The following "Investment Outlook" is by William H. Gross, the Co-Managing Director of PIMCO, an investment firm. Gross manages the highly regarded $200 billion plus PIMCO Bond Fund. Although his analysis is limited to finance and investment, he does not shy away from the serious crisis capitalism is faced with worldwide. I think Gross penetrate the crisis better than Keynesian economists who seem to think that they can do away with it through inflating the economy. Marxist economists who typically do not address problems of finance and investment may find Gorss' analysis dovetailing their own theories and empirical research on the crisis of the "real" economy.
--KN
* * *
By William H. Gross, PIMCO, August 2012
 |
| William H. Gross, Credit: Bloomberg News |
The cult of equity is dying. Like a once bright green
aspen turning to subtle shades of yellow then red in the Colorado fall,
investors’ impressions of “stocks for the long run” or any run have mellowed as
well. I “tweeted” last month that the souring attitude might be a generational
thing: “Boomers can’t take risk. Gen X and Y believe in Facebook but not its
stock. Gen Z has no money.” True enough, but my tweetering 95-character message
still didn’t answer the question as to where the love or the aspen-like green
went, and why it seemed to disappear so quickly. Several generations were
weaned and in fact grew wealthier believing that pieces of paper representing “shares”
of future profits were something more than a conditional IOU that came with
risk. Hadn’t history confirmed it? Jeremy Siegel’s rather ill-timed book
affirming the equity cult, published in the late 1990s, allowed for brief
cyclical bear markets, but showered scorn on any heretic willing to question the
inevitability of a decade-long period of upside stock market performance
compared to the alternatives. Now in 2012, however, an investor can
periodically compare the return of stocks for the past 10, 20 and 30 years, and
find that long-term Treasury bonds have been the higher returning and obviously
“safer” investment than a diversified portfolio of equities. In turn it would
show that higher risk is usually, but not always, rewarded with excess
return.
Got Stocks?
Chart
1 displays a rather different storyline, one which overwhelmingly favors stocks
over a century’s time – truly the long run. This long-term history of inflation
adjusted returns from stocks shows a persistent but recently fading 6.6% real
return (known as the Siegel constant) since 1912 that Generations X and Y
perhaps should study more closely. Had they been alive in 1912 and lived to the
ripe old age of 100, they would have turned what on the graph appears to be a
$1 investment into more than $500 (inflation adjusted) over the interim. No
wonder today’s Boomers became Siegel disciples. Letting money do the hard work
instead of working hard for the money was an historical inevitability it
seemed.
Yet
the 6.6% real return belied a commonsensical flaw much like that of a chain
letter or yes – a Ponzi scheme. If wealth or real GDP was only being created
at an annual rate of 3.5% over the same period of time, then somehow
stockholders must be skimming 3% off the top each and every year. If an economy’s
GDP could only provide 3.5% more goods and services per year, then how could
one segment (stockholders) so consistently profit at the expense of the others
(lenders, laborers and government)? The commonsensical “illogic” of such an arrangement when
carried forward another century to 2112 seems obvious as well. If stocks
continue to appreciate at a 3% higher rate than the economy itself, then
stockholders will command not only a disproportionate share of wealth but
nearly all of the money in the world! Owners of “shares” using the rather
simple “rule of 72” would double their advantage every 24 years and in another
century’s time would have 16 times as much as the sceptics who decided to skip
class and play hooky from the stock market.
Cult
followers, despite this logic, still have the argument of history on their side
and it deserves an explanation. Has the past 100-year experience shown in Chart
1 really been comparable to a chain letter which eventually exhausts its
momentum due to a lack of willing players? In part, but not entirely. Common
sense would argue that appropriately priced stocks should return more
than bonds. Their dividends are variable, their cash flows less certain and
therefore an equity risk premium should exist which compensates stockholders
for their junior position in the capital structure. Companies typically borrow money at
less than their return on equity and therefore compound their return at the
expense of lenders. If GDP and wealth grew at 3.5% per year then it seems only
reasonable that the bondholder should have gotten a little bit less and the
stockholder something more than that. Long-term historical returns for Treasury
bill and government/corporate bondholders validate that logic, and it seems
sensible to assume that same relationship for the next 100 years. “Stocks for
the really long run” would have been a better Siegel book title.
Yet
despite the past 30-year history of stock and bond returns that belie the really
long term, it is not the future win/place perfecta order of finish that I
quarrel with, but its 6.6% “constant” real return assumption and the huge
historical advantage that stocks presumably command. Chart 2 points out one of
the additional reasons why equities have done so well compared to GNP/wealth
creation. Economists will confirm that not only the return differentials within
capital itself (bonds versus stocks to keep it simple) but the division of GDP
between capital, labor and government can significantly advantage one sector
versus the other. Chart 2 confirms that real wage gains for labor have been
declining as a percentage of GDP since the early 1970s, a 40-year stretch which
has yielded the majority of the past century’s real return advantage to stocks.
