The Myth of Sound Fundamentals
The recent correction in the US stock market is now being characterized as a fleeting aberration – a volatility shock – in what is still deemed to be a very accommodating investment climate. In fact, for a US economy that has a razor-thin cushion of saving, dependence on rising asset prices has never been more obvious.
NEW HAVEN – The spin is all too predictable. With the US stock market clawing its way back from the sharp correction of early February, the mindless mantra of the great bull market has returned. The recent correction is now being characterized as a fleeting aberration – a volatility shock – in what is still deemed to be a very accommodating investment climate. After all, the argument goes, economic fundamentals – not just in the United States, but worldwide – haven’t been this good in a long, long time.
But are the fundamentals really that sound? For a US economy that has a razor-thin cushion of saving, nothing could be further from the truth. America’s net national saving rate – the sum of saving by businesses, households, and the government sector – stood at just 2.1% of national income in the third quarter of 2017. That is only one-third the 6.3% average that prevailed in the final three decades of the twentieth century.
It is important to think about saving in “net” terms, which excludes the depreciation of obsolete or worn-out capacity in order to assess how much the economy is putting aside to fund the expansion of productive capacity. Net saving represents today’s investment in the future, and the bottom line for America is that it is saving next to nothing.
Alas, the story doesn’t end there. To finance consumption and growth, the US borrows surplus saving from abroad to compensate for the domestic shortfall. All that borrowing implies a large balance-of-payments deficit with the rest of the world, which spawns an equally large trade deficit. While President Donald Trump’s administration is hardly responsible for this sad state of affairs, its policies are about to make a tough situation far worse.
Under the guise of tax reform, late last year Trump signed legislation that will increase the federal budget deficit by $1.5 trillion over the next decade. And now the US Congress, in its infinite wisdom, has upped the ante by another $300 billion in the latest deal to avert a government shutdown. Never mind that deficit spending makes no sense when the economy is nearing full employment: this sharp widening of the federal deficit is enough, by itself, to push the already-low net national saving rate toward zero. And it’s not just the government’s red ink that is so troublesome. The personal saving rate fell to 2.4% of disposable (after-tax) income in December 2017, the lowest in 12 years and only about a quarter of the 9.3% average that prevailed over the final three decades of the twentieth century.
As domestic saving plunges, the US has two options – a reduction in investment and the economic growth it supports, or increased borrowing of surplus saving from abroad. Over the past 35 years, America has consistently opted for the latter, running balance-of-payments deficits every year since 1982 (with a minor exception in 1991, reflecting foreign contributions for US military expenses in the Gulf War). With these deficits, of course, come equally chronic trade deficits with a broad cross-section of America’s foreign partners. Astonishingly, in 2017, the US ran trade deficits with 102 countries.
The multilateral foreign-trade deficits of a saving-short US economy set the stage for perhaps the most egregious policy blunder being committed by the Trump administration: a shift toward protectionism. Further compression of an already-weak domestic saving position spells growing current-account and trade deficits – a fundamental axiom of macroeconomics that the US never seems to appreciate.
Attempting to solve a multilateral imbalance with bilateral tariffs directed mainly at China, such as those just imposed on solar panels and washing machines in January, doesn’t add up. And, given the growing likelihood of additional trade barriers – as suggested by the US Commerce Department’s recent recommendations of high tariffs on aluminum and steel – the combination of protectionism and ever-widening trade imbalances becomes all the more problematic for a US economy set to become even more dependent on foreign capital. Far from sound, the fundamentals of a saving-short US economy look shakier than ever.
Lacking a cushion of solid support from income generation, the lack of saving also leaves the US far more beholden to fickle asset markets than might otherwise be the case. That’s especially true of American consumers who have relied on appreciation of equity holdings and home values to support over-extended lifestyles. It is also the case for the US Federal Reserve, which has turned to unconventional monetary policies to support the real economy via so-called wealth effects. And, of course, foreign investors are acutely sensitive to relative returns on assets – the US versus other markets – as well as the translation of those returns into their home currencies.
