60bp, after already giving up 100bp since the beginning of the year, and, at the short end of the curve, expected rate increases moved forward in time about 1 1/2 quarters after being fairly stable all year.

Since October 15, rates at the long end have moved back up about 20bp and the rate increase timing has moved back by about 1 1/2 months.

For all the questions regarding credit markets and Fed policy, the movements up to today looks to me like just a general ebb and flow of long term growth sentiment, first worsening, and now recovering slightly.

Today, all the movement was in the timing of the rate hikes.  Long term rates remained roughly level, even falling slightly by the end of the day.  The expected rate hikes moved back, so the entire curve shifted back in time by about 1 month today.  This, combined with the small decline in equities, suggests that the Fed statement today was taken as a slight tightening, implemented through stronger resolve in implementing rate hikes.

CoreLogic Housing Analysis

Here is an interesting report on housing from CoreLogic.  (HT: @esoltas )  Several slides are brilliant, which is to say they corroborate my stated positions on housing  ;-) .

Here are three slides, in particular:

The first graph shows relative cyclical behaviors of several housing market factors.  This suggests that the remaining low home market values, relative to mortgages, remain a dampening factor.  Every other factor is well below normal levels.  The most important question I will be looking at over the next few months will be how much these other factors are improved after the FHFA rule changes are implemented.  Will it be enough to help homes recover while LTV remains so high?

The next graph shows the proportion of credit scores among home buyers.  First, the obvious issue here is that FICO scores are incredibly high right now.  Mortgage markets are extremely tight now.  There is tremendous weight on housing demand now due to limited credit.  But, I think FICO scores in the 2001-2005 period are just as interesting.  It would be nice to see this data farther back in time.  But, in the 2001-2005 period, there was no trend in FICO scores indicating looser lending standards - at least according to CoreLogic.  We've heard a lot of anecdotal evidence of poor credit buyers being prodded into expensive homes. And, I've seen CMOs in that period that were being purchased at low rates, despite being composed of loans with high and homogeneous risk profiles.  And, I've seen evidence of increases in sub-prime lending on an absolute basis during that time.  But, this data suggests that the profile of the typical home buyer was stable.

The next graph again shows how tight credit conditions are now.

But, again, I want to point to the 2001-2005 and to the 2006-2007 time periods.  Conditions were relatively stable through 2005.  Relative home prices topped out at the end of 2005, and from the end of 2005 to the middle of 2007, delinquencies remained slightly elevated, but not out of normal range.  Note that during this period, FICO scores were rising.  So, by these measures, the housing market was operating with a fairly normal, prudent set of trends.

Natural recoveries in long term real interest rates caused a pause in relative home prices, which created some cyclical risks in the housing market.  Lenders responded with slightly tighter lending standards.  And, the result of these adjustments was a slightly increased, but manageable delinquency rate.

But, by mid-2007 the narrative had taken hold of this country, that home prices must have been too high, and it must have been because bankers were driven by greed to prod us into a speculative frenzy, and so a policy regime that would have allowed for more possible gains in home prices would be unacceptable.  So, beginning in 2007, the Fed began flatlining their balance sheet, and currency in circulation followed suit.  As liquidity problems started to create crises, they were handled with extraordinary policies instead of with basic monetary expansion.  Even though our collective wisdom through the marketplace had been signaling for a decade that home prices should be higher, our conscious consensus view was that this couldn't possibly be the case.  So, we weren't going to let it happen.  And the Fed obliged.  The Fed could have lowered the Fed Funds Rate and increased its treasury holdings in early 2007.  In fact, because of the effect this would have on housing supply, this might have actually led to lower CPI inflation readings in 2007 and 2008.  It would probably have led to some resurgence in home prices.  Credit standards could have loosened back up to the previously stable levels.  But, the same 300 million people who would have been bidding those home prices up in practice couldn't believe that home prices should be bid up in theory.  So the Fed pissed in our soup bowl just like we wanted, and most people say "Thank you" to the Fed and then blame the soup cook.  I think it could be reasonably argued that Fed policy was too tight all the way back to mid 2006, when rent inflation started to rise strongly (because of a supply shock in housing credit markets) and Core minus Shelter inflation started to drop.  But, it was manageably tight.  Lower the Fed Funds Rate to 4%, and enjoy 4 more years of expansion.  In mid-to-late 2007 it went from slightly tight to recessionary.  Lower short term rates a little sooner or a little faster and maybe see unemployment peak at 6%.  And by September 2008, it was crisis-level tight.

