Wednesday, January 16, 2019

Equity Values and Business Cycles

This chart is basically a "Financial Accounts of the US" version of the P/E ratio.  Also, here I show corporate debt as a ratio with corporate profit.
Source

These are as of the 3rd quarter of 2018.  After the recent pullback in equities, while earnings are strong, the P/E ratio (blue) is back to the teens.  And, corporate leverage is in a conservative range too.

Going forward it seems that there are two likely paths:

1) Stable NGDP growth leads to slightly lower profit growth, but higher wage growth and higher real total growth.

2) Unstable NGDP growth leads to lower profits and wages.

If (2) happens, equity losses will be widely blamed on valuations and debt even though they will more likely be caused by unstable NGDP growth.  In hindsight, it will always look like high valuations caused equity contractions and high debt levels, because equity prices will be lower and vulnerable firms will suddenly be too leveraged.  But cyclical contractions rarely have anything to do with valuations or corporate debt.

Friday, January 11, 2019

December 2018 CPI Inflation

Mostly moving sideways.  I thought there was a chance that inflation would really step down this month, which would be bearish.  Of course, if the Fed is trying to be a counterweight, then there is the bad-news-is-good-news phenomenon, but here I think bad news would call for a pull back in the target interest rate, and the best we can hope for is for the Fed to hold the target rate steady for a while.  (This is sort of a strange phenomenon.  Before the past couple of decades, it was unusual for the Fed Funds Rate to have a plateau like it did in 2000 and 2006-2007.  But, that seems to have become normal now.)  So, bad news is still bad news, and it seems as though it is just a matter of waiting for the Fed to get to far behind a falling natural rate.

Maybe there is some chance that the natural rate can chug its way back above the target rate again and the slow recovery can continue.  The yield curve inverted pretty deeply earlier this month.  It has levelled out quite a bit since then, but it is still inverted.  So, I think this is like 2006 or 2000, where the inversion will bounce around a little bit but not go away until rates start to decline.  In 2006 and 2007, homeowners with housing bubble capital gains could tap home equity lines or sell their homes to create some monetary breathing space.  That isn't the case today, so my hunch is that the time between the initial inversion and the eventual fall will be shorter - more like 2000.  But, I haven't been particularly accurate in my predictions of timing so far.

Last January had a noisy spike in non-shelter core inflation, so even though non-shelter core is at 1.5% this month, it is more likely that after this month it will notch down to about 1.2%.  The last quarter has been running at closer to 2%, but without that January spike, the YOY rate has been around 1.2% so if inflation is to build from here, that is where it would be building from.

Tuesday, January 8, 2019

Housing: Part 341 - Arbitrary categories should not determine sentiment and policy

Housing can be consumed in three basic ways:

1) Tenancy

The capital is provided by an investor.  The investor takes the risk of changing value and the responsibility for maintenance.  The tenant pays for the service of shelter in the form of a cash payment.

2) Mortgaged Ownership

The capital is provided by an investor.  The tenant takes the risk of changing value and the responsibility for maintenance.  The tenant makes a fixed payment to the investor for the use of her capital.  The tenant does not make a cash payment for the service of shelter, because the tenant is also the owner.

3) Free and clear Ownership

The capital is provided by the tenant.  The tenant takes the risk of changing value and the responsibility for maintenance.  The tenant used her own capital, so she makes neither a fixed payment to an investor nor a cash payment for rent.


The production and consumption of shelter is basically the same in all three scenarios.  There is simply a shift between who plays the various roles.  In the first scenario, we say that the investor is providing landlord services to the tenant.  In the second scenario, we say that the investor is providing financial services to the tenant.  In the third scenario, we say (or at least the BEA says) that the investor is earning "rental income of persons".

But really, we're just shuffling around a group of agents who, together, are providing capital for shelter, maintaining the shelter, and consuming the shelter over time.  The way they are shuffled has little bearing on the aggregate amount of capital and the aggregate value of the shelter.  Yet the way we think about each different scenario and the way it affects public policy is tremendous.

