Wednesday, June 6, 2018

Lost decades: Italy 3 - Japan 0.

The last decade has not been good for many advanced economies. The Global Financial Crisis, a second recession in the Euro area and central banks hitting the zero lower bound have led to disappointing GDP growth rates. But GDP growth rates can be a  misleading indicator about the true performance of different economies. For example, as Matt O'Brien summarizes well, Japan has done much better than what most people believe.

The confusion comes from the fact that there are two forces driving GDP growth. One is the number of hours we work and the other one is how productive those hours are. The absolute number of hours we work is a function of the population of a country. Because of that reason we usually measure GDP per capita growth instead of GDP growth. But this is not enough. Hours per capita can change in response to two forces. First, age matters. Typically engagement in the labor market declines with age, an aging country is likely to have fewer hours per capita. Second, the labor market. Even for groups of the population where labor market engagement should be the highest (prime-age workers) we see interesting variation over time and across countries that reflect on the performance of the labor market.

In this post I judge the performance of countries separating two factors:

  1. Productivity, measured as GDP per hour worked.
  2. The labor market: measured as employment to population for the group of 25-54 years old.

I am just leaving one factor out, which is aging (over which policy makers have little influence except for immigration policies or incentives to increase fertility rates).

Using data from the Conference Board (for productivity) and OECD (for labor market), I have compared the performance of a sample of advanced economies for two periods. 1999-99, which happens to be a pre-Euro period, and 2000-17.

All the numbers are expressed as the value achieved by the variable in the last year as compared to the initial year which is made equal to 100. So an index of 110 means that in the whole period, that variable grew by 10%.

Two caveats: I am measuring performance ignoring initial levels. A country with a very high employment rate is unlikely to increase that rate over time so its performance would seem disappointing. Second, this is about relative performance. Compared to the other advanced economies, how did a particular country perform?

We start with productivity (click for a larger image). Japan does well on both periods. The 4th best performer in the 90s and the 6th one since then. The US climbs up in the post-2000 period ranking. Among the Euro members, Germany loses a few positions with the Euro, same as France, although the change in ranking is smaller. Among the Southern European members, different fortunes. Spain seems to benefit from the Euro membership while Italy and Greece drop to the lowest positions, from already a very low level. For these two countries, performance has been low since 1990 and it got worse since the introduction of the Euro.

There are some countries like the Netherlands that are towards the bottom in both tables. But the Netherlands has one of the highest GDP per hour levels among these countries so it is natural that its growth rate is low. That's not true for Greece or Italy that remain as two of the countries with the lowest GDP per hour level.

What about the labor market? I focus on prime-age workers so that we cannot ignore issues related to aging and effective retirement age. Here Japan is a low performer in the 1990s but then it becomes the best performer in terms of improvements in labor market outcomes for this group. Some of this is related to Abe's policies in particular the increase the female labor force participation. Some Euro members are strong on both periods (Germany and Spain). Italy manages to improve its relative performance in this period although remains in the lower part of the table. Greece, on the other hand, and as a reflection of the large effects of the crisis, becomes the worst performer since the Euro was launched. 

And, interestingly,the US falls to the bottom of the table in the post-2000 period. While productivity-wise the US has done well since the year 2000, the labor market has underperformed relative to the other advanced economies. The UK labor market does well in the post-2000 period and partially compensates for its average productivity performance.

This is still a partial analysis of the data because we are looking at relative performance without considering initial levels (more to come in future posts). But the data so far points to some interesting conclusions:
  • Once the effect of an aging population is removed, Japan has done very well since 1990. It has sustained a good productivity growth while becoming a leader in terms of labor market outcomes in the post 2000 years. No lost decades despite a deflationary environment.
  • Southern Europe has not followed a unique trajectory after the introduction of the Euro. Spain has improved its productivity while maintaining significant improvements in the labor market. Italy was a low performer in the 1990s and since the launch of the Euro its productivity performance declined while its small improvement in the labor market could not do enough to compensate. Italy stands out among the largest advanced economies because performance on all dimensions is low across all decades and this is more remarkable if we consider that both in terms of productivity and in terms of labor markets, its initial level was already relatively low.
  • The US has seen a relative improvement in productivity while the labor market has deteriorated at a rate that only Greece can match.
Antonio Fatas

on June 06, 2018 |   Edit

Thursday, May 10, 2018

It's a (low inflation) trap!