Tuesday, October 28, 2014

Wages, Inflation, and Interest Rates in the Recovery

It seems reasonable that as the recovery ages, sticky wage issues would be less of an issue.  I have seen the problems of low inflation more as an ingredient regarding frictions in short term savings and investment and in the residential real estate market, which remains underpriced and over-leveraged.  But, looking again at some graphs on wage growth, I'm not so sure that they don't still signal a continuing wage floor.

Here is a graph of nominal YOY wage growth.  In the last several cycles, wage growth has dropped down to about 2-3%, but never lower for an extended period of time.  Normally, this measure is in constant flux over a business cycle, but in the early 1990's and again since 2010, it has moved down to a low, slightly positive level and remained there for several years.  This seems like a classic indicator of a natural price floor.  After 5 years, wage growth is still moving sideways.

Here is a graph of real YOY wage growth.  Note that when nominal growth is above 2%, real growth can drop well below 0% during cyclical shocks.  But the nominal floor around 2-3%, combined with low inflation, has kept wage adjustments from dropping as much in the more recent cycles.

This suggests that a little more inflation could help labor markets, and that disinflation now might be damaging.  On the other hand, with unemployment now falling into the 5%'s, real wage growth might be expected to be strong enough to escape the floor without the help of inflation.

Here is a messy graph comparing wage growth, inflation, home market value growth (right scale), and interest rates.  All in all, this lifts my spirits a bit, regarding cyclical issues over the next year.

Recoveries in wages and fixed income markets in the "Great Moderation" period have not necessarily correlated with inflation rates that closely.  Most cyclical fluctuations in wage growth have been real.  In the late 1980's and the 2000's, half or more of the change in nominal wage growth rates from the nadir to the peak was real.  In the 1990's, inflation was dropping throughout the recovery.  Total home market values were growing at a moderate pace during the 1990's recovery, as I fear they will now without further accommodation.  The 1990's pattern suggests that changes in real wage growth can remain strong under the conditions I fear.

As far as interest rates go, I see them as more of a market phenomenon than a Fed phenomenon, although the Fed dominates in the very short term at the short end of the yield curve.  But, if the market for real short term rates tops out at 1%, the Fed target will top out there, too.  If wages show sustained increases in growth rates, we might expect short term rates to begin to rise.  And, if they are going to rise, an increase of 2% to 3% within a year of the initial hike would be typical.  I don't know if there is very much room for the first hike to shift back in time.  Prime speculative positions in forward rates probably are still in the 2016-2017 contract periods, and would gain more from gains in subsequent rates than from the change in the date of the first hike.

But, if inflation continues to moderate, it might be possible that we are basically in 1994 right now.  If the tightening of the end of QE3 is the equivalent of the rate hikes of 1994, and real short term interest rates are topping out at less than -1%, then zero nominal short rates might be the terminus Fed policy.  Just as in the 1990's, we could see rising wages in a low inflation context.  In fact, as the housing market slowly deleverages, we could see a very slow acceleration in total home market values as we did in the late 1990's.  There could be a very long, very strong commercial & industrial economy for another 5 years in that scenario, with strong wage growth until some bump in inflation well in the future causes a follow-up tightening in Fed policy, like in the late 90's.

I'm probably a broken record on this (a scratched CD for my younger readers), but the difference between those two interest rate scenarios is probably a product of real estate credit markets.  Depending on what happens there, the Fed Funds rate in 2017 will probably be either 0% or 3%, with not much chance of anything in between.