In this graph, the top line is the total value of shelter consumed, as a percentage of GDP.  It is pretty stable over long periods of time.  During the 1960s and 1970s, it was 8-9% of GDP.  During the 1990s and 2000s, it was about 10%.  Since the crisis, it has run at more like 11%.  (Clearly, this isn't because we have created more shelter since the crisis.  This is because demand for shelter can be inelastic.  Rent inflation has been high because we are not producing enough new housing, so we are spending more for less.)  All that being said, this is consumption that is stable over quite long periods of time.

In the graph, the next line down is gross value added - the cost of housing before maintenance and upkeep.

The next line down is operating surplus - the net income to the agents providing the capital in each scenario after subtracting maintenance and upkeep, consumption of capital (basically natural depreciation), taxes, and subsidies.

Finally, the red line is the portion of the housing capital income that goes to the investor in scenario 2.  This is actually a bit misleading, because the operating surplus is real income.  It increases over time with inflation.  Interest income includes a premium for expected inflation that is paid in cash over time and appears as financial income when it really is not.

That last red line, then, is a fairly arbitrary measure, both because it doesn't even measure real income and because it is only one type of income from one of the three scenarios of ownership.  But, it is the scenario that is labelled "financial", and it gathers more attention than any of those other, stable, less arbitrary measures.

During the housing bubble, the expansion of the housing stock was allowing households to moderate their housing consumption by moving to cities where the capital providers don't capture economic rents from political oligopolistic power over real estate.  So, the operating surplus to housing (which is the non-arbitrary measure of housing income) was declining.  But, the arbitrary measure got all the attention.

Maintaining lower interest rates that weren't contractionary would have kept the red line low, and possibly would have kept net operating surplus moving lower.  Since then, there has continued to be a lot of focus on the arbitrary red line, and a lot of happiness about how much lower it has moved.  At the same time, the non-arbitrary measure of income to housing has moved up (because of a lack of supply, which is ironically related to that declining arbitrary red line) to a level not seen since the early days of the Great Depression.

By railing against "financialization" and "Wall Street" profits, we have managed to shovel more income into the hands of oligopolists than any housing bubble ever could have.

Sunday, January 6, 2019

Housing: Part 339 - Self-Imposed Stagnation

Here is a graph comparing long term real GDP growth per capita and per worker.  Also, I show the 10 year trailing average annual real total return on the S&P500.

Real GDP per capita had been rising by about 2% for many years.  Real GDP per worker generally rises at about the same rate, but in the 1970s, it dipped down to less than 1%.  This is because the baby boomers were entering the workforce, so the labor force was increasing faster than population was, and we weren't getting as much productivity growth per worker as we had previously.  Some of this might just be a product of worker composition and young workers being less productive.  But, I think this shows why the 70s were a decade of economic insecurity even though it doesn't necessarily show up in real GDP growth or even real GDP growth per capita.


One plausible reason that equity risk premiums have been high recently and real bond yields low is that an aging population means that there are many households in the saving phase of their lives.  But, that doesn't explain the 1970s when real bond yields were also low.  In the 1970s, there was a surge of young adults.

Notice in this graph that total returns in equities seems to track pretty well with GDP growth per worker.  Since investor expectations can't be measured it has become widely accepted that even long term stock market movements are the product of fickle sentiment and that stock market returns are more volatile than changing economic growth rates because of that fickle sentiment.  Relationships like this suggest that sentiment isn't as fickle as it has been claimed to be.

There also seems to be a widely held belief that the US stock market is overvalued because of loose monetary policy.  To the extent that that sentiment affects public policy, and I think clearly it has, it is probably one reason why real growth has been so slow.  I'd like to stake out the principle that in order to propose the goal that the central bank should aim to lower real returns for existing shareholders, your model of how the world works should be at a level of confidence that is practically certain in a way that few economic models have ever been.

