According to an article in The Economist on August 2, “economists trying to explain the feeble pace of America’s recovery regularly blame deleveraging”. This raises two questions: can the US recovery sensibly be described as feeble and, if it can, is deleveraging to blame? Read more

In a comment on my recent blog regarding the equity risk premium, “Le gun” asked for a guide to making long-term investment decisions and I promised to try.

In 2009 TengTeng Xu and I addressed this issue in a paper called “Investment and Spending Strategies for Endowments”. We were specific because the need for income and the investor’s time horizon should both be taken into account when deciding on a sensible policy for individual investors. We considered the use of only three asset classes: equities, long-dated bonds and short-term deposits (cash). We did not include property because we were unable to find suitable long-term data and dismissed commodities, including gold, as combining poor returns with high volatility. With regard to the possible portfolios, we came to several conclusions which I will adapt here for all long-term investors, rather than just endowments. Read more

I assume and hope that Scotland will vote to maintain the union on September 18. I am, however, sceptical of the barrage of claims that Scotland will either be necessarily better or worse off if a majority vote “Yes”.

Countries have grown at hugely different rates in the past. Chart one (below) shows the relative growth rates in terms of gross domestic product per head of Ghana and South Korea. In 1950, when the data series starts, the standard of living of Ghanians was 30 per cent higher than those in South Korea, but the latter were ahead by 1965 and, by 2008, when the data series ends, had living standards twelve times higher.

 Read more

The gross domestic product data for the second quarter of 2014 showed that the US economy bounced back strongly, and with enough vim to justify the view that its first quarter weakness was largely due to bad weather.

However, the productivity figures provided another bad surprise. In the first quarter GDP per hour worked fell, and it would therefore have been reasonable to expect it to improve with the sharp recovery shown in the second quarter. In fact, there was another fall.

 Read more

Ed Balls, who has a high chance of being the UK’s next chancellor of the exchequer, has announced that the opposition Labour party is “examining the case for introducing an allowance for corporate equity, to redress the systemic bias in favour of debt finance”. This would be very sensible, but it needs to be done sensibly.

Allowing interest as a deduction before calculating the profit on which corporation tax should be paid encourages excessive debt, buybacks of equity in preference to long-term investment and debt-financed takeovers. The views of economists on its undesirability are one of the few instances on which they are almost all agreed. It is one of the rare exceptions to the old rule that “n economists = n+1 opinions”. Read more

The UK has a seriously unbalanced economy, with little spare capacity and a slow trend rate of growth. To correct its imbalances, the current account deficit and the cash flow surpluses of the corporate sector need to fall. This would permit a fall in the fiscal deficit, but requires a fall in the real exchange rate and in the share of consumption in gross domestic product.

The fall in the trend rate of economic growth comes from a combination of a slower growth in the population of working age and a drop in productivityRead more

In some of my more gamesome moments I have challenged my students to produce an article about the equity risk premium, which made a useful contribution to our understanding of the way financial markets work. So far the challenge has not been met. This may reflect the modesty and good manners of those I teach but also, I hope and believe, the fact they are too sensible to wish to defend the way this often ill-defined and generally useless concept has been habitually discussed. In practice, comments on the ERP seem to me to have been a source of confusion and error rather than illumination.

The ERP can be defined in at least two ways. One is the historic difference between the returns on bonds and equities and another is the expected difference in these returns. Alternatively, the “risk-free rate” can be used in place of bonds. Read more

A few weeks ago, I promised to write about claims that the stock market could be valued by comparing earnings yields to bond yields. This approach is sometimes called the “Fed model”. This was fashionable in the 1990s and seems to have some followers even today. It is not only nonsense but is the most egregious piece of “data mining” that I have encountered in the 60-plus years I have been studying financial marketsRead more

Competition is essential if capitalism is to work well for the benefit of the consumers and the economy in general. It is, however, much disliked, notably by businessmen and trade unionists. The present system of management remuneration has very similar impacts on the economy as a decline in competition. Companies have a great deal of short-term monopoly power and chief executives are encouraged by their pay packages to exploit this more aggressively than they used to do. The result is a rise in profit margins, a fall in investment and productivity and a structural savings’ surplus in the business sector, which is the corollary of the structural fiscal deficits of the UK and the US.

I would like to see the damage done to our economies by these perverse incentives understood and the system changed. I was therefore pleased to contribute to a booklet published by the Trades Union Congress on the need for reform (though I pleaded in vain for its title, “Beyond Shareholder Value”, to be changed). As the author of one of the chapters I was asked to participate in a discussion organised for its launch. Read more

In the past governments have funded their deficits – for example, they have borrowed in the bond market rather than through treasury bills. This is despite the fact that, for the past 80 years, the rate of interest on bonds has been greater than that on Treasury bills; that is, we have had an upward sloping yield curve.

I suggested in a recent blog that this was because governments correctly perceived that there were considerable economic risks in not funding, and that it was worth paying the additional cost to avoid these risks. Quantitative easing, which is a form of underfunding, must therefore have increased these risks. Defenders of QE need either to argue that these risks have not risen or that the benefits we have received from QE outweigh the rise in risks. To be consistent, those who hold that no additional risks have been incurred must now hold that governments should not have funded in the past and must now stop. But their silence is deafening, and such views are implausible, being held, I think, in the hope of dissuading discussion rather than from any conviction that they would survive much debate. Read more

While it is sometimes useful to make a distinction between treasuries and central banks, they are fundamentally both part of government. When central banks buy bonds as part of quantitative easing, governments are in practice ceasing to fund, ie, they are issuing short-term rather than long-term debt. If this is potentially harmful, we need to worry; if not, we need to ask why have governments funded in the past? Read more

US gross domestic product was increased last year by much more than the growth of the economy. This sleight of hand was achieved by changing the way GDP is measured. The UK is due for a similar make-over this year. Reality won’t change and we need to be alert to the comments of those who will think it has.

