Category: residential investment

Slow Growth

Leave a comment

April 21, 2019

by Steve Stofka

Happy Passover and Happy Easter. Now that tax day is past, let’s raise our heads and look at long-term growth trends of real, or inflation-adjusted, GDP. For the past seventy years real GDP has averaged about 3% annual growth. In the chart below, I’ve charted the annual percent change in a ten-year average of GDP (GDP10, I’ll call it). As you can see on the right side of the graph, growth has been below average for the past decade.

In 2008, growth in the GDP10 crossed below 3%. Was this due to the Financial Crisis (GFC) and the housing bust? No. The GFC barely figured into the computation of the ten-year average. The housing market had been running hot and heavy for four to five years, but this longer-term view now puts the housing boom in a new perspective: it was like lipstick on an ugly pig. Without the housing boom, the economy had been faltering at below average growth since the 1990s tech boom.

The stock market responds to trends – the past – of past output (GDP) and the estimation of future output. Let’s add a series of SP500 prices adjusted to 2012 dollars (Note #1).

For three decades, from the late 1950s to the mid-1980s, the real prices of the SP500 had no net change. The go-go years of the 1960s raised nominal, but not real, prices. Investors shied away from stocks, as high inflation in the 1970s hobbled the ability of companies to make real profit growth that rewarded an investor’s risk exposure. From the 2nd quarter of 1973 to the 2nd quarter of 1975, real private domestic investment lost 27% (Note #2). In less than a decade, investment fell again by a crushing 21% in the years 1979 through 1982.

In the mid-1980s, investors grew more confident that the Federal Reserve understood and could control inflation and interest rates. During the next decade, investors bid up real stock prices until they doubled. In 1996, then Fed chairman Alan Greenspan noted an “irrational exuberance” in stock prices (Note #3). The “land rush” of the dot-com boom was on and, within the next five years, prices would get a lot more exuberant.

The exuberance was well deserved. With the Fed’s steady hand on the tiller of money policy, the ten-year average of GDP growth rose steadily above its century-long average of 3%. A new age of prosperity had begun. In the 1920s, investment dollars flowed into the new radio and advertising industries. In the 1990s, money flowed into the internet industry. Construction workers quit their jobs to day trade stocks. Anything less than 25% revenue growth was the “old” economy. The fledgling Amazon was born in this age and has matured into the powerhouse of many an internet investor’s dream. Thousands of other companies flamed out. Billions of investment dollars were burned.

The peak of growth in the ten-year average of GDP output came in the 1st quarter of 2001. By that time, stock prices had already begun to ease. In the next two years, real stock prices fell almost 50%, but investment fell only 12% because it was shifting to another boom in residential housing. As new homes were built and house prices rose in the 2000s, long-term output growth began to climb again.

From the first quarter of 2006 to the 3rd quarter of 2009, investment fell by a third, the greatest loss of the post-war period. In the first quarter of 2008, growth in the GDP10 fell below 3%. In mid-2009, it fell below 2%. Ten years later, it is still below 2%.

The Federal Reserve has had difficulty hitting its target of 2% inflation with the limited tools of monetary policy. There simply isn’t enough long-term growth to put upward pressure on prices.  Despite the low growth, real stock prices are up 150% since the 2009 lows.  A prudent investor might ask – based on what?

The supply side believers in the Trump administration and Republican Party thought that tax cuts would spur growth. In the first term of the Obama administration, believers in Keynesian counter-cyclical stimulus thought government spending would kick growth into gear. Faced with continued slow growth, each side has doubled down on their position. We need more tax cuts and less regulation, say Republicans. No, we need more infrastructure spending, Democrats counter. Neither side will give up and, in a divided Congress, there is little likelihood of forging a compromise in the next two years. The stock market may be waiting for the cavalry to ride to the rescue but there is no sign of dust on the horizon.

Economists are just as dug in their ideological foxholes. The Phillips curve, the correlation between employment and inflation, has broken down. The correlation between the money supply and inflation has also broken down. High employment but slow output growth and low inflation. Larry Summers has called it secular stagnation, a nice label with only a vague understanding of the underlying mechanism. If an economist tells you they know what’s going on, shake their hand, congratulate them and move to the other side of the room. Economists are still arguing over the underlying causes of the stagflation of the 1970s.

A year ago, I suggested a cautious stance for older investors if they needed to tap their assets for income in the next five years. The Shiller CAPE ratio, a long-term evaluation of stock prices, is at the same level as 1929. At current prices in a low growth environment, stock returns may  struggle to average more than 5-6% annually over the next five years.