In my Upside Down CAPM model of thinking about capital markets, expected real total returns are fairly stable, at about 7% annually.  This is a combination of expected growth and current income.  When growth expectations decline, savers become risk averse.  So, two things happen to equity returns.  First, the equity risk premium (the difference between Treasury yields and equity returns) widens because safe-seeking investors are willing to accept lower returns while total expected returns on at-risk capital like equity remains relatively level.  Second, the growth portion of expected returns declines, which means that the income portion increases.

Recently and in the 70s and 80s, payout rates were high (dividends + buybacks) and in the 90s they were lower.  Generally, payouts are referred to as a bottom up phenomenon, as if firms can't find good investments, so they send the cash back to investors.  I think this is more appropriately viewed as a product of low growth, so that there may be some correlation between high payouts and low growth, but that it is more directly a product of low growth because equity investors require more cash flow in their total returns to make up for the lack of capital gains growth they expect.

The changes in real returns over time are related to the changes in GDP per worker, due to both the real shock of lower productivity and lower expectations that will naturally come along with that.  Those past equity investors, on the margin, expected returns of around 7% plus inflation, and where their realized returns differed from that, it was due to changing profits and changing expectations from those unforeseen changes in real production.

This is all a long-winded way of getting to the point I want to make, which is about the current decline in growth.  Here is a similar graph, but here I am comparing GDP growth per worker and per capita to the percentage of GDP going to residential investment, because that is the main reason for the recent decline.


Before the financial crisis, there was little relationship between Residential investment and GDP growth.  Some of the short-term growth in the 2000s before the crisis might have been related to it.  But, as I tend to point out, that was at least as much a product of building in the 1990s being below long term norms than it was a product of excessive building in the 2000s.  The low ten year moving average in 1999 was unprecedented in post-WW II data.  The high ten year average in 2007 was not.  So, maybe a lot of the rise in per capita GDP growth from just under 2% to somewhat above 2% was from homebuilding.  But it was homebuilding production that was reasonable and sustainable.

But, what I want to talk about is the post-crisis decline.  That decline can clearly largely be attributed to collapsing residential homebuilding.  GDP growth per capita declined from about 2% to about 1%, and residential investment declined by 2% of GDP.

I like Arnold Kling's conception of patterns of sustainable specialization and trade.  It is better to think of an economy as a coordination problem with frictions rather than as a set of accounting identities.  And, I think it would be uncontroversial in any audience to suggest that this is a large part of what happened after the crisis.  There were millions of construction affiliated workers after the crisis that faced frictions in finding work in a different sector.  Possibly, the recent uptick in per-worker GDP growth, the recent low levels of unemployment, and anecdotal claims that construction workers are hard to come by, are signs that those adjustments have finally been made.

My disagreement with the consensus on this is that none of that had to happen.  For the past decade, those workers should have been engaged in building homes, and GDP growth per capita should have been 2% instead of 1%.  Not only would that have meant that none of those painful adjustments needed to happen.  But, it also would have meant that we would have about $2 trillion worth of housing providing the service of shelter for American households.  And, the result would have been that American households would be shoveling a few hundred billion dollars less each year of unearned rental income to real estate owners.  (Of course, this is complicated by the fact that many of those real estate owners are homeowners, who can only capture that "income" by staying in a home that has inflated rental value, but a suppressed market price, so they can't actually realize the gains from their economic rents except by living in a home that has rental value higher than it should have to begin with.  But, this is getting too far down the rabbit hole.)

But, here we are, a decade later, and maybe most of those former construction workers have either moved to other sectors or just dropped permanently out of the labor force.  So, then, what do we do about the housing shortage?

Well, I have written some about the inequities in the way we have contracted the housing market, and I expect to write some more.  But, really, in the end, there is nothing unsustainable about this context.  We could have achieved similar ends by raising property taxes, or any number of things.  All consumption has some foundation of technological, tax, and regulatory factors that has an effect on supply and demand.  Just because our current context seems inequitable to me, that doesn't mean it can't exist as it is.  Non-owners will consume less housing, owners will consume more, and real estate investors will earn higher returns than I think they would in my preferred regime.  But, it's a sustainable regime.