Mark Carney did his best yesterday to justify the decision of keeping interest rates at 0.5% at the same time that it was promising that the economic momentum will be regained and that interest rates will have to rise soon.

Unfortunately, this is not new. Since March 5th, 2009 (more than nine years ago), when interest rates were lowered to 0.5% in the UK, we have not seen much action despite all the talk and promises of higher interest rates. And inaction of interest rates has mostly come as a surprise as projections on interest rates were always much higher than what was later delivered by the central bank (see image below).

What we are seeing in the UK is not different from what we have seen in the US after the Federal Reserve stopped quantitative easing and engaged in a slow path of increasing interest rates. So far there have only been surprises on one direction: the Federal Reserve ended up postponing an interest rate increase that was anticipated by the market. And the ECB or the Bank of Japan are still far to get to the point of talking about higher interest rates but when they do, they are likely to face the same issues.

Either central banks are setting the wrong market expectations or they are being themselves as surprised as everyone else by the slow pace of economic growth and wage and price inflation. Regardless of the reason, this is a reminder that the last 9 years have not been normal for monetary policy. That we have learned that getting out of a low inflation environment is much harder than what we thought. And let's not forget (if history is an indication) that one of these days we will have another global crisis and interest rates will have to come down (from 0.5%?) and we will start all over again, hoping to get out within the next 10 years. Will interest rates be clearly above zero in these markets 10 years from now? Chances are that they will not be. 

And given all these lessons and persistence of low interest rates you would think that we would have spent some time thinking about how to avoid falling into similar situations in the future. Unfortunately we have not. The most obvious solution is to raise the inflation target so that we all move away from 0%, but that is clearly not an option in any of these countries. I do not like the expression "the new normal" because it is applied too often even when nothing has really changed but in this case there is no doubt that 10 years ago monetary policy entered the new normal and we are not sure when we will get out of it.

Antonio Fatás
on May 10, 2018 |   Edit

Friday, January 19, 2018

The shrinking (US) Risk Premium

As the US stock market continues to climb and reaches "record-high" levels, questions on overvaluation and bubbles become more common. Robert Shiller CAPE measure of the US stock market shows now a market that is at a higher level than during the Great Depression. The market has only been more expensive in the years 1998-2000 in the run up to the burst of the internet bubble.

While high CAPE values signal potential overvaluation, one has to compare those numbers to levels of interest rates to assess whether stock prices are truly overvalued relative to other asset prices. One simple way to compare the two is to calculate the stock market risk premium implied by current levels of stock prices, earnings, nominal interest rates, expected inflation as well as expectations of future earnings growth. In previous posts I have explained in detail the data and methodology to calculate the risk premium. Below is the most updated analysis including the value of 10-year interest rates that just hit 2.642% today.

A combination of higher stock prices and increasing interest rates has led to a sharp decrease in the risk premium which is quickly approaching 4%. Not far from the values in 2007. But, of course, still really far from the 1990s bubble. 

So the market is becoming more expensive and either investors are expecting an improvement in long-term growth expectations relative to the potential growth estimates from CBO or they are willing to accept a lower risk premium. A lower risk premium seems like a surprise to some given that there are good reasons not to ignore downside risks in 2018.  

While none of these valuation measures are perfect predictors of future returns, stock market bubbles are always preceded by rising prices and decreasing risk premium - signals that the market is underestimating risk. Today, these ingredients are becoming more obvious in US stock markets. Maybe these indicators are not that useful to understand stock prices and it is all about "narratives" (as Robert Shiller argues), but all narratives come to an end when some of the risks are materialized and markets have to face reality.

Antonio Fatás
on January 19, 2018 |   Edit

Friday, January 5, 2018

The narrative of high debt and powerful central banks

In 2017 GDP growth picked up solidifying a global expansion phase that had previously been slow and erratic. The number of countries growing at rates consistent with their potential increased to levels not seen since prior to the global financial crisis. As the expansion gathers pace and, in some cases, becomes long by historical standards, it is time to wonder where the next crisis will come from and how we will deal with it.