Driven by the momentum of trends in employment, industrial production, consumer sentiment, and corporate earnings, the case for sound fundamentals plays like a broken record during periods of financial market volatility. But momentum and fundamentals are two very different things. Momentum can be fleeting, especially for a saving-short US economy that is consuming the seed corn of future prosperity. With dysfunctional policies pointing to a further compression of saving in the years ahead, the myth of sound US fundamentals has never rung more hollow.
The Economic Message from Equity Markets
Everyone – not just those who hold stocks – should be concerned about a major stock-market plunge. While it is impossible to predict such a plunge, or whether it will coincide with the next recession, it is now clear that last year's unusually low financial and economic volatility is over.
CAMBRIDGE – The recent stock-market correction – the first in the United States in two years – has invited substantial commentary about what investors should do, the role machines have played, and the implications for the real economy. But only some of what has been said is useful.
Many investment advisers have emphasized the need to think long term, rather than panicking when prices fall. They are right: the decline in early February is not a good reason to sell. What is a good reason to sell is that stocks are too high from a longer-term perspective.
The fact is that prices are still very elevated relative to fundamentals. As the Nobel laureate Robert Shiller pointed out two weeks before the correction, the US cyclically adjusted price-to-earnings ratio has been higher than it is now only twice in the last century: at the peaks that preceded the stock-market crashes of 1929 and 2000-2002. The implication is that the rate of return on stocks is likely to be substantially lower over the next 15 years than it was over the last 15 years.
Another popular response to the recent correction has been to complain that the market has been made more volatile, because trading is increasingly carried out by machines, rather than humans. True, if a computer is programmed to respond to declining prices by selling more stocks, it will exacerbate the decline. But the same is true of the commonly used stop-loss order, whereby investors instruct their stockbroker to sell if the price falls to a specified level.
While automated high-speed trading does not, in my view, serve a useful social purpose, it is destabilizing only if it is programmed to be. If programmed instantly to “buy on the dip,” a computer would generate demand for falling stocks and thus tend to stabilize prices, just like a human investor who buys when prices fall. Machine or human, what matters is the instruction. And, in fact, a person writing an algorithm – calmly, in advance – might make smarter choices than one who is watching prices plunge in real time.
Another key question raised by the recent correction is whether it matters for the real economy. The truth is that the stock market can crash while the economy is doing well, and vice versa.
The first reason for this is that stock-market busts can be triggered by interest-rate increases, which are often a response to economic expansion. The correction in February bears this out. It seems to have been triggered by a February 2 report that US wages had increased more than expected, as well as the fact that inflation has risen in the US and the United Kingdom.
For the US, such news all but ensures that the Federal Reserve will raise interest rates in March. And the Bank of England announced on February 7 that UK rates could “be tightened somewhat earlier and by a somewhat greater extent” than had previously been forecast.
A second reason why the stock market is disconnected from the real economy is that there is much randomness in markets. In a speculative bubble, for example, everyone buys because everyone else is buying, causing prices to become disconnected from economic fundamentals. At a certain point, the bubble bursts, and everyone sells.
Last year, a “risk on” mood prevailed in financial markets, rooted in unnaturally low perceptions of future volatility. When the VIX volatility index hit all-time lows, it was not because fundamentals demanded it. On the contrary, it was no secret that substantial risks – such as a pick-up in inflation and faster-than-expected interest-rate hikes – were lying in wait.
But, all too predictably, the VIX would not adjust until the shock materialized and prices plunged. It took the correction in February to wake up investors to the reality of risk. The VIX has now adjusted to more normal levels, but securities prices probably still have a substantial distance to fall. After all, the market is still not far below its peak.
A third reason why the stock market is disconnected from the real economy is that stock prices represent only the current and expected profits accruing to corporations. That is not the same as national income. In the past, this distinction was not as pronounced, because a relatively stable share of national income went to workers. But, over the last decade or so, that relationship has broken down. Owners of capital control a rapidly-growing share of GDP, probably owing to higher economic “rents,” which reflect decreased competition and increased monopoly power in many sectors.
It is possible that last year’s stock-market boom may have been fueled partly by the expectation that US President Donald Trump and congressional Republicans would cut corporate taxes. Now enacted, those cuts will almost certainly do more to expand capital’s slice of the income pie than they will to enlarge the pie itself.