So, the "economy" doesn't need housing to recover.  It could be that we now are at a new pattern of sustainable specialization and trade, and the new pattern just includes less consumption of shelter by the have-nots.  The workers that have been on the sidelines for a decade instead of building homes have slowly found other productive things to do.  So, fixing the housing shortage is more about equity than it is about growth.  It is possible that we have finally entered a new phase of growth, that ten years from now, GDP per worker will have risen by 20% and equity investors will have earned 12% annually plus inflation, that working class families will be moving to Sacramento by the thousands so that young entrepreneurs can rent their old studio apartments in San Francisco for $7,000 a month, and that marginal workers will still be paying $1,000 rent to live in homes in Cleveland that they could buy for $60,000 because we have decided as a public policy objective that it is too dangerous for them to have a mortgage.

Every line in those graphs could move back toward the top while the residential investment line stays at the bottom.  We would just live in an economy where some households don't consume housing like we did in the past, and real estate capital earns slightly higher returns.

PS: Since equities aren't as tied to domestic production as they used to be, it could be that the rate of real total return on equities will be less volatile going forward as a function of changing domestic productivity.  So, it could be that equity returns for the S&P 500 over the past ten years are higher than they would have been 40 years ago, given the same slow rate of GDP growth per worker, and that it won't rise as high as it used to with rising US productivity.

Saturday, January 5, 2019

Another view of the Eurodollar market

Here's another way to look at the yield curve.  Here are Eurodollar futures contracts, which I have tracked over time with fixed maturities.  This gives an indication of the recent relative moves in the yield curve.

I suspect that in the 2020ish contracts, there will be a good position to take for a move down to nearly zero.  But, my hunch is that this recent move will be reversed somewhat, and either the Fed will do one more hike, or they will keep the short term rate where it is, and eventually they will start moving the Fed Funds rate down, too late, and that will be where the big move happens.

(Caveats about taking investment advice from strangers with blogs, etc. etc.  Rule of thumb: Don't make any investment decisions you would blame me for if they went bad.)

Friday, January 4, 2019

International Comparisons of Equity Markets and Economic Growth

I don't really have anything interesting to say about these things, but I was comparing equity markets from some of the "housing bubble" countries, and I realized that while the US market has basically doubled from its pre-crisis high, Canada, Australia, and the UK all remain below it (in dollar terms, using US-based national ETFs).


idiosyncraticwhisk.com   2019
Maybe it's not that interesting.  Maybe, the US, Canada, and Australia are all basically moving in the same direction, and Canada and Australia had equity booms in 2007 because they are highly weighted in commodities.  And, maybe the UK has suffered from the double whammy of being the financial center for a stagnant continent.

But, at first glance, this throws me a bit for a loop.  My story is that first our economy was being held back by urban housing constraints, and now it is being held back by credit market constraints.  Both constraints, as far as I can tell, have been more severe than the constraints in the other countries.  Certainly the constrained mortgage market has been.  Yet, during the decade where our banks have been unable to fund housing and rising rents are reducing real economic growth, we are the outlier with fantastic equity growth.

Now, I can tell a just-so story here - that the housing problem costs households but it actually protects urban firms from competition to the extent that their host cities maintain a geographic monopoly on their core networks of skilled labor.  And much of those firms' profits are from overseas revenues.  The rising stock market is somewhat divorced from the broader economy, and housing is part of it.  But, I'm not sure I have a way to confirm that that isn't an ad hoc story.

Source
Here are graphs of GDP growth and unemployment rates.  Here, clearly Australia is the winner and the UK is the loser.  It's a pretty stark contrast between Australia's straight-as-a-post GDP growth and the collapse of its equity market during the crisis.  But, again, this is probably mostly due to the economics of commodities.