Labor gaveth, capital tooketh away in part due to the significant shift to
globalization and the utilization of cheaper emerging market labor. In
addition, government has conceded a piece of their GDP share via lower taxes
over the same time period. Corporate tax rates are now at 30-year lows as a
percentage of GDP and it is therefore not too surprising that those 6.6%
historical real returns were 3% higher than actual wealth creation for such a
long period.
The
legitimate question that market analysts, government forecasters and pension
consultants should answer is how that 6.6% real return can possibly be
duplicated in the future given today’s initial conditions which historically
have never been more favorable for corporate profits. If labor and indeed government must
demand some recompense for the four decade’s long downward tilting teeter-totter
of wealth creation, and if GDP growth itself is slowing significantly due to
deleveraging in a New Normal economy, then how can stocks appreciate at 6.6%
real? They cannot, absent a productivity miracle that resembles Apple’s
wizardry.
Got
Bonds?
My
ultimate destination in this Investment Outlook lies a few paragraphs ahead so let
me lay its foundation by dissing and dismissing the past 30 years’ experience
of the bond market as well. With long Treasuries currently yielding 2.55%,
it is even more of a stretch to assume that long-term bonds – and the bond
market – will replicate the performance of decades past. The Barclay’s U.S. Aggregate Bond
Index – a composite of investment grade bonds and mortgages – today yields only
1.8% with an average maturity of 6–7 years. Capital gains legitimately emanate
from singular starting points of 14½%, as in 1981, not the current level in
2012. What you see is what you get more often than not in the bond market, so
momentum-following investors are bound to be disappointed if they look to the
bond market’s past 30-year history for future salvation, instead of mere
survival at the current level of interest rates.
Together
then, a presumed 2% return for bonds and an historically low percentage nominal
return for stocks – call it 4%, when combined in a diversified portfolio
produce a nominal return of 3% and an expected inflation adjusted return
near zero. The Siegel constant of 6.6% real
appreciation, therefore, is an historical freak, a mutation likely never to be
seen again as far as we mortals are concerned. The simple point though whether
approached in real or nominal space is that U.S. and global economies
will undergo substantial change if they mistakenly expect asset price
appreciation to do the heavy lifting over the next few decades. Private pension
funds, government budgets and household savings balances have in many cases
been predicated and justified on the basis of 7–8% minimum asset appreciation
annually. One of the country’s largest state pension funds for instance
recently assumed that its diversified portfolio would appreciate at a real rate
of 4.75%. Assuming a goodly portion of that is in bonds yielding at 1–2% real,
then stocks must do some very heavy lifting at 7–8% after adjusting for
inflation. That is unlikely. If/when that does not happen, then the economy’s
wheels start spinning like a two-wheel-drive sedan on a sandy beach. Instead of
thrusting forward, spending patterns flatline or reverse; instead of thriving,
a growing number of households and corporations experience a haircut of wealth
and/or default; instead of returning to old norms, economies begin to resemble
the lost decades of Japan.
Some
of the adjustments are already occurring. Recent elections in San Jose and San
Diego, California, have mandated haircuts to pensions for government employees.
Wisconsin’s failed gubernational recall validated the same sentiment. Voided
private pensions of auto and auto parts suppliers following Lehman 2008 may be
a forerunner as well for private corporations. The commonsensical conclusion
is clear: If financial assets no longer work for you at a rate far and
above the rate of true wealth creation, then you must work longer
for your money, suffer a haircut on your existing holdings and
entitlements, or both. There are still tricks to be played and gimmicks to be employed.
For example – the accounting legislation just passed into law by the Congress
and signed by the President allows corporations to discount liabilities at an
average yield for the past 25 years! But accounting acts of magic aside,
this and other developed countries have for too long made promises they can’t
keep, especially if asset markets fail to respond as they have historically.
Reflating
to Prosperity
The primary magic potion that policymakers have always
applied in such a predicament is to inflate their way out of the corner. The
easiest way to produce 7–8% yields for bonds over the next 30 years is to
inflate them as quickly as possible to 7–8%! Woe to the holder of long-term bonds in the process!
Similarly for stocks because they fare poorly as well in inflationary periods.
Yet if profits can be reflated to 5–10% annual growth rates, if the U.S.
economy can grow nominally at 6–7% as it did in the 70s and 80s, then America’s
and indeed the global economy’s liabilities can be “reflated” away. The problem
with all of that of course is that inflation doesn’t create real wealth and it
doesn’t fairly distribute its pain and benefits to labor/government/or
corporate interests. Unfair though it may be, an investor should continue to
expect an attempted inflationary solution in almost all developed economies
over the next few years and even decades. Financial repression, QEs of all sorts and sizes, and
even negative nominal interest rates now experienced in Switzerland and five
other Euroland countries may dominate the timescape. The cult of equity may be
dying, but the cult of inflation may only have just begun.
No comments:
Post a Comment