Among the many potential reasons why the world might fall into another recession there is one that is repeated very often and it is linked to the narrative we created after the 2008 crisis. We find ourselves again at a point where debt levels are at record high, asset prices are in bubble territory and the only reason why we have growth is because of the artificial support of central banks.

As an example, here is Stephen Roach looking at 2018 and being worried because 
"Real economies have been artificially propped up by these distorted asset prices, and glacial normalization will only prolong this dependency. Yet when central banks’ balance sheets finally start to shrink, asset-dependent economies will once again be in peril. And the risks are likely to be far more serious today than a decade ago, owing not only to the overhang of swollen central bank balance sheets, but also to the overvaluation of assets."

Or from an opinion article at the Financial Times worrying about Global Debt levels: 
"In two respects, the global economy is living on borrowed time. First, global economic growth is so debt-addicted that no big economy can cope with a rapid tightening in monetary conditions. Second, central banks need to reverse their policies, since continuing low rates and excessive leverage may well result in an explosive cocktail of multiple asset price bubbles." 
These are just two examples of the same narrative. One that sees central banks as responsible for generating "artificial" growth that has led to imbalances in the form of overvalued asset prices and excessive debt.

This narrative is not without merit. Many of the past crisis are preceded by excessive credit growth and asset price bubbles. However, there are many nuances that matter in this analysis. Not every debt is bad and judging risk by looking at record-level values of the stock market is not enough. 

Here is a non-exhaustive list of arguments where details matter for this narrative:

1. Central Banks are not that powerful. The notion that a (selected) group of central banks has managed to create artificial global growth and reduced interest rates across all maturities in (almost) all countries in the world without creating any inflation cannot be right (at least I have not seen any economic model that can generate this prediction). The idea that liquidity created in some central banks is traveling across the world and propping asset prices everywhere is not right, that's not what central banks do. Central banks issue liquidity (which becomes an asset for someone else) by removing a different type of asset. For every liability there is an asset. 

The narrative of very powerful central banks sounded reasonable when the US stock market seemed to be driven by the size of the balance sheet of the central bank...

...until the central bank stopped growing its balance sheet and the stock market went up by another 40%.

2. Not all debt is bad. Two obvious points here. First, as much as we like to criticize financial markets for their excesses, we cannot forget that financial development is key to economic development. There is a very strong correlation between GDP per capita and measures of financial development. And a common measure financial development is the ratio of debt to GDP. Higher debt means financial transaction that could not have occurred otherwise. Buying a house with a mortgage means you can own a house today instead of having to save the full value of the house before you can own it. This does not mean excessive spending. In fact, you might not be increasing your expenditures in housing services at all. Instead of renting a house, you own the asset and pay rent to yourself. The risk goes in both directions. If you own it and prices go down you will be unhappy. But if you are renting and prices go up, consider yourself poorer. Second, one cannot forget that the world has no (net) debt. For every liability there is an asset. It cannot be that we (all citizens of the world) are living beyond their means as they bring future consumption to the present. Once again, details matter and we need to look for specific imbalances within parts of the economy, it can be countries or different economic agents (government, private sector, households, a particular set of companies,...) or a combination of both. 

3. Yes, asset prices are high but this does not imply bubbles ready to burst. The difference between this episode and previous bubbles is that this time all asset prices are high. In the run up to the 1990s stock market bubble, stock prices climbed to levels never seen before. But what was worse is that compared to other assets, for example bonds, those prices looked even more out of sync with reality. The implied stock market risk premium in the late 1990s in the US was probably as low as 1%. That makes no sense. In contrast, today stock prices are high (measured against earnings) but so are bond prices. The implied stock premium is likely to be around 4-5%. Slightly below historical averages but not close at all to the bubble levels in the 1990s. These overvalued asset prices across many asset classes fits better with a narrative of a different balance between global saving (high) and global investment (low). As long as those forces do not change, high asset prices and low interest rates are here to stay.

If my arguments are correct, why is it that the simplistic narrative of debt and excesses remains so present in today's economic analysis? I think that it makes for a simple, yet convincing, narrative along the lines of what Robert Shiller describes in this article. Shiller argues that when it comes to economics, storytelling and powerful narratives dominate our perception of reality.