//////////////////////

Notes:

  1. Adjusted for inflation by the Federal Reserve’s preferred method, the Personal Consumption Expenditures Price Index (FRED series PCEPI). Prices do not include dividends
  2. Real Gross Private Domestic Investment – FRED Series GPDIC1.
  3. A video of the 1996 “irrational exuberance” speech

Investment Declines

Leave a comment

September 4, 2016

The market seems awfully quiet leading into September, a month that is the most consistently negative for the past century. LPLResearch notes that it has been about 35 years since the market was this quiet for this long.  It has been 30 trading days (at the end of August) since the SP500 had strayed more than 1% from its 10 day average.  A year ago in August 2015 the market spent 17 trading days in this quiet zone then fell 6% in 3 days. In September 2014, the market acted like a sailing ship in the horse latitudes before sinking 6% over the following ten days.  We wish the market went up after these long quiet periods, but the trend is usually down.

Investment

Let’s look at a disturbing long term trend – a decline in private investment in housing (residential), as well as factories, equipment and office buildings (non-residential).  What is private?  Non-government, i.e. companies and individuals in the private market.

First, let’s look at private investment as a whole before we look at the parts.  As a percent of GDP, we are near post-WW2 lows.

“Oh, that was the housing bubble and financial crisis,” we might say.  Everytime we think we’ve got it figured out, that is the beginning of the journey of learning, some Zen master probably said at some time.  Be humble, little tree frog, or wax on, wax off.  Something like that.

Only this year has the economy surpassed the 2008 level of inflation adjusted private investment.  To get a sense of the damage done by the financial and housing crisis, the chart below is a rolling 5 year sum of investment and covers most of the post-WW2 period.  Look at the historic dip – not a pause, not a flattening, but a genuine crater in investment growth.  Here we can see the over-investment during the tech bubble of the late nineties when the 5 year sum climbed at a 60 degree angle, followed by the 45 degree climb as the housing bubble climaxed. Even scarier is the possibility that we may still be above the growth trend of the 70s, 80s and early 90s – that there is still a bit of correction left.

Housing Investment

Seven years after the official end of the recession, ten years after the height of the housing bubble, investment in residential housing is still near all time lows.  As a percent of the economy (GDP) it has been rising but from a great depth.

Slow household formation after the financial crisis, i.e. Johnny and Mary staying home or moving back in with Mom and Dad, has contributed to the slow recovery in housing investment.  The millennial generation, bigger in numbers than the aging Boomers, doesn’t have the same preference for owning their own home.  Census Bureau data shows that the home ownership rate in the under-35 crowd has declined from 39% in 2010 to 34% in 2016.  While it may be more noticeable in the millennial aged cohort, the data shows a decline in all age groups, and across incomes (page 10).   Competition for a dwindling stock of apartment rentals has caused a sharp rise in median rental rates across the country.

Why a dwindling number of rental units?  As home ownership rose in the 2000s, the investments in new apartment building began to decline in 2007, then fell abruptly during the crisis.  Only in 2011 did it finally start to rise up from its trough.  The drop in investment was so huge that just posting a number doesn’t do it justice.  Millennials are now being squeezed by a lack of rental housing stock.  Sharply rising home values in popular areas like Denver make it more difficult for millennials to shift preferences to home ownership.

The business Side

Now let’s look at investments in office buildings, equipment and factories.  These can be somewhat cyclical but the long term trend is down.  Since China was admitted to the WTO in 2001, the highs in the cycle have been trending lower.  During the 2000s Americans were not saving enough to fund business investment growth and our economy increasingly relied on foreign investment dollars.  Today we are on the decline in that investment cycle and we can expect further declines.

Does low inflation hurt investment?

It makes sense that a stable environment of low inflation should encourage business investment.  Low interest rates should encourage lending to business, etc.  This is the conventional narrative that has guided policy making at the Federal Reserve.  Stop an economist on the street and ask them if low interest rates encourage business investment and they will probably say yes. Here’s a quote from an economics course “If the expected rate of return [on the new investment] is greater than the real interest rate, the investment makes sense.”

Makes sense but what if it is partially wrong? Is it possible that low interest rates could, in some cases, discourage investment?  This is the opposite of the conventional narrative but let’s walk this path for a bit.  We often think of interest rates as a dependent variable, a response to something indicating a demand for money.  What if it is also an independent variable, a cause affecting the demand for money? Yep, it’s one of those interdependent cyclic things that might make you want to meditate on the universality of love and being, but stay with me 🙂

Interest rates can be a heuristic for investors, a signal of the demand for money, a weather vane of the underlying strength of the economy as seen by the top economists in the country, the folks at the Federal Reserve.  Low rates could be seen as a cautionary warning to investors.  If the economy were really getting stronger, would interest rates remain low?  Of course not, an investor might reason.  They would rise in response to stronger demand for money.  But they are not rising so better to be cautious, the investor reasons.  The dog chases its tail.

Do low interest rates cause reckless borrowing?