Monday, October 27, 2014

Bank Credit 2014 3Q

Here is an updated graph of bank credit at all commercial banks.  Credit had been growing healthily between QEs, but then growth declined during QE3, and then started to recover again as QE3 was tapered.  But, as the taper has come to an end, growth rates in bank credit have moderated.  I attribute much of this to the fact that QE3 was ended before the housing market was fully recovered.  Partly this is a function of household real estate leverage and partly this is a function of pro-cyclical regulatory sentiment.  I hope the recent signals from FHFA that regulatory liabilities will be reduced soon help to alleviate risks here.

PS.  Whether commercial real estate has stronger legs than residential, or whether it is just lagging the residential trend is a question, I suppose.  I suspect that there are less frictions from distressed properties, so that it might more easily see sustained growth.  I have noticed in Arizona that many corner lots at major intersections, which have always been saved for commercial development, are now being filled in with residential developments.

Thursday, October 23, 2014

September Inflation

Core minus Shelter inflation still looks pretty weak, while shelter inflation remains strong.  My position is that shelter inflation reflects a negative supply shock and core minus shelter inflation reflects a negative demand shock.  The economy might be strong enough to limp along with no help from the housing sector and with negligible core minus shelter inflation, but the downside risk is significant if it can't.

Looking at the 1 year inflation indicators in the next graph, it might be worth noting that core minus shelter inflation was this low in 2004 when short term rates began increasing and the economy continued to recover (along with inflation).  But, inflation expectations were rising then, while they are falling now, and mortgage markets were flying then and are dead now.

We now have 4 months with no cumulative core minus shelter inflation.  I think the best hope at this point is coming from FHFA.  Clearly the implicit regulatory liabilities banks now have for mortgage credit are stifling.  If this can be corrected, maybe it will pull out some pent up housing demand and we will see home prices begin to climb again.  If that happens, it's smooth sailing.  If it doesn't, it's hard to tell how things will work out in the near future.

Wednesday, October 22, 2014

Follow up on Earnings Yield

In the previous post, I compared the earnings yield to interest rates and leverage.  In one graph, I added inflation to the earnings yield so that it was comparable to nominal interest rates, but that was not the best way to do it.  The better way to do it is by taking inflation out of nominal interest rates.  I am just subtracting CPI TTM inflation from the 10 year rate, so this is hardly a perfect measure of real 10 year rates, but it seems to come pretty close.

There are several relationships here:

1) leverage seems to be related to nominal interest rates

2) to compare equity earnings yields to the bonds yields, I think the appropriate comparison is between the earnings yield and the real interest rate.

3) the effect of leverage on the earnings yield should be reasonable without any inflation adjustments.

Here is the original graph I posted in the earlier post, which has nominal interest rates, unadjusted earnings yield, and leverage.

Below is the same graph with real interest rates instead of nominal interest rates.  This is the best version of the graph for looking at the earnings yield relationships.  I have shortened the time frame because inflation adjustments before the modern era are very volatile.

I think this makes a much stronger case for the earnings yield being associated with leverage.  There may be an inverse relationship between earnings yield and real bond rates.  And, this does suggest that in low interest rate contexts, risk insensitive investors are capturing some premium from the risk averse debt investors.  Looking at it in the way I framed it in the previous post, if the entire universe of savers shifted to a more risk averse position, the total return to assets (risk free rate + equity premium, which is the forward looking version of the earnings yield) might need to rise, in which case the equity premium would rise by even more than the real risk free interest rate was declining.  This looks like it may have been the case in the late 1970s & early 1980s.  So far, though, in this cycle, the total required return to assets doesn't seem to be unusually high.

Maybe that is the difference between low inflation and high inflation, and thus low leverage and high leverage.  The high risk aversion we see today might have a slight effect on equity earnings yields, but the low leverage of corporations is a stronger effect, and so equity earnings yields remain in the normal range.

