The very long run equity bull market
The rebound in global equities since mid October once again leaves markets in nosebleed territory. The likelihood of an imminent sell-off depends on the economic cycle, the central banks, and temporary extremes in valuation. All of these factors are the staple diet of this blog.
But today I would like to reflect on whether we can expect the much longer up-trend in risk assets, which started in the early 1980s, to continue into future cycles. (Warning: some of this is a bit technical; skip to the end for the bottom line for investors.)
Thomas Piketty’s work has shown that a rising wealth/income trend is not a “natural” state of affairs in the very long run. He argues that, in many economic growth models, the wealth/income ratio is broadly stable in equilibrium, and his data suggest that this has been the case in the UK and France for several centuries [1].
The opposite has been true in recent decades. Two factors are primarily responsible: the long term decline in the global real rate of interest, and the continuous rise in the share of profits in national income.
This combination has led to rising expectations of future profits, discounted at ever lower real interest rates, a recipe for surging equity prices. Lower inflation has also reduced the inflation risk premium, which has further exaggerated the gains in both bond and equities.
That much is fairly obvious. But in an interesting new paper, Charles Goodhart and Philipp Erfurth at Morgan Stanley suggest that these factors are directly linked. All of them are basically caused by a long term decline in the ability of labour to maintain the growth of real wages in line with productivity. Until this is reversed, the very long run trends in asset prices may survive intact.
It is obvious that the inability of workers to maintain their previous trend growth in real wages would tend to increase the share of profits in GDP, and therefore be beneficial for equities, but why has this also led to a decline in real interest rates? The reason given in the Goodhart/Erfurth paper will be familiar to readers of recent work by Lawrence Summers and Paul Krugman on secular stagnation.
Essentially, the argument is that lower real wages have increased inequality in the western economies, and this has depressed aggregate demand by redistributing real income and wealth away from the relatively poor towards the rich. Since the poor have a higher propensity to consume than the rich, this redistribution reduces consumer demand.
The decline in demand is then addressed by policy makers, either by fiscal expansion (reducing taxes and increasing subsidies on the poor) or by reducing interest rates set by the central banks. Since the fiscal response results in bigger budget deficits and higher public debt/GDP ratios, more and more of the burden of policy adjustment eventually falls on the monetary authorities. It is likely that this feedback loop will tend to increase both asset prices and inequality from one cycle to the next.
A pernicious additional consequence of this loop is that private sector debt/GDP ratios are also likely to rise through time. Falling real interest rates increase the incentive to borrow, while rising asset prices, especially in the housing market, increase credit worthiness and therefore the ability to borrow.
Debt ratios rise until they cause a crash, which of course is what occurred in 2008. This causes even greater and more permanent declines in real interest rates, which adds another twist to the cycle.
As the BIS has pointed out, what appears to be a sensible response by the monetary authorities to a downturn in any individual cycle in fact simply exacerbates the long term problem. But it is extremely difficult to step off the monetary policy escalator without causing an almighty crash. No central banker is ever willing to allow that to happen on their watch.
This neat amalgamation of the Keynesian secular stagnation view with the Austrian theory of excess debt seems capable of explaining how the western economies reached their present predicament with surprisingly high asset prices, along with surprisingly low levels of real and nominal GDP, and worryingly high debt. None of this reasoning is original, but it is interesting to piece it all together into a single narrative.
What does this narrative mean for investors?
It certainly does not rule out a bear market, of the variety seen in 2000 and 2008.
But in the very long run, investors should also be looking at the fundamental driving force for the entire long term process of rising wealth, i.e. the drop in the labour share in national income. If this were to reverse, demand would rise more rapidly and real interest rates could be allowed to increase, bringing down the rate of growth in private debt. Although this would be healthy from many points of view, it would also deliver a double blow to equities by reducing expected profits growth and raising discount rates.
So will the inexorable fall in the share of wages in GDP be reversed?
This may have been caused by the increase in the supply of unskilled workers into the world marketplace as a result of globalisation, or by technical progress which has displaced low paid workers, or by legal and other attacks on trade unions.
None of these three factors seems to be fundamentally changing direction in the developed economies today. In the absence of strong evidence to the contrary, it seems odd to assume that a trend which has manifested itself so strongly for 35 years will suddenly reverse itself.
A major shift in economic policy could of course change the picture. In particular:
A sharp rise in the minimum wage could alter the climate in the labour market.
Greater reliance on equity funding, rather than debt funding, in housing and corporate investment could hit current equity holders through dilution of their existing holdings.
A shift towards fiscal rather than monetary expansion could change the path for real interest rates, and change the distribution of income.
But any of these changes is fraught with political difficulties. Last week’s mid term elections in the US certainly point in entirely the opposite direction.
The future behaviour of wages is of course critical. A modest up tick in wages growth might be enough to trigger a hostile Fed, causing a peak in the current market cycle.
But it would take a very large rise in wages, much larger than we have seen in the last three economic recoveries, to suggest that the 35 year up trend in the profits share in GDP, and therefore in global equity prices, is finally being reversed.