Are low interest rates prompting companies to borrow excessively?  Well, yes and no.  Yes, they are borrowing more but the growth trajectory, the rate of growth, is about the same as it has been since 1990.  As we can see in the chart below, each recession is a pause in the growth of corporate debt.  After each recession, the level rises again on approximately the same slope.  The “pause” in this last recession lasted a whopping four years, during which corporate debt declined as much as $600 billion, or about 5.6%.

The problem is what they are borrowing it for.  Companies typically buy back their own shares at their hghest, not lowest value.  By lowering the number of shares outstanding, buybacks raise the earnings per share even if there is no real growth in earnings.  Instead of buying low, selling high, companies tend to buy high, sell low. FactSet gathers and crunches a lot of market data.  Their mid-year analysis of share buybacks shows that total dollars spent on buybacks is approaching the highs of 2007.  Investment in real growth, in productive plants, equipment and office buildings, has declined the past three quarters but share buybacks, the appearance of growth, have increased.

A simple example

How could low inflation hurt investment?  If predicted inflation is rather low, about 2%, sales growth will not get that extra kick from inflation. Let’s say that a company’s sales are $1000 and the owners have an extra $50 to invest.  They are considering a plan to invest $50 and borrow $50 from the bank to expand in the hopes of making more sales.

First they consider the return by not expanding.  They put their $50 in the bank and make 2% interest or $1.  At 2% inflation, $1000 sales grows to $1020.  Let’s say that the company has a 30% gross margin, which gives an extra $6 profit on the extra $20 in sales.  The combined extra return to the owners is $7, a $6 profit and $1 in interest income.

Then they consider a second scenario.  Let’s say that the interest rate on the borrowed money is 6%, or 4% above the inflation rate of 2%.  As in the first scenario, they assume that the savings rate, or opportunity cost, of the invested $50 is about 2%.  The owners can expect an extra $4 imputed and actual cost on that combined $100 of investment.  If inflation is averaging 2% per year, then they can expect sales of $1020 even if there is no real sales growth.  Again, they use a 30% gross margin to arrive at an extra profit to them of $6, the same as the first scenario. If the extra investment does not produce any real sales growth, then the owners will net an extra profit of about $2, much less than the scenario of no expansion.  To make the same extra profit as in the first scenario, the owners need to generate an extra $11 in profit.  Minus the $4 in costs, the extra profit will be $7, the same as the first scenario.  Note that the owners are now trying to break even with the extra profits of not expanding.  To do that they must have sales of about $1037, or almost 2% real sales growth in addition to the 2% inflation growth.

Now, let’s consider a higher inflation rate of 4%.  Let’s imagine that the cost to borrow money is 8%, or 4% higher than inflation, as before, so that the cost of borrowing the $50 for a year is $4. As before, we’ll assume that the savings rate, or opportunity cost, of the $50 from the owner’ pockets is the same as inflation, or 4%, so that the imputed cost of the owners’ investment is $2.  Borrowed and imputed cost of the extra $100 invested in the company is now $6. If there is no real sales growth, total sales will now be $1040, or $40 more.  A 30% margin gives a gross profit of $12, leaving the owners with about $6 extra profit on investment.

Note that a doubling of the inflation rate in this scenario has produced a tripling of extra profit even with no real sales growth. Still the extra profits are less than not expanding at all.  They must still have a real increase in sales, but it is very small.

So a stable higher inflation rate and interest rate encourages business investment.  The key word here is stable.  We could keep doing this calculation with higher and higher rates producing more net profits to the owners but….  As inflation gets higher, it becomes less stable, less predictable and this unpredictability actually hurts business investment.

The Federal Reserve has set a target inflation rate of 2%.  I think it is too low and the lackluster growth of the economy seems to bear that out. Since the 1970s, prominent economists (Taylor and Tobin, for example) have suggested alternative targets that the Federal Reserve could use to replace the “dual mandate” set by the Congress in 1977.

A prominent alternative is a growth target in nominal GDP, called NGDP,  There are several variations but the one most favored has been level targeting, the calculation of GDP targets over the following five years or so based on an agreed growth rate.  The Fed would then take action to offset deviations from those targets. Two prominent economists, Robert Hall and Greg Mankiw, wrote a paper in 1993 explaining these alternative targets and the policy tools that the Federal Reserve could employ to help reach those targets.  During the period called the “Great Moderation,” from 1985-2007 national income grew at a rate just a bit more than 5%.

Hall and Mankiw noted (pg. 5) that the consensus among macroeconomists at that time was in favor of a targeting of nominal national income because it was a transparent measure, a clear, simple target.  The authors commented (pg. 4): “A rule like ‘Keep employment stable in the short run but prevent inflation in the long run’ [the current rule, by the way] has proven to be hopelessly vague; a central bank can rationalize almost any policy position with that rule.”