In a regression, both leverage and real rates are strong variables for estimating the earnings yield, with leverage being the strongest.  But, this may not mean much because leverage and earnings yield both have equity market values in the denominator of the variables.  Let me know in the comments if you have an idea for avoiding that problem.
I would like to make a subtle distinction from the typical use of that relationship.  I think it is generally seen as a sort of arbitrage situation, where investors should rebalance to equities until the return on equities is bid down to something close to the return to bonds.
But, I don't think this is an arbitrageable relationship.  The difference between these rates of return is a product of a public sentiment toward risk.  There will probably be a change in sentiment at some point, but the difference between these rates of return will come mostly from a rise in long term rates as that sentiment changes.  So, the equity investor does receive the higher return on investment, and avoids the low returns on bonds.  But the convergence of this rates of return isn't so much an arbitrage as it is a speculative position on changing sentiment.
In some ways, it's a distinction without a difference, since a risk insensitive investor would still tend to want to add weight to equities in this context, all else equal.
As I noted in earlier posts, historically, the 1940 to 1970 period was the golden era of equity risk premiums (see chart to the right).  That comes through very clearly in the chart above, as the earnings yield was consistently above the real interest rate throughout that period.
With regard to monetary policy, a looser policy that brought inflation to the 3-4% range might not create much of a boost for investors through changing yields.  The earnings yield would probably rise slightly along with some corporate releveraging, and that increase in required returns would keep equity prices from increasing.  But, that releveraging would be partly the product of short term debt markets that would be freed of the frictions caused by the zero lower bound and of long term debt markets freed of the frictions still remaining in the mortgage market.  Improvements from looser monetary policy wouldn't, therefore, lead to higher stock prices because of the first order effect of changing rates.  They would move higher because the more optimal monetary policy would be leading to more real economic activity due to the removal of those frictions.  (edit: TravisV points out in the comments that I neglected to note that the higher NGDP growth that would come from a 3-4% inflation range would also be likely to reduce equity risk premiums because it would reduce the risks associated with very low interest rates, which would have all sorts of positive effects, including rising equity prices.)

The Earnings Yield, Interest Rates, and Leverage

In some previous posts I have shown how high PE ratios and profit margins can, ironically, be a reflection of lower risk.  Given a set level of operating profits, and, say, an 8% required return on the unlevered firm's assets, a firm facing 3% interest rates with a 5% equity premium, at the optimal allocation of capital, will have lower leverage, higher net profit margins, and a lower share price and a lower PE ratio, than the same firm facing 5% interest rates and a 3% equity premium.

Low Interest Rates High Interest Rates
High Equity Premium Low Equity Premium
Leverage Low High
Net Profit Margin High Low
Share Price & Enterprise Value Low High
PE Ratio Low High

This is complicated in a business cycle shock because frequently firms experience operational dislocations and/or are pushed out of their optimal capital allocation targets.  But, at this late point in a cycle recovery, when dislocations have been generally repaired, when interest rates go up, leverage will go up, profit margins will decline, and share prices will increase from both revenue growth and multiple expansion.

This might seem counterintuitive in some ways, but this should follow from a Modigliani-Miller framework where corporate income is taxed.  Where I think intuition is wrong is that we tend to conceive of debt in a consumption context.  Debt tends to be described as a risky and greedy attempt at overconsumption, or for corporations, a dangerous way to create false growth that exposes them to higher risk.

Of course, a firm leveraged imprudently would face high risk.  And, firms that have been exposed to deep revenue shocks tend to meet their ends when they can't pay the interest payments on their debt any more.  But, I think what we see mixes with these perceptual biases in a way that creates a false interpretation.  If a firm didn't have any debt, it might fail at the point when it couldn't pay its workers anymore.  Would we say that hiring workers is a risky proposition that, generally, causes firms to fail?  I suppose in any failure we can claim that workers were overpaid or unproductive.  But, generally, clearly, firms need workers to produce.  So, while hiring workers inefficiently would be a problem, workers themselves are not a source of risk.  I propose that debt is the same.  It can be handled poorly, but it is simply a part of the stakeholder structure of the firm, and is not, in and of itself, a risk.  Some workers might have fixed salaries while others receive wages tied to profits or revenues in some way.  And, some capital (debt) receives a fixed payment while some capital (equity) received residual payment.  All firms must decide on a mixture of fixed and variable costs, but there will always be a reasonable level of fixed costs above zero.....Anyway, I'm going on too long.