“Nearly all scientists believe that there is a clear-cut distinction between fact and theory…William Whewell (1794-1866) denied that any such sharp distinction existed.” Peter Medawar, the Nobel laureate, whom I am quoting, agreed with the denial; and, as GDP data are generally considered to be facts, the revisions show that Whewell was spot on. The calculation of GDP depends on the theoretical model on which it is based. The change in GDP involves a change in the model being used and, in my view, the new model is worse than the old one. Read more

The US seems expensive relative to other major stock markets. As it is probable that cheaper markets will give better returns, this implies that investors should underweight US equities. This conclusion applies, however, only over the longer term. Timing matters and this involves other considerations.

Chart one illustrates that G5 stock markets are strongly correlated with the US and so, to a large extent, markets go up and down together. The chart also shows that this tendency has been strengthening over time. Read more

Abenomics, the term given to the reform package Japanese prime minister Shinzo Abe launched to revive the country’s economy, is based on two myths. One is that the economy has performed badly and the second is that this non-existent failure has been due to deflation. Despite its lack of intellectual justification, the attempt to stop deflation has been a success as the accompanying rhetoric and monetary policy have produced yen weakness. This was an essential step towards solving Japan’s fiscal problem and, as the rhetoric has been about deflation rather than devaluation, the dramatic weakness of the currency has been achieved without international opprobrium.

Over time the devaluation should result in an improved current account. This will allow the fiscal deficit to fall while the economy moves ahead, but it is not enough on its own. The other essential is to reduce the cash flow surplus of the business sector. Having achieved success in step one, largely by accident, there is a chance that Abenomics will succeed in step two. If it does, it is again likely to be an accident. Read more

Ian McCafferty, an external member of the Bank of England’s Monetary Policy Committee, believes “Britain’s ‘productivity puzzle’ will persist as the economy recovers because much of the decline in output is structurally entrenched.” As a result, Mr McCafferty believes that the Bank of England “should not ‘hold back too long’ on interest rate rises”.

Scarcely a day passes without some reference to the UK’s “productivity puzzle” and a claim that the poor productivity is “inexplicable”. This reflects a failure to understand how and why the economy has changed. Poor productivity is so readily explicable that it should cause no surprise. It is, as I have sought to explain before, the natural result of the change in management incentives. Read more

Cyclically adjusted price-earnings ratio (Cape) appears to be a valid way to measure the value of the US stock market, but this does not mean that it can sensibly be used for other indices. As I explained in a previous blogpost, Cape is only valid if it can pass two tests: first, that the real return on equities has been mean reverting; and second, that profit margins have also been mean reverting and have rotated quickly around their average.

Real returns on equities has been less strongly mean reverting in other markets than they had been in the US. This weakens the case for Cape in other major stock markets, but does not, I think, necessarily rule it out. Even if returns would otherwise have been mean reverting, they will not have been if countries had suffered unexpected and catastrophic losses, such as occurred in world wars. I had already explained in Growth and returns, another blogpost, that these losses were the probable explanation for the exceptionally low returns on equity investment in the first half of the 20th Century in countries such as Germany and Japan. Read more

The cyclically adjusted price-earnings ratio (Cape) has become well known as a way of valuing the US equity market. Its moderate success in this role has led to the assumption that the same approach will be valid for other markets. Unfortunately this seems doubtful, as I will try to explain. I should warn readers that, despite trying to make my explanation as simple as possible, I have been unable to avoid raising some quite technical points.

There are two fundamental and very different ways in which equity markets can be measured. One of these is q, by which the market value of companies is compared to the real value of their assets. This follows from the basic principle that, in any reasonably competitive economy, the value of anything depends on the cost of creating it — and it is therefore the macroeconomic approach. The other way treats equities as financial assets and values them by discounting the expected future returns at an appropriate rate. Cape is based on this approach and depends for its validity on the data for any particular stock market being consistent with the theory behind it. Read more

It is widely, but by no means universally, accepted among economists that the “rate of interest” is closely related to growth. It is, however, also generally accepted that this applies to a closed economy, such as the world as a whole.

The growth rate of G5 countries has been declining steadily for years, and this trend has recently accelerated, as chart one shows. It seems likely that low growth has become endemic and this is being widely interpreted as implying that real interest rates will remain low. This view strikes me as being unjustified on theoretical grounds and is also a very dubious conclusion to draw from the past. Read more

I wrote in an earlier blog that I would become more cautious about US equities if profit margins came down. We have just had the figures for the first quarter of 2014 and profit margins have narrowed. I should therefore keep readers up to date and explain why I do not think the latest data are signalling the top of the market.

As I pointed out in “US corporate debt and cash flow”, US companies have been the key buyers of the stock market and the rate at which they have been buying shares is unsustainable, because debt cannot continue to grow at the pace needed to finance the purchases. The difficulty with things that cannot go on is deciding when they will stop and I will try to explain why I think this point has not yet arrived, despite the uncertainty that anyone must have about such things.

 Read more

As reported by Harriet Agnew and Kate Burgess in the Financial Times on May 29, a new global accounting standard is due to take effect in 2017. A key aim is to improve and make more consistent the way in which sales are recorded. In my view the key aim should be to downgrade the importance placed on sales and insist on output data being readily available.

Sales are to a large extent meaningless, particularly when used to compare profit margins between different countries or their changes over time.

Profit margins can be measured in different ways. They can, however, only sensibly be described as being high or low if they are mean reverting, ie they must be pulled back towards some average level. Read more