A final thought before we look forward to a great 2018: there are plenty of risks to be worried about for the coming year, there should be no room for complacency. But the emphasis on debt, bubbles and the negative influence of central banks is overemphasized. If we keep looking there for a clue of when the next crisis will come from we might miss it.

Antonio Fatás

on January 05, 2018 |   Edit

Thursday, December 29, 2016

Make the Risk Premium small again

In one my previous posts I looked at the stock market valuations in the US to conclude that they were in line with recent historical data. In fact the stock market looked cheap relative to most years since the mid 1980s.

But that was before the US election! Since the election the stock market has gone up and interest rates have gone up as well. How do stock market valuations look like today?

I follow the same methodology of the previous post and start with the Price-Earnings ratio constructed by Robert Shiller. We know that this P/E ratio has been high relative to historical averages (today it stands above 28, a level only achieved before in the 2000 bubble or in 1929.

But the P/E ratio depends on several macroeconomic variables, in particular the level of real interest rates. In my previous post I made the argument that once we correct for the level of the real interest rate the current P/E ratio looks reasonable.

In particular, if we express the price of stocks as the net present (real) discounted value of earnings. Under the assumption that current earnings are expected to grow (in real terms) at a rate G and using R to denote the risk-adjusted discount rate we can write:

P = E / (R-G)

In other words the Price-to-Earnings ratio can be written as

P/E = 1 / (R-G)

To make the expression easier to read let's invert it

E/P = R-G

And let's express the risk-adjusted discount rate as the sum of a risk-free rate (RF) and a risk premium (RP).
E/P = RF + RP - G

This expression says that the E/P ratio is a function of three factors. Each of them can make the ratio low (i.e. stock prices high relative to earnings): either real interest rates are low, or investors expect earnings to grow fast or they feel good about risk and they are willing to accept a low risk premium.

The last two terms are the ones that depend on expectations, can be more volatile and are capturing the optimism or pessimism of investors regarding macroeconomic conditions (both potential growth and perceptions of risk). While there is nothing in this formula that allows us to assess how irrational investors are, one would expect that at times where stock prices are seen as "bubbly" are when either estimates of growth are too high or the risk premium is too low. Let's combine the two together by rewriting the equation above to construct a potential "bubble" index of the stock market

"Bubble" Index = G - RP = RF - E/P

Measuring the real risk free rate using 10-year interest rates and inflation expectations from forecasts of inflation from the survey of professional forecasters posted at the Philadelphia Fed we can get the updated picture below.

We can see that after the election the index has increased both because of higher stock prices and also higher interest rate. The stock market is more "bubbly" than back in October but still in line with historical estimates.

One issue that might be relevant for this chart is that we have been downgrading expectations of potential growth over all these years. How much would our assessment change if we took this into account?

Using CBO potential growth estimates for the following 10 years as a measure of estimated real earnings growth we can calculate the implicit risk premium as:

RP= E/P -RF + G

This number tells us the implicit compensation that markets expect for risk given current E/P ratios, real interest rates and assuming markets share the views of the CBO about future growth rates (and that earnings grow at similar rates as GDP).

Below are the results of such calculation. 

What we can see in this chart is that today the risk premium remains in line with historical estimates although it has come down after the election, as expected. The risk premium reached a very low level at the end of the 1990s when we combined extremely high P/E ratios (above 40) with fairly high real interest rates. This is strong sign of a bubble because either markets overestimated growth (relative to CBO forecasts) or underpriced risk.

The risk premium was extremely high during the 2008-09 crisis when P/E ratios were extremely low and interest rates had come down very fast, but those were times of very high uncertainty. In the last coupe of years the risk premium has been around 6%. While stock prices climbed, interest rate fell and kept the risk premium stable.

Since the election, the risk premium has gone down by 1% and it is about 5%. That is not a low number but the change is significant. Clearly markets are either:

a) upgrading their expectations of growth relative to CBO estimates
b) or assuming the policies of the new administration will make earnings grow faster relative to GDP
c) or feeling that uncertainty has gone down with the election of Trump as the next president

How much growth will increase remains a source of debate. While some believe that potential expansionary fiscal policy might boost growth, it is still unclear how much of it will be implemented and the actual policies that will be adopted might not be as growth friendly as markets believe. Given what we know so far I remain skeptical about the potential for acceleration of growth rates in the coming years.