Over time, total required real returns on firm capital appear to be fairly stable.  Generally, when interest rates fall, equity risk premiums rise.  This suggests that there are fairly stable factors regarding delayed consumption and the myriad other factors that create profit for investment and that within the ownership claims on investment, there is a risk trade between debt and equity.  Debt holders trade risk with equity holders.  So, instead of having a single class of owners in a unlevered firm, there are owners with a certain payout structure and owners with the remaining residual payout structure.  Because certainty has value, debt holders accept a discounted payout, and thus, the equity premium is always positive.

The long term balance between debt and equity does seem to follow the trends I described in the table above, and this can be explained with the Modigliani Miller framework as a product of corporate taxation.  But, note, this also aligns with a risk-trading perspective.  Low interest rates are a sign that investors have become risk averse, and they are willing to trade away a higher discount from the unlevered return on assets to the remaining equity holders in order to minimize local risk.  We might imagine that the demand for low risk ownership would push debt levels up.  But, this would leave a bifurcated set of investors - many investors with low-return/low risk payouts, and few investors with very risky payouts.  It may be more realistic to imagine a normal distribution of investors where the mean level of risk aversion has increased, and the entire body of investors has shifted or skewed.  So, when investors as a group become more risk averse, driving down interest rates, the marginal investor in the switch between equity and debt will also be more risk averse.  Corporate deleveraging changes the nature of equity, making it less volatile, and thus low interest rates are associated with falling debt levels as the marginal investor is attracted into the less volatile equity position.

Earnings Yield

If there is any truth to my framing above, the comparison of the earnings yield on equities and the yield on bonds is not very helpful.  There may be a tendency for earnings yields to decline when interest rates are low.  But, this may be related to the deleveraging of equities, so that the lower earnings yield simply reflects the lower relative risk of equities in that context.

A low earnings yield may not be a signal to a risk-insensitive investor to switch to bonds.  It may be a signal to leverage up or beta up her equity portfolio.

First, please let me know if anyone knows a source for S&P 500 debt/equity ratios that goes back further than 1952.  I'd love to see how it looks with a longer time frame.

Regarding the graph, the earnings yield looks like it tracks with leverage as much as it tracks with interest rates.  (Note, as an aside, the unusual behavior during two demand shock recessions in the 2000's, where revenue shocks caused earnings to decline and leverage to increase, both temporarily, as corporations were thrown into disequilibrium.)

One could say that leverage and earnings yield track simply because they both have equity value as the denominator.  That is true.  It is interesting that debt as a proportion of net operating profits is fairly stable over time, and that is what leads to this co-movement.

On the other hand, the co-movement of the earnings yield and bond yield is problematic for another reason.  The bond yield includes an inflation premium.  The earnings yield is simply a measure of the trailing earnings.  The inflation premium will come from future nominal growth of earnings and share price.  When this adjustment is made, these indicators don't move together as tightly in the high inflation 1970s.  In fact, using an equity risk premium (which takes growth expectations into account) instead of an equity yield, there tends to be an inverse relationship so that inflation adjusted interest rates and equity premiums tend to add up to a fairly stable return level.

I suspect there are times when a low relative earnings yield should signal higher weights in bonds and other times when a low relative earnings yield signals higher weights in equities (to make up for low leverage).  I don't know if there is a coherent way to decipher the signal.  As such, I'm not sure how useful earnings yield relative to bond yield is as an allocation tool.