Of course, while Wall Street is not Main Street, there are important connections between the two. A big decline in the market could work to depress consumption and investment spending, reducing income all around.
It is impossible to predict when such a plunge will occur, or whether it will coincide with the next recession. All we can say with confidence is that the abnormally low financial and economic volatility of last year is over.
Editors’ note: After reading this piece in Barron’s, John C. Bogle, founder of Vanguard Group, had a few comments for Jeffrey Frankel. Read their exchange below.
To the Editor:
I’m not sure how a mere A.B. from Princeton (’51) found the temerity to challenge a Ph.D. from MIT (and professor at Harvard), but an error in the recent Other Voices essay “VIX Surge Is a Wake-Up Call for Investors” is so egregious and so pervasive that I just can’t help myself.
Jeffrey Frankel wrote, “In a speculative bubble…everyone buys because everyone else is buying…[then] the bubble bursts, and everyone sells.” Really?! The simple, self-evident fact is that when “everyone” is buying, someone else is selling, dollar for dollar. And when “everyone” is selling, someone else is buying. This is the eternal reality of the financial markets.
Yes, I realize that my simple statements are not precisely correct, but are surely 99%-plus correct. I’d also, again humbly, take issue with the conclusion that “we can say with confidence…that the abnormally low financial and economic volatility of last year is over.” I’ve been in this business for 67 years now, and I’ve been well served by my unwillingness to say anything about short-term market behavior with confidence.
But I did agree with the thrust of this well-reasoned essay.
John C. Bogle
Founder, Vanguard Group
Jeffrey Frankel responds:
First let me say, you are a hero of mine. That isn’t something I have said lightly…or ever. For 35 years, I have put my spare savings into Vanguard index funds, and done very well with it. As a professional economist, maybe twice a decade I form a view that some major market is out of line…my response is to write about it, but to shift only about 5% of my portfolio. It seems to me that I have usually been right, judged at a two- to three-year horizon. But in giving general advice to others, I am a true believer…diversify in Vanguard index funds and leave it alone.
Now to your questions. 1) You are right, of course, that for every buyer there is a seller…it is the price that adjusts. The language you identified was knowingly loose, for journalistic purposes. I would never use those words in a more scholarly paper.
2) My language on the end of last year’s low volatility was also shorthand. Word limits, you know.
It stood for two propositions. First, I am willing to bet that volatility from here on will be higher than in 2017 (both realized and the VIX). Second, we already know for sure that the period of continuous low volatility ended four weeks ago!
Thanks for your comments.
Professor, Harvard University’s Kennedy School of Government
Rational Irrational Exuberance?
We tend to be uncomfortable with the notion that an economy’s fundamentals do not determine its asset prices, so we look for causal links between the two. But needing or wanting those links does not make them valid or true.
SANTIAGO – The timing was exquisitely ironic: equity markets peaked – and a week later began crashing – just as pundits left this year’s World Economic Forum meeting in Davos, where they concluded that the global economy was on a steady upswing. In the weeks since, experts have divided into two camps.
Some, including new US Federal Reserve Board chairman Jerome Powell, believe that economic fundamentals are strong, and that what stock markets experienced in early February was only a temporary hiccup. In this view, there is nothing keeping major central banks from carrying out “beautiful” (that is, gradual and painless) monetary-policy “normalization.”
Then there are those who believe that fundamentals are in fact weak, that the current upswing will prove unsustainable, and that investors should regard stock-market gyrations as a necessary wakeup call. If so, the challenge for monetary and fiscal authorities is not to “normalize” policies but to develop new tools to fight the slowdown that will come, sooner or later.
Both schools of thought share a focus on fundamentals, unlike a third – and, in my opinion, highly plausible – view: that the asset-price volatility we have been seeing has little or nothing to do with changes in fundamentals.
Fundamentalists claim that faster year-on-year growth in US average hourly earnings was the immediate trigger for the crash. But the claim that such a slight change – from 2.7% in December to 2.9% in January (which observers view as an aberration, caused by seasonal factors) – could trigger a stock-market correction is in itself a strike against the fundamentalist view.