Source
On the unemployment rate, the US was the clear loser during the crisis, which I would attribute to the collapse of the construction sector after the mortgage industry was fettered and to less stabilizing monetary policy.  Although, real GDP didn't drop particularly sharply compared to the others.

But, unemployment has improved with the rising stock market, even though GDP (relative to the others) has not.  The same can be said for the UK.  Unemployment has been surprisingly positive there even though both GDP growth and the stock market have been poor.

Broadly speaking, I have spent most of the past few years double checking the conventional narratives about what has been happening economically, and I have become accustomed to finding data that decisively bends convention over and paddles it across the rear.  This is an unusual case where the data doesn't easily form a story that jumps out with a clear explanation.

Maybe part of what is going on here is that stock markets map to where the securities are traded, and that isn't very correlated any more to where the value is added.  Maybe stock markets just aren't good proxies any more for domestic production.  Not because of old shibboleths like "the stock market isn't the economy", but because the stock market is basically representative of parts of the economies of various locations around the world.  They are more representative of sectors than of geographical areas.

Wednesday, January 2, 2019

Upside Down CAPM: Part 7 - Debt is Ownership

I was reading this piece on debt jubilee (HT: JW) and it occurred to me that this is an issue that gains clarity from the Upside Down CAPM idea. (In short, capital is inherently at risk.  It has a natural long term real rate of return of about 7%, which is basically the return on equity ownership.  Fixed income is a trade between capital owners in which the lenders are the true consumers.  They want to transform risky capital into riskless deferred consumption.  They pay a premium <earning less than 7%> in order to avoid risk.)

I have written skeptically about jubilee before.  The idea is popular because the first order effect is forgiveness of debts.  It is imagined to be a transfer from the powerful to the powerless.  But, that just isn't a very useful way to think of debts, in the aggregate.  We tend to think of debts through the prism of consumer debt, but consumer debt is more of a transactional device.  Most household debt is mortgage debt, which is a clear case of Upside Down CAPM.  The ownership of the house is split between an equity holder who takes responsibility for upkeep and maintenance and takes on the risks of market volatility, and the debt holder who exchanges those risks for a fixed return.  The only reason mortgage financing works is that home equity is, itself, very nearly a fixed income type of ownership, in which most of the return comes from rental value.  (That is one of the core problems with Closed Access housing supply.  It makes home equity less like fixed income and causes a breakdown that makes housing financing less functional.)

Thinking about jubilee from an Upside Down CAPM perspective helps to clarify this.  Modern economies have already incorporated jubilee financing deep into our economic systems.  Capital markets are already dominated by a financial security that automatically forgives the debtor all of their principal when they are unable to pay it.  That security is called shareholder equity.

Sometimes, borrowers (for lack of a better word) opt out of jubilee by selling fixed income securities instead of equity.

Incidentally, I wonder how much overlap there would be on a Venn diagram of people who think debt jubilee would be a great idea and people who think limited liability corporations have been a good idea.

The problem comes from contexts where selling equity is difficult or impossible.  The problem with selling equity as an individual is that this is essentially indentured servitude.  Where that can be managed safely (see, currently, Lambda School, which seems to be a great example of this) it can work, but it is difficult.  So, where jubilee is discussed today, it typically has a focus on things like student debt.

But, student debt is an anomaly.  It probably shouldn't exist in the way that it does, and it only does because it is subsidized by Federal guarantees.  Debt is a service provided by the borrower to the lender - providing risk free deferred consumption.  Students aren't remotely in a position to provide that service.  So, the government steps in to provide that service in their name.  But, since policymakers have not come to terms with the incoherency of this program, the program has been designed to leave many indebted former students in dire straits with unpayable debts that they should never have been in a position to take on.

I hope that developments like Lambda School can help lead us to a new financial technology that better matches funding with students, and creates an equity-like funding mechanism (a jubilee-eligible mechanism, as it were) for school funding.  That probably means being more honest about the demand for education, and the difference between the development of marketable human capital, which is a powerful source of economic equity and betterment, and education that is less vocational and is better viewed as consumption than investment.