Thursday, October 16, 2014

Update on Interest Rates

Well, interest rates got interesting fast after I posted my update Wednesday.  Here are updated versions of a couple of the graphs.

The market reaction seemed overblown compared to the information contained in the economic data that was released Wednesday.  I have been pleasantly surprised by the reaction from FOMC officials that suggests they are willing to loosen up, at least a little bit.  I'm not sure if it will be enough to make much difference.

In the meantime, labor markets continue to look strong.  So, I think we might still be looking at a situation of weak signs in financial markets but a strong economy in terms of production and employment.

I think this is a speculator's market.  These are the kind of situations I look for in individual equities, like in my current favorite Hutchinson Technologies.  The ability of markets to provide stable and efficient prices breaks down when the distribution of possible outcomes deviates from normal behavior.  For some time, prospects for HTCH on a 5 to 10 year horizon have been such that they are likely to be worth very little or something more than $10.  They have been trading in the $2 to $5 range.  The distribution of outcomes is kind of an upside-down normal curve.  It is highly unlikely that HTCH will be trading at $3 in 5 years.  This kind of situation causes the expected cash flows of the marginal investor to take a back seat to other issues, like reputation, fear of losses, etc.  Expected monetary returns can be very high, and returns to unobservable stock picking skills become very high.

We have a similar situation now in the broader market. It has been that way for some time.  Under QE, investors were split between high inflation expectations and worries about perma-QE at the zero lower bound.  I think the decline in the TIPS spread in 2013 might have reflected a reduced variance in expected inflation more than a reduced mean expectation for inflation.  In fact, that was the subject of my very first post on this blog, and a couple of follow ups.

After the rate increases in mid 2013, through most of 2014, I had a slightly bullish position on rates (short bonds) that I traded as a synthetic short option.  (I traded so that I gained from mean reverting volatility).  That is because I forecasted a positive labor market for 2014.  I predicted that, on net, the distribution of possible outcomes in the near future would become less variable.  This is because the taper of QE3 would quell fears about inflation while the strengthening labor market would quell fears about deflation.  I expected housing to eventually recover more strongly than others seemed to expect, which would eventually bias markets even more away from deflation worries.  In the meantime, I traded the transitory volatility in the day to day markets.

I think we have mainly gotten to the place I expected us to.  Except, housing credit markets haven't seemed to recover enough to pull home prices up to levels that would re-establish a sustainable housing credit market.  So, I have retracted my bullish position on real estate and home building for now, and my bullish position on interest rates (bearish on bonds).  And, the volatility dynamics are now reversed.  Instead of reverting to the mean with declining volatility, the end result for interest rates is now probably a two-tailed monster.  Much like with HTCH above, the odds that June 2017 Eurodollar contracts will expire at 2% are very low.  But, the problem is we don't know if they will expire at 0.1% or at more than 3%, and much of the outcome depends on coming arbitrary Fed decisions.  So, a directional speculative position will eventually pay off very well here.  But, which direction is anyone's guess.  The trick now will be to take a position on that direction before the market fully prices it in.

In the meantime, this tipping-point context might mean that seemingly small pieces of information in one direction or the other could create large swings in market prices.

That said, looking at the forward Eurodollar curve, this recent move doesn't look as pessimistic as it first did.  With such a large decline in equities, it seemed like the market reaction was a reaction to more possible demand shocks.  But, especially after recovering a little, the change in rates looks like it has come mostly from an expected delay in rising rates, which could reflect some pessimism about near-term markets, but this pessimism appears to be paired with an expectation of a counter-effect of appropriately looser monetary policy.  The end result of the last three days' interest rate moves has been a move back in time of about 1 month in the first rate hike and a slightly slower expected rate of rate increases after that.  The expected date of the first rate hike had already begun moving back earlier in the month, so that, as a whole, since early October, the expected date of the first hike has moved from about June 2015 to about September 2015, according to my model.  I think that's a lot smaller change than some observers realize.