Moreover, whereas the wage growth in question was supposed to be a harbinger of inflation, ten-year break-even inflation moved down, not up, during the recent episode. And, as Anatole Kaletsky has stressed, ten-year Treasury yields did not break the 3% ceiling, while exchange rates hardly moved, all of which suggests that rumors of inflation have been greatly exaggerated.
The human brain is wired to structure knowledge around narratives in which we can tell if and how A (and B and C) causes X. We tend to be uncomfortable with the notion that an economy’s fundamentals do not determine its asset prices, so we look for causal links between the two. But needing or wanting those links does not make them valid or true.
The idea that asset-price movements can be unrelated to fundamentals is not strange to students of economic theory. After all, there are two reasons to hold an equity claim: because it will pay a dividend or because its price is expected to go up. Price movements (the expected capital gain) can drive buying and selling decisions even in the absence of changes to expected dividends (the fundamentals). In other words, it is perfectly rational to pursue a “keep buying because the price will keep rising” strategy – until it is not.
But when will that be? When will the bubble burst? Economic theory is silent on the matter. Or, at best, theorists can wave their hands about an exogenous (read: unexplained) shock to expectations. Bubbles can persist for decades (think of real-estate prices in fashionable cities) or just minutes (as in hard-to-justify intraday fluctuations). The only sure thing, John Maynard Keynes is supposed to have claimed, is that the market can remain misaligned much longer than you or I can remain solvent.
The widespread use of machine-driven trading is likely making all of this worse. The algorithms used vary, and are becoming much more complex. But, to the extent that they contain a stop-loss element – and they often do – they will cause bouts of selling into declining markets, and that in turn will amplify volatility.
It is not just nerdy professors who are skeptical on the importance of fundamentals. The Financial Times reports the rise of a new breed of oil trader who is “not necessarily reacting to news about supply and demand or utterances from Riyadh.” Instead, he or she trades “based on moves in currencies, interest rates, or the price of oil itself.” Ready for an oil price bubble, anyone?
There might already be a huge one in the US stock market. On January 23, just a few days before equities crashed, Robert Shiller reminded us that the US had the world’s priciest stock market, with the highest cyclically adjusted price-earnings (CAPE) ratio of 26 stock markets for which there are comparable measures. Shiller pointed to the common practice of share repurchases as one possible explanation, but then concluded that, “it is impossible to pin down the full cause of the high price of the US stock market.”
So if the price of a financial asset is not guided – at least for some periods – by fundamentals, where does that leave central banks? I believe it leaves them between a rock and a hard place.
On one hand, central banks cannot be so relaxed that they will permit asset prices to go anywhere as a result of self-fulfilling expectations. Sometimes, they must step in to change expectations, as Mario Draghi, the European Central Bank’s president, did in July 2012, when he announced that the ECB would do “whatever it takes” to defend the euro (and the prices of eurozone government bonds).
On the other hand, central banks are not in the business of controlling asset prices. When they venture in that direction, they get into trouble, as experience with fixed-but-adjustable exchange rates makes abundantly clear. A little volatility is a good thing, both to discourage speculative capital flows and to put the fear of God into investors looking for the next Greenspan-Bernanke put.
Where should the line be drawn? When does a little “good” volatility turn into excessive “bad” volatility? These are difficult questions, and the answers can only be time- and context-specific.
A final disclaimer: believing that fundamentals do not always pin down asset prices is not the same as believing they are irrelevant, much less that current US fundamentals are in good shape. An additional fiscal stimulus at a time of near-full employment and large public debt is exactly what the doctor did not order. Precisely because of all the offsetting factors, the US Congress Joint Committee on Taxation estimates that the recent tax cuts will add just 0.08 percentage points to the average annual growth rate over the next decade, and the long-run output effects could be smaller or even negative.
Yet the US business community remains gung-ho on the reform. So it is possible that conservative American business executives will invest more not because the tax cut will improve the fundamentals of the US economy and increase demand for their products, but just because they believe it will.
Now, that, too, would be an exquisite irony.
Is the Stock Market Loaded for Bear?
