How long secular stability?

Economics is a curious field of study. For a subject that focuses so much on rational behaviour it is distinctly human. The tribalism borders on parody – post-keynesians, new keynesians, liberal, conservative, heterodox and mainstream. Not to mention market monetarists and MMTers.

Research in macroeconomics also betrays an understandably human response to the trauma of not just being wrong about seminal events, but not even identifying the problem. This seems to explain the tendency to obsess with the past, although it provides little, if any guide to the future. The trauma of 1970s stagflation is the main reason why we created a body of macroeconomics focused (obsessed) with inflation expectations, which resulted in complete neglect of the financial system. It is not even clear that economics contributed to the death of inflation – microeconomic change may be the real cause. Either way, it is no coincidence that models built to understand 1970s stagflation in no way equipped us to make sense of the inflation-stable world which proceeded it.

The same is true of the post-GFC world. The financial sector has never been scrutinised more intently by the economics profession, but with very little insight or relevance unfortunately. After all, the basis of a stable banking system is relatively straightforward. Keep capital and liquidity ratios high. Liquidity ratios have never been higher – exactly what we should expect after a run on global liquidity brought the system to its knees.

Wolf-crying about recession is also a very human response to the trauma of the last one, given its severity. Even usually thoughtful and detached observers have succumbed to ‘this recovery is long in the tooth’ hocus pocus. Seven heads in a row doesn’t change the probability on the next toss. And the economy is rigged.

The most significant shifts in the global macroeconomy since the GFC are barely recognised by most of the economics commentariat. Nor have they resulted in a major reassessment of our models.

The global real economy has been defined by:

1. A continued decline in the volatility of real GDP and inflation. Just as we collectively laughed at Bernanke’s foolishness in proclaiming the Great Moderation we entered the Greatest Moderation. After all, inflation as a source of instability was eliminated two decades ago, what might happen if you regulate instability out of the banking system?

2. Real interest rates (cash rates and government bond yields) have continued to decline despite a) stable global growth and b) declines in unemployment in the developed world to the lowest levels since the 1970s.

The global financial economy has been defined by:

1. The volatility virus – the GFC may have been an early and particularly virulent strain

2. An immovable cost of equity (until recently)

3. Periodic harmless panics in sectoral or regional markets which have hijacked monetary policy

The global policy framework is defined by:

1. Defunct monetary policy

2. An institutional neutering of fiscal policy in the Eurozone

3. A rebalancing in China’s fiscal stance to more measured responses to cyclical challenges. China’s post-crisis ‘scarring’ is that fiscal policy can been too successful cyclically and leave a large structural mess in its wake.

So, where next?

It is not unreasonable to assume current trends persist, but there are early signs that changes may be afoot. A final oddity of macroeconomics is the lack of basic cross-sectional country awareness. Central and eastern European economies are clearly signalling that at a certain point tight labour markets do indeed cause a significant acceleration in real wage growth. They also reveal that wage acceleration and inflation don’t have to move hand-in-hand. Unless jobs growth is somehow derailed across the developed western world, this trend is likely to broaden. Of course, high real wages and trivial inflation rates should be welcome. The main damage will be to post-crisis narratives. Could de-regulated, competitive product markets end up being pro-labour? Could neo-liberalism have the last laugh?

At some point the coefficient of scarring will also decay to near-zero. That will be the time to worry, and there is no reason to expect us to be equipped – history tells us to expect to be unprepared. An early sign is the recent more pronounced shift in the cost of equity.

Econs, like most humans, are very confused by stock markets. A prime example is a repeated bemoaning of the fact that investment spending hasn’t responded to low interest rates. There are many problems here – not least that vast swathes of investment are expensed and not treated as investment, in addition firms invest for many reasons, many sector specific, and the cost of capital is only one consideration. But most obviously to an observer of asset prices, why would you expect an investment boom when the cost of equity remains elevated? The private sector does not discount risky projects using the fed funds rate or 10-year treasuries. ‘Bond-proxies’ have seen yields collapse, but most investment spending does not have bond-like returns.

It is a shame central bankers and policy economists have made no attempt to address the stubbornness of the cost of equity over the last decade, and the widening of the equity risk premium. Again, banks were the last problem, so that is where all the focus has oriented.

My best guess is that high earnings yields and a rising equity risk premium have largely reflected volatility aversion – a GFC legacy and feature of the volatility virus – and an elevated post-crisis recession risk premium, despite the fact that recession probability in fact collapsed.

Why might this be shifting now? Recession forecasts are increasingly falling on deaf ears, and those desperate to call the next one, having failed so miserably last time around, are starting to feel somewhat foolish. Logically, the associate risk premium will fall. Hence in the last six months the PE multiple on the S&P500 (best proxied by using 12-month forward PEs – no one prices their cost of equity using Shiller PEs) has risen to levels only bettered during the tech bubble of the late 1990s. Calling ‘bubble’ at this point, as a vocal minority will, is unhelpful. Likewise the trivially bullish argument that if equilibrium r* has fallen with minimal evidence of a lower g the PE *should* be higher. That was helpful last August in the midst of panic. We are now in the land of price driving price and experience dominating legacy fears and serious grey-haired men warning of recessions.

What might be the consequence? Alertness to these developments is a starting point. But a more violent shift in animal spirits may be on the horizon. Expect to be surprised.

About The Author

Eric Lonergan is a macro fund manager, economist, and writer. His most recent book is Money (2nd ed) published by Routledge. He is also a supporter of Big Issue Invest (BII), the investment arm of The Big Issue, and is one of the initial limited partners in BII’s Social Enterprise Investment Fund LP. In a personal capacity, he makes direct investments in social enterprises. He also supports and advises The Empathy Museum.

8 Responses

  1. Brent sheather

    I don’t get how mr lonegan can argue that the cost of equity is high and at the same time describe “current pe multiples as only bettered during the tech bubble “.

    Reply
    • Eric Lonergan

      Very fair. The term ‘high’ is a bit vague. For most of the post crisis period – the last decade, earnings yields have been well within the historic range, or at the high end – globally. The S&P has traded above the global mean. This is very different to real interest rates, which collapsed relative to historic levels. Hence the difference – the equity risk premium – has been very high, and still is.

      Reply
      • Eric Lonergan

        In the last six months there has been a material increase in the global PE. In the US case it has only traded higher in the post 1996 phase. In the rest of the world PE multiples remain unexceptional, and many measures of the cost of equity, such as the dividend yield, are v reasonable in the context of history.

      • Ravi

        Do you believe S&P is a momentum index? You get paid each month, x% of your salary goes into a DC plan that gets sent to one of those blackboxes of the big Blackrocks, Vanguards etc etc and it get invested automatically regardless of valuation, global growth, PER, earnings yield.

  2. Mark Appleton

    Low real yields support higher P/e multiples in the absence of a deterioration in the potential growth outlook.The question is,I guess, whether long term potential global growth does not ultimately deteriorate with faltering demographics.This could perhaps justify a relatively high equity risk premium?

    Reply
    • Eric Lonergan

      Very fair point. I am not sure this alone justifies a higher equity risk premium, but it might. At the moment, however, I think the market is grappling with a recognition that recession probability is low and there hasn’t been a trade-off between lower interest rates and corporate profitability.

      Reply
  3. Mark Appleton

    Agreed. It seems risk assets will have a relative valuation tailwind for a while yet although somewhat more challenged in the longer term..

    Many thanks. Indeed thought provoking.

    Reply

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