As we move out on the yield curve, forward rates had collapsed since the beginning of the year, from more than 5% to about 3.5%, and the last leg of that collapse had come in early October, along with collapsing inflation expectations.  But, with the rate drops this week, the forward rates at the long end of the curve actually held their own.

I suspect that the long end of the curve is partly a comment on the odds of being stuck at the zero lower bound.  Long term rates have shrunk by about a third, and the slope of the curve during the rate hike phase (2015-2018) has also dropped by about a third (from about 34 to about 23 bps per quarter).  This could represent a bifurcated expected outcome distribution, with a 2/3 chance of seeing rates increasing at more than 1% per year starting sometime around 2015-2016 and topping out at around 5%, and a 1/3 chance of never leaving zero.  (The slope still seems a little low, which I attribute to a weak housing credit market.)  Anyway, if this is a true reflection of market expectations, then the flip out this week may not have reflected any increase in the odds of staying at zero.

All in all, I would say that this week's move signals some confidence in forward monetary policy.  Let's hope that's true.

More Amazing Stuff on Labor Force Participation from the Atlanta Fed

Here is a link to some great labor force participation data from the Atlanta Fed. (HT: EV)  Be sure to check out all the information on this page, too, including the interactive chart and the downloadable data.

Here are a couple of graphs.  But there are tons more.

I think this data generally backs up the notion that much of the decline in LFP has been age related.  I have attributed the disability problem mostly to aging, but the data here makes it clear that there has been a sharp increase in disability, even after adjusting for age.  In fact, among prime age workers, while most employment indicators are now improving, disability is still growing as a reason for dropping out of the labor force.

In the second graph I have posted here, most of the decline in Prime Age LFP in the "Don't want a job" category is due to higher disability claims.  Part of this is due to the unusually large number of 50 year+ workers in the population distribution right now.  But, part of this is due to an increase in disability claims within that age group  (Paging Benjamin Cole!).  Prime-Age includes 25-54 year olds, and much of the decline is due to more schooling at the low end of the age group and more disability at the high end of the age group.

Most of the increase in disability claims during the recession has been among the older working age population, but disability since 1999 has increased across all age groups.

Anyway, don't stop with my post.  Go to the links.  This is great stuff for data nerds.

Wednesday, October 15, 2014

Forward Rates and the Business Cycle

Interest rates have taken a dive recently.  This has mostly been at the long end of the curve.  Here is a kind of messy graph of expected future changes in interest rates (assuming pure expectations) and realized changes in rates.  Forward rates appear to have been a fairly unbiased predictor of rate changes in normal times, but they have tended to overstate forward rates at the extremes.  While flat yield curves have predicted economic contractions, ensuing collapses in interest rates have been much more negative than predicted by the yield curve.

One question is, does the recent decline in rates foreshadow a coming contraction?  I would say, according to the first chart, no.  A fall in the long term yield slope is not unusual, even in the early stages of rising short term rates.

In the past few cycles, the recoveries ended with short term rates that rose higher than the yield curve had predicted, then collapsed.  The same pattern happened in the mid 1990's, but we avoided the recession in that episode.

Here is another view of recent rate movements.  This is from Eurodollar markets.  We can see here that expectations about rate increases in the near term have been very stable since the beginning on QE3.  The June 2016 contract has been relatively level since late 2012.  Both long rates and near term rates rose in the summer of 2013, which I consider to be evidence that those movements were a product of improved expectations, and were not related to tapering issues.  But, once, tapering began in late 2013, long term rates began a long decline.  The recent decline worries me, because we are seeing a correction in equities at the same time that we are seeing rates fall across the yield curve.