As 2018 progresses, business leaders and market participants should – and undoubtedly will – bear in mind that we are moving ever closer to the date when payment for today’s recovery will fall due. The capital market gyrations of recent days suggest that awareness of the inevitable reckoning is already beginning to dawn.
NEW YORK – In recent days, the initial New Year optimism of many investors may have been jolted by fears of an economic slowdown resulting from interest-rate hikes. But no one should be surprised if the current sharp fall in equity prices is followed by a swift return to bullishness, at least in the short term. Despite the recent slide, the mood supporting stocks remains out of sync with the caution expressed by political leaders.
Market participants could easily be forgiven for their early-year euphoria. After a solid 2017, key macroeconomic data – on unemployment, inflation, and consumer and business sentiment – as well as GDP forecasts all indicated that strong growth would continue in 2018.
The result – in the United States and across most major economies – has been a rare moment of optimism in the context of the last decade. For starters, the macro data are positively synchronized and inflation remains tame. Moreover, the International Monetary Fund’s recent upward revision of global growth data came at precisely the point in the cycle when the economy should be showing signs of slowing.
Moreover, stock markets’ record highs are no longer relying so much on loose monetary policy for support. Bullishness is underpinned by evidence of a notable uptick in capital investment. In the US, gross domestic private investment rose 5.1% year on year in the fourth quarter of 2017 and is nearly 90% higher than at the trough of the Great Recession, in the third quarter of 2009.
This is emblematic of a deeper resurgence in corporate spending – as witnessed in durable goods orders. New orders for US manufactured durable goods beat expectations, climbing 2.9% month on month to December 2017 and 1.7% in November.
Other data tell a similar story. In 2017, the US Federal Reserve’s Industrial Production and Capacity Utilization index recorded its largest calendar year gain since 2010, increasing 3.6%. In addition, US President Donald Trump’s reiteration of his pledge to seek $1.5 trillion in spending on infrastructure and public capital programs will further bolster market sentiment.
All of this bullishness will continue to stand in stark contrast to warnings by many world leaders. In just the last few weeks, German Chancellor Angela Merkel cautioned that the current international order is under threat. French President Emmanuel Macron noted that globalization is in the midst of a major crisis, and Canadian Prime Minister Justin Trudeau has stated that the unrest we see around the world is palpable and “isn’t going away.”
Whether or not the current correction reflects their fears, the politicians ultimately could be proved right. For one thing, geopolitical risk remains considerable. Bridgewater Associates’ Developed World Populism index surged to its highest point since the 1930s in 2017, factoring in populist movements in the US, the United Kingdom, Spain, France and Italy. So long as populism lingers as a political threat, the risk of reactionary protectionist trade policies and higher capital controls will remain heightened, and this could derail economic growth.
Meanwhile the market is mispricing perennial structural challenges, in particular mounting and unsustainable global debt and a dim fiscal outlook, particularly in the US, where the price of this recovery is a growing deficit. In other words, short-term economic gain is being supported by policies that threaten to sink the economy in the longer term.
The Congressional Budget Office, for example, has forecast that the US deficit is on course to triple over the next 30 years, from 2.9% of GDP in 2017 to 9.8% in 2047, “The prospect of such large and growing debt,” the CBO cautioned, “poses substantial risks for the nation and presents policymakers with significant challenges.”
The schism in outlook between business and political leaders is largely rooted in different time horizons. For the most part, CEOs, hemmed in by the short termism of stock markets, are focused on the next 12 months, whereas politicians are focusing on a more medium-term outlook.
As 2018 progresses, business leaders and market participants should – and undoubtedly will – bear in mind that we are moving ever closer to the date when payment for today’s recovery will fall due. The capital market gyrations of recent days suggest that awareness of that inevitable reckoning is already beginning to dawn.
The Market Dogs That Didn’t Bark
Did February’s equity-price reversal mark the end of the bull market, or was it just a temporary correction? In addressing this question, one must look not just at the stock market, but also at oil prices, long-term US interest rates, and currencies.
LONDON – Three months ago, I argued that rising stock markets around the world were a consequence of improving economic conditions, not a sign of “irrational exuberance.” Since that commentary was published, share prices accelerated upward, and some “irrational exuberance” did start to appear, leading to a sharp fall in early February. Although most stock markets are still well above their levels of last November, the question lingers: Did February’s reversal mark the end of the bull market, or was it just a temporary correction?