So the idea of nominal income or production targeting is familiar to economists and policymakers for several decades but has never been adopted. We can only assume, as the Nobel winner James Buchanan posited, that there is a very good reason for that.  When an obscure policy remains in place, it does so for a reason.  Enough policymakers want the obscurity that the policy provides.  I’m reminded of a letter John Adams wrote to Jefferson lamenting some of the vague language used in the Constitution which both of them had helped to craft.  Adams noted that the vagueness was necessary to reach consensus at the Constitutional Convention.  Efforts to achieve more precision in language or attempts to add specific detail were sometimes met with hardened disagreement.  The “general Welfare” wording of the tax and spending clause, Section 8, was one example.  Some argued that the lack of precision would give future generations of lawmakers some flexibility in determining what, in fact, was the general welfare of the United States.

 Whatever the Fed is doing now is only partially working and a different approach might be in order.  The use of the Labor Market Conditions Index, a broad composite of over twenty employment indicators, in guiding monetary policy shows that the Fed is reaching for a broader set of guidelines.  As Hall and Mankiw indicated, nominal targeting might give the Fed that broad guide, one that is less influenced by the needs and whims of elected politiciams.

Investment decline and the stock market

Let me finish on a somber note.  The year over year growth rate in the SP500 and private investment have both gone negative this year, for the first time since the end of the recession in 2009. The SP500 data is copyrighted so here’s a link to that chart. Pay attention.

/////////////////////////////

Notes:
If you would like to read more on the relationship of investment to savings, check out this 2006 NBER paper.

///////////////////////////

Happy Labor Day and put a shrimp on the barbie as a toast to the summer passing!

Investment Flows

Leave a comment

October 18, 2015

When economists tally up the output or Gross Domestic Product (GDP) of a country, they use an agreed upon accounting identity: GDP = C + I + G + NX where C = Consumption Spending, I = Investment or Savings, G = net government spending, and NX is Net Exports, which is sometimes shown as X-M for eXports less iMports. {Lecture on calculating output}

In past blogs I have looked at the private domestic spending part of the equation – the C.  Let’s look at the G, government spending, in the equation.  Let’s construct a simple model based more on money flows into and out of the private sector.  Let’s regard “the government” as a foreign country to see what we can learn.  In this sense, the federal, state and local governments are foreign, or outside, the private sector.

The private sector exchanges goods and services with the government sector in the form of money, either as taxes (out) or money (in).  Taxes paid to a government are a cost for goods and services received from the government. Services can be ethereal, as in a sense of justice and order, a right to a trial, or a promise of a Social Security pension.  Transfer payments and taxes are not included in the calculation of GDP but we will include them here.  These include Social Security, Medicare, Medicaid, food stamps and other social programs.  If the private sector receives more from the government than the government takes in the form of taxes, that’s a good thing in this simplified money flow model. There are two types of spending in this model: inside (private sector) and outside (all else) spending.

Let’s turn to investment, the “I” in the GDP equation.  In the simplified money flow model, an investment in a new business is treated the same as a consumption purchase like buying  a new car.  Investment and larger ticket purchase decisions like an automobile depend heavily on a person’s confidence in the future.  If I think the stock market is way overpriced or I am worried about the economy, I am less likely to invest in an index fund.  If I am worried about my job, I am much less likely to buy a new car.  In its simplicity this model may capture the “animal spirits” that Depression era economist John Maynard Keynes wrote about.

We like to think that an investment is a well informed gamble on the future.  Well informed it can not be because we don’t know what the future brings.  We can only extrapolate from the present and much of what is happening in the present is not available to us, or is fuzzy.  While an investment decision may not be as “chanciful” as the roll of a dice an investment decision is truly a gamble.

Remember, in the GDP equation GDP = C + I + G + NX, investment (the I in the equation) is a component of GDP and includes investments in residential housing. In the first decade of this century, people invested way too much in residential housing.

In the recession following the dot-com bust and the slow recovery that followed the 9-11 tragedy, private investment was a higher percentage of GDP than it is today, six years after the last recession’s end.  Much of this swell was due to the inflow of capital into residental housing.

The inflation-adjusted swell of dollars is clearly visible in the chart below.  It is only in the second quarter of this year that we have surpassed the peak of investment in 2006, when housing prices were at their peak.

Investment spending is like a game of whack-a-mole.  Investment dollars flow in trends, bubbling up in one area, or hole, before popping or receding, then emerging in another area.  Where have investment dollars gone since the housing bust?  An investment in a stock or bond index is not counted as investment, the “I” in the equation, when calculating GDP.  The price of a stock or bond index can give us an indirect reading of the investment flow into these financial products.  An investment in the stock market index SP500 has tripled since the low in the spring of 2009 {Portfolio Visualizer includes reinvestment of dividends}

Now, just suppose that some banks and pension funds were to move more of those stock and bond investments back into residential housing or into another area?