Earnings could grow faster than GDP growth with policies that are friendly to companies but as the labor market becomes tighter it is not obvious how large this effect can be.

And this takes us to the last issue: risk. Clearly investors are not pricing much risk in the stock market, quite the contrary. This is a surprise. Regardless of what you believe about Trump's stated policies, he has provided very few details on what his actual policies will look like, he has contradicted himself in numerous times and some of his statements open the door for very damaging events from a political and economic point of view that could lead to a global economic slowdown or a recession (not to mention other, more catastrophic, events). The market is clearly not pricing any of this risk. I find this puzzling.

Is this a bubble? We will find out soon but it starts looking like the beginning of one where two very dangerous features are present:

a) investors associate high P/E ratios with potentially higher stock market returns because they extrapolate recent trends. This is wrong. High valuations mean lower future returns (if everything else remains constant)
b) investors seem to be underpricing risk at time where some cautions might be needed

We are still 1% point from the risk premium at the 2007 peak and very far from the 2000 craziness so there might still be some room to go. But let's remember that those are the years that preceded a significant fall in the stock market, not the right benchmark to use.

Antonio Fatás

on December 29, 2016 |   Edit

Monday, November 28, 2016

The OECD procyclical revision of fiscal policy multipliers

The OECD just published its November 2016 Global Economic Outlook.  Their projections suggest an acceleration of global growth rates in particular in countries with plans for a fiscal expansion. In the case of the US, and based on the "plans" of the Trump administration, the OECD projects an acceleration of GDP growth to 3% in 2018.

I am very glad to see that the OECD is more open to the idea that a fiscal expansion might be the right policy choice in a low growth environment. I am also very happy that they are ready to admit that fiscal policy multipliers are larger than what they previously thought.

But I am puzzled that they seem to ignore their previous disastrous economic policy advice. And I am even more puzzled that they are upgrading their estimates of fiscal policy multipliers (in particular for tax cuts) at the wrong time in the business cycle, when the economy must be closer to full employment.

Here is the history: back in 2011 many advanced economies switched to contractionary fiscal policy at a time where their growth rates were low and unemployment rates remained very high.  During those years the OECD seemed be ok with fiscal consolidation given the high government debt levels (consolidation was necessary). They understood that there were some negative effects on demand but as they assumed multipliers or about 0.5 (in the middle of a crisis with very high unemployment rates!) the cost did not seem that high.

Today, in an economy with unemployment rate below 5%, and wages and inflation slowly returning to normal vales and a central bank ready to raise interest rate, the OECD turns around and decides to change the fiscal policy multipliers to something close to 1 even if the announced fiscal measures consists mostly of tax cuts to the wealthier households with low propensity to consume.

This is what I would call a procyclical revision of fiscal policy multipliers. Encourage consolidations in the middle of a crisis and expansion in good times. Not quite what optimal fiscal policy should look like.

And, of course, the media (including the Financial Times) reported on the OECD study as a validation of the new US administration policies.

And I leave for another (longer) post the absence of any serious discussion of the risks associated to a Trump presidency. This is coming from an organization that has been obsessed with the risks of inflation and excessive asset appreciation during the crisis.

Antonio Fatás
on November 28, 2016 |   Edit

Monday, October 17, 2016

The stock market looks cheap

How expensive is the US stock market? Have the strong gains since the financial crisis of 2008 built yet another massive bubble that will require a correction? Some investors fear that recent stock market record levels are a sign that this is the biggest bubble ever. Of course, such a simplistic comparison of stock prices is flawed both because stock prices are nominal and therefore likely to go up over time and also because they are driven by (real) earnings which are also likely to increase as (real) GDP increases.

To correct for these trends we can do a simple adjustment and look instead at the price-to-earnings ratio. I will use here the one constructed by Robert Shiller (although some ague that recently the index could be less informative because of the way earnings are being calculated).

The P/E ratio shows that the end of the 90s bubble was by far the period were stocks looked the most expensive relative to earnings. What do P/E ratios look like today? On the expensive side. With a ratio above 26 it stands right at the level before the 2008 crisis and a lot higher than previous similar historical episodes. Most tend to compare it to 16, as the average P/E ratio in recent decades, to signal that the stock market is very expensive. Without going back many decades, we could say that the stock market today looks as expensive as it has been since 1981 with the exception of the bubble of the late 90s.