Here is another view of yield curve movements during the current year.  Here, again we can see that the character of rate increases in the 2015-2017 time frame has been fairly stable.  But long rates have been on a relentless, steady decline.  They are almost down to the ridiculously low level I had expected of them, though I didn't originally expect it this quickly.  I had been positioning for a strong economy this year that would push rates up more quickly than the yield curve predicted.  In effect, I was ready for that bump in rates that we saw at the end of recoveries in the first graph.  But, I have become worried about credit markets in the near term because real estate credit hasn't seemed to have picked up its own steam in the face of the end of QE3.  So, I think we could have a catastrophic period ahead if rates continue to collapse and the Fed delays further accommodation.  It is possible that real estate credit regains momentum and my original yield curve forecast still could hit the mark.  It is also possible, I think, for the economy to have enough strength outside real estate to help us muddle through for a while, in which case rates and inflation might remain low for a couple more years, followed by a delayed rebound in rates.

Here is one more chart, which compares the 3 month rate with the (5,2) forward rate (the rate from,  roughly, year 5 to year 7).  Here we can see the yield curve recession indicator.  The three recessions in this period happened after the short rate hit the same level as the forward rate.  But, I think this graph is interesting, because we can see that in 1984 and 1994 the Fed raised short rates up to the level of the forward rate.  The reason forward rates remained above the short rate was because the forward rate rose along with short rates, and the Fed stopped raising short term rates when the forward rates started to decline again.  But, in 1988, 2000, and 2006, the Fed kept raising the short term rate even as forward rates were falling or remaining level with the short rate.

The worst case scenario is that the forward rate keeps falling even without any short term rate increases.  That was happening before QE3 helped boost forward rates.  The forward rate has a smoother trend than constant maturity treasury rates, because it doesn't include the volatile short part of the yield curve.  (I have bootstrapped treasury rates to estimate the forward rates.)  If forward rates fall back to 2012 levels of below, that will probably be a bad sign.  If they don't, then the interaction of the short term rate with the forward rate might be something interesting to watch.

Tuesday, October 14, 2014

We really have no idea what we're doing

This would be baffling if it wasn't so predictable.  The New York Times reports of concerns among global leaders at last week's IMF meeting:
As economists and politicians heap pressure on global central banks to continue, and even escalate, their unusually loose monetary policies in order to spur global demand, the fear that these measures could provoke another market convulsion is spreading. 

“A major lesson of the last crisis is that accommodative monetary policy contributed to financial excesses,” said Lucas Papademos, a former vice president of the European Central Bank. “We are pursuing a similar policy for good reason. But there are limits — if you do this for too long, risks in the financial markets will materialize.”
Inflation is low and collapsing, households have undertaken unprecedented deleveraging, low risk bonds pay little to nothing, equity premiums are very high.....on and on and on.

And our best and brightest think monetary policy has been "unusually loose" and think our major concern right now is too much risk-taking because financial institutions are going farther and farther afield to bid up safe assets.  I think everyone agrees that the 1970's was a period of loose monetary policy.  What exactly is going on now, in terms of financial risk taking, that mimics the 1970's?  If loose money is the key factor, this should be an easy question to answer.

We tend to think of interest rates and risk premiums in an additive fashion.  We start with a risk free rate and add risk premiums to model risky assets.  I wish we, instead, began with a benchmark required return for assets and then thought of the rate on debt as a discount from that required return.  It looks to me like the market asset real required return has been fairly stable over time.  If we looked at it this way, then we would now say, "Short term risk free bonds are paying an 8% discount in order to avoid exposure to manageable cash flow risk."  It would be easier to think of increases in debt ownership as a flight from risk.  High corporate profit levels are, in part, a product of a huge pool of risk averse savers saying, "Hey, if you're willing to take the residual risk, you keep the profits.  Give me 1% a year, and leave me out of the rest of it."  Since corporations tend to deleverage when debt rates are low (and are currently not very leveraged), some savings is drawn back into equity (because it is now less volatile) and into non-corporate debt.

This is why the tendency to demonize the financial industry seems so dangerous to me.  Market prices contain a wealth of information, which we frequently misinterpret.  (Why would we expect to always understand it?).  We view investors as some sort of Frankenstein monster in a tux, and we demand that it be controlled by committees that can't tell the difference between loose and tight monetary policy.

Here is an educational video about the politics of finance and monetary policy.