Wednesday, May 10, 2017

Equity Returns and GDP Growth

Part of the secular stagnation story is about demographics.  Real GDP growth has been lower than at any previous time since at least WW II.  But, if we adjust this for labor force growth, we see that real GDP growth is low, but it is within the range of previous periods.

Even so, notice that real GDP growth per worker is currently very low, even though we are in a recovery phase, and it has been near zero twice since the recession.  In the post-WW II era, this has generally been associated with a recession.  Maybe this is related to the Great Moderation.  When real GDP growth per worker was low in the 1970s, quarterly growth whipsawed through recessions and recoveries.  Now, both the top and bottom have been moderated, so we get a slow, grinding recovery with the same level of real GDP growth per worker.

S&P Data from Robert Shiller
It looks to me like, over the long term, returns on equities are related more to real GDP growth per worker than they are to unadjusted real GDP growth.  They certainly are more related to real GDP growth, over the long term, than to nominal GDP growth, even though the zeitgeist currently seems to accept some sort of Austrian business cycle idea that monetary accommodation leads to real stock market gains.  I think this is an error.  The stock market rises when the Fed accommodates because monetary policy has been too tight throughout the current period, so accommodation leads to real growth, and a rising stock market is a secondary effect of real economic growth.

As we see in the second chart, the returns to equities are much more variable than changes in GDP (a 200% ten year return corresponds to average annual GDP growth of around 2%).  This makes it look like there is a reaction of equities to nominal growth, because if nominal accommodation leads to real growth, equity returns will have gains in excess of the real GDP gains.

But, the point here is that, even adjusting for the demographic problem, there is a stagnation problem.  It's not particularly worse than the problem we had in the 1970s, but it is a problem.  GDP growth, adjusted for labor force size, needs to recover if we are going to see better returns to equities over the next decade.  (Total returns to equities have been much worse than they look in the past couple of decades because returning capital through buybacks instead of through dividends creates a side effect of inflating the stock indexes, but it doesn't really change total returns.  So, whenever someone uses an unadjusted stock index, like the S&P 500, without adding in dividends, it will be skewed.  I am probably making a separate error here, because I am comparing S&P returns to GDP, even though corporate revenues have become increasingly global.  That's something to keep in mind.  Maybe adjusting for foreign profit would add a downward trend to the equity returns, and make them look more like the unadjusted GDP growth.)

I'm still not sure if the secular stagnation problem is a demographic problem.  There seems to be a general sin wave pattern of 35 years or so that goes back at least to the early 20th century.  Maybe, this is a shadow of the demographics issue.  Maybe, when baby boomers were crowding into the labor force in the 1970s, they were bringing down productivity because there was an inflow of young, inexperienced workers.  And, today, they are bringing down productivity because low labor force growth today is the result of retiring baby boomers who are leaving the labor force at their peak levels of productivity, taking a lifetime of experience with them.  Maybe, we have another decade or so of this, and when the baby boomer retreat has peaked, growth per worker will naturally begin to rise again.  Buying in after the next recession might be like buying in after WW II or after the 1982 recession.  It's probably more like the post-WW II period, because inflation and nominal bond yields are low, so that there will probably be a period of significant excess returns to equity, like there were in the 1945-1970 time period.


  1. Tyler Cowen has pointed out that U.S. young males make about one-third less, in real terms, than in 1969.

    In short, labor is now cheap. That decreases the incentives to invest in productivity-improving plant and equipment.

    As you know, I am a fan of tight labor markets (if only to convince voters that free enterprise is a good system).

    It may be labor markets will tighten up. But we have an establishment that obviously likes to import labor, and barring that, to offshore business. And we have a central bank that seeks a minimum unemployment level, one that results in more people looking for work than there are jobs, at all times.

    Far from "labor shortages, the US has chronic "job shortages" (yes, I understand that if there were no minimum wage, then labor markets would clear...or possibly also if push-cart vending and retail property zoning and some other regulations were ended we would also radically decrease unemployment).

    Given those realities, my guess is productivity is stuck in low, and that GDP growth will be sluggish for many a moon.

    I expect living standards for employees to keep falling, and house prices to keep rising in cities with strict zoning.

  2. Kevin: Yes, NGDPLT…but even Market Monetarists can set the bar too low. There is still an anti-labor bias in most monetary types, and also too much timidity regarding "setting off inflation."

    In the 1990s, Milton Friedman chided the Fed for being too tight---when inflation was at 3%.

    Today 3% inflation sends shudders through monetarist types.

    Strangely, I think if you ask many monetary types, "Would you prefer long-term 5% real growth with 5% inflation, or 2% real growth with no inflation?" they would assent to the latter….

    BTW, from 1982 to 2007 real growth was about 3% and inflation about 3% also in US GDP….

    So why is the Fed targeting 2% inflation?

    Never let central bankers make monetary policy. It is akin to allowing USDA officials make farm policy…or letting generals declare war….HUD bureaucrats run housing policy….

    1. Yes. I agree with you about that. I'm not sure what drives down the target growth rates. Maybe it is to appease the audience that is hawkish. It looks to me like 2-4% inflation is generally where it is least disruptive. I'm not sure why we're seeing prospective targets at 4-5%. It could be that with a more stable business cycle, we would need less of a cushion. I could buy that. But it especially seems strange to me when MMs look at, say, 2005, and say that level of NGDP growth could have caused a housing bubble because we were running too hot. But NGDP growth in 2005 was very low compared to most past expansion periods. It's only high compared to these NGDPLT target levels, which are totally arbitrary. I'm with you. I don't get it. On the other hand, if they said the target would be 7%, they would lose a lot of potential interest because there is so much inflationphobia.

  3. KE-

    Yes, I have wondered if Market Monetarists, seeking credibility and acceptance, have publicly pointed to low NGDPLT.

    The whole topic of central banks and monetary policy is dominated by tight-money types. It is not a topic others have cared much about.

    It is like trying to find an intelligent non-liberal defense expert who thinks the US can spend a lot less on defense. The problem is, the topic of national security is dominated and owned by people in national security. They have a monopoly, often, on the information too.

    Same with farm policy, or housing policy, or many other areas of government.

    I agree that a 2% to 4% inflation band is a sweet spot for real growth in developed Western economies. I would prefer NGDPLT, maybe at 6%.

    Well, I can offer my wisdom to the world…