The strongest evidence, as Sherlock Holmes might have remarked, comes from the dog that didn’t bark. More precisely, it comes from three vehement guard dogs – oil prices, long-term US interest rates, and currencies – that slept peacefully through the commotion on Wall Street.
Why this evidence is so significant becomes clear when we recognize that the main risks to the global economy are now completely different from the “New Normal” of secular stagnation, “low-flation,” recession, and European instability that markets have spent the past decade worrying about. The real threats to global expansion and asset prices now come from accelerating inflation, unsustainably rapid growth, and political mismanagement in the United States.
I noted some reasons for this reversal in my earlier column: the world economy is now firing on all cylinders. Every region is now following the US post-2008 roadmap of aggressive monetary stimulus and bank recapitalization, but with long delays that have ranged from three years in Japan and China to six years in Europe and even longer in large emerging economies such as India, Russia, and Brazil.
The danger of recession or a major slowdown has therefore disappeared in most of the world economy, at least for the next year or two. But economic growth does not eliminate financial risks. On the contrary, some of the biggest stock-market crashes have occurred during periods of rapid growth, usually triggered by accelerating inflation and rising interest rates.
The question now is whether these inflation risks are looming over the horizon. Or is it still too early to worry about overheating, given that inflation in most economies is still at or below 2%, interest rates are still negative in Japan and Europe, and plenty of labor and capital remains underemployed?
It is in addressing this question that we should note the dogs that didn’t bark. The biggest inflation threat this year comes from rising oil prices. The collapse of oil prices from above $100 a barrel in 2014 into what looked like a stable range with a ceiling around $50 has been a major boon to the world economy. But US oil prices broke through the $50 ceiling last autumn, and by January they seemed to be heading for $70, with many traders forecasting a return to $100.
Sharply higher oil prices, at a time when inflation is already creeping up, would be a disaster for the world economy, forcing central bankers to raise interest rates aggressively and possibly provoking a panicked sell-off of long-term bonds. But, luckily, oil prices did not continue rising as share prices declined. Instead, they fell sharply. If oil prices stabilize near their current level, the most immediate risk to the world economy and the bull market in equities will have been removed.
The US bond market was the second dog that did not bark this month, although it did stir a bit uneasily. Much has been written about the rise of ten-year Treasury yields from around 2.5% in early January to almost 3% today. What is really significant, however, is that the 3% level, which has acted as a ceiling since 2011, has not been breached. If US bond yields rose substantially above 3%, this would certainly raise a question mark about US asset valuations. But this has not happened yet – and, more important, the bond market seems to believe that a sustained breakout above 3% in the foreseeable future is very unlikely.
The bond market’s complacency about US interest rates and inflation may be surprising – and in my view it will turn out to be an expensive mistake at some point – but it is a fact. The proof is that the 30-year US bond yield is still only 3.2% – exactly where it was a year ago and in most of 2015 and 2016. It is almost a full percentage point lower than in 2013 and two full points below the level in 2007. In other words, the bond market believes that the long-term outlook for growth and inflation is more or less the same as it was in the period from 2015 until early last year – and much weaker than it was a decade ago.
This confidence may vanish in the future, if bond investors wake up to the long-term risks of US inflation and fiscal profligacy. When that happens, long-term yields will rise steeply and investors really would have something to worry about. For the moment, however, the behavior of long-term US interest rates implies an almost unshakeable confidence among investors that inflation will never again become a serious threat, despite President Donald Trump’s decision to slash taxes, boost government spending, and abandon deficit limits in a US economy already nearing full employment.
This points our investigation toward the third dog that didn’t bark. Currencies were almost completely unmoved by the stock-market commotion. This quiescence makes sense: If investors are unperturbed by inflationary pressures in the US economy, they can surely be much more confident about the rest of the world. In Europe, Japan, and many emerging markets, cyclical upswings are more recent, inflation is lower, and economic management is sounder than in the US. The implication is obvious: The global expansion and bull market will continue, but leadership will move from America to the more promising economies of Europe, Japan, and the emerging world.