Why asset-turn could drive market valuations higher
Better productivity growth would challenge the consensus late-cycle hypothesis
Even with the sound on, you never hear television pundits talking about asset-turn. That is a shame because the ratio is key to understanding these annoyingly indecisive bond and equity markets. To be fair, it is not a widely known term. Worse, it could mean anything and is written inversely to how it is calculated (revenues divided by assets). Asset-turn is also hard to conceptualise.
Finance students may remember it as one of the three ratios the DuPont Corporation began multiplying together in the 1920s to derive return on equity (RoE) — the other two being leverage and net margin. While most people more or less get profitability and debt, the sales a company generates from its assets is less intuitive. Quickly now: is 0.9 or 0.6 the better number?
The reason the answer has not mattered much is that margin growth has been the primary driver of RoE and stock markets over the past 20 years. So successfully has profitability boosted returns that investors are most ignorant of the long-run decline in asset-turn. From a dollar of S&P 500 assets supporting one dollar of revenues in 1995, for example, half the turnover is made today.
In other words, assets have been expanding faster than sales. This is an ugly secret of the corporate world— in developed and developing countries alike. And it is doubly embarrassing when you consider the rise of tech companies with huge top lines and assets they could hide in a cupboard. Facebook’s asset-turn ratio is still 1 if the cash on balance sheet is excluded.
What happened was that buoyant profitability from declining interest rates, stagnant wages and global tax fiddles was squandered on wasteful investment. Hence the overcapacity in numerous industries and subdued inflation pressure. Indeed, applying the appropriate deflator to each type of spending, real capex as a percentage of output is at record highs in the US and Europe. Investors ignored such profligacy because returns on equity were sustained by margin growth.
Sounds bad. Actually, the asset-turn story could well drive market valuations significantly beyond the current expectations of investors. Since the second half of 2016, this ratio has begun to move higher almost everywhere. Perhaps worried that rising interest rates and nominal wages will make easy margins gains a thing of the past, companies are beginning to invest in ways that spur growth. It is no coincidence global activity picked up around the same time.
The missing link between asset-turn and the direction of capital markets is productivity. Output per worker has been below trend for so long investors barely think about it any more. In America it has barely broken 1.5 per cent year-on-year growth since 2011. But if companies spend faster and smarter, productivity should recover. There is a strong correlation between the two as ageing capital is replaced by more efficient stock.
Productivity could also jump as wages are rising in many developed markets. Historically, this has tended to lead productivity growth as companies are forced to innovate to boost returns per employee. In fact, anything that puts companies under pressure helps. For example, there is a close relationship between the dollar and productivity growth in the US. A rising currency hurts exporters and they compensate by raising productivity.
Output per worker is crucial to watch because it is central to economic growth as well a fixed income and equity markets due to its effect on inflation and margins. If employee wages rise faster than their productivity, the companies paying those wages have two choices. They can either pass on the extra costs to customers, thereby leading to rising inflation. Or they can absorb the hit, which results in lower profit margins — all else being equal.
This is an economic identity. It states that an increase in nominal wages must equal the sum of productivity improvements, price rises and changes to labour’s share of output (which is the inverse of profit margins). In other words, if productivity surprises to the upside, companies are no longer forced to make the choice outlined above. Nominal wages can rise without threatening the bond market through higher inflation or stock prices via lower margins.
Were productivity growth to accelerate, it would challenge the consensus late-cycle hypothesis, or at least delay it. Nominal wages could recover (as they are already in the US and elsewhere), which lifts aggregate demand and global output. But inflation would remain subdued and there would be no spike in interest rates, which is benign for fixed income markets. Likewise, margins can remain elevated or even rise if productivity grows fast enough — lending support to stretched equity market valuations.
It starts with asset-turn. Leave the talking heads on mute while you analyse the important stuff.