But that cannot be the end of the analysis as we know that the P/E ratio depends on several macroeconomic variables, in particular the level of real interest rates. And we know that real interest rates are at very low levels today and likely to say low for a long period of time. How does the above analysis change if we adjust for changes in the interest rate?

Let's go back to the basic finance equation that links the P/E ratio to macroeconomic fundamentals. Start with a simple expression of the price of stocks as the net present (real) discounted value of earnings. Under the assumption that current earnings are expected to grow (in real terms) at a rate G and using R to denote the risk-adjusted discount rate we can write:

P = E / (R-G)

In other words the Price-to-Earnings ratio can be written as

P/E = 1 / (R-G)

To make the expression easier to read let's invert it

E/P = R-G

And let's express the risk-adjusted discount rate as the sum of a risk-free rate (RF) and a risk premium (RP).
E/P = RF + RP - G

This expression says that the E/P ratio is a function of three factors. Each of them can make the ratio low (i.e. stock prices high relative to earnings): either real interest rates are low, or investors expect earnings to grow fast or they feel good about risk and they are willing to accept a low risk premium. The last two terms are the ones that depend on expectations, can be more volatile and are capturing the optimism or pessimism of investors regarding macroeconomic conditions (both potential growth and perceptions of risk). While there is nothing in this formula that allows us to assess how irrational investors are, one would expect that at times where stock prices are seen as "bubbly" are when either estimates of growth are too high or the risk premium is too low. Let's combine the two together by rewriting the equation above to construct a potential "bubble" index of the stock market

"Bubble" Index = G - RP = RF - E/P

What this equation says is that the stock market is going to look expensive when the risk free rate looks high relative to the earnings-to-price ratio, given that the only way to justify such high stock prices is through expectations of high growth or perception of unusually low risk.

What does this index look like? I constructed the difference between RF - E/P by using price-to-earnings ratio and 10 year nominal interest rate from Shiller. And I converted nominal into real interest rates using forecasts of inflation from the survey of professional forecasters posted at the Philadelphia Fed  (I mostly use 10-year inflation forecasts that match the duration of the nominal interest rate. But for the earlier years only the 1-year inflation forecast is available to I have decided to plot both series, which looks almost identical).

This is what the stock market "bubble" index looks like

This chart tells a very different story from the unadjusted P/E ratio. The 90s bubble is still there, as you would expect because interest rates were high. This means that the very high stock prices during those years could only be justified by very optimistic views on growth or perceptions of unusually low risk. Both were present and they turned out to be wrong, that's what a bubble looks like.

We can also see that the financial crisis of 2008 sent stock prices close to the lowest levels, similar to what happened during the double recession of the early 80s. Since then stock prices have recovered but they remain low relative to any of the previous years. Even if we ignore the 90s as an aberration, compared to the expansion of the 80s or the 2000s, the stock market today remains "cheap". And by cheap we mean that to justify current prices we do not need a very optimistic view on growth or that investors are demanding a very high risk premium. In other words, the stock market tells us that either investors are pessimistic about growth or very risk averse (which is the opposite of what you expect to see during a typical bubble).

Does this mean that the stock market is undervalued? No, it all depends on whether our current growth expectations or risk assessment are correct. Growth might surprise us and be even lower than what we think today, risk could be a lot higher, maybe 10 year interest rates are a really low indicator of what interest rates are going to look like in the next 10 years. In all these scenarios the stock market will look more expensive than what it looks today. But growth could also surprise us through gains in productivity. And it might be that some of the current risks do not look that likely a few years from now. And then the stock market will look really cheap. That's the uncertainty that we always have when trying to assess the pricing of the stock market.

A note on real growth expectations: our view on growth has clearly been revised downwards because of unfavorable changes in demographics and productivity. It is possible that future real GDP growth today is 1% below what it was in the 80s or the 2000s. But even if we were to make that correction to our index, the stock market would not look expensive. If you look carefully at today's index the number is about 1.5% lower than in the 80s and about 2-3% lower than in the 2000s. These differences are larger than revisions to potential GDP growth rates.

In summary, unlike the strong warning signals we get when looking at record-level nominal stock prices or even at the P/E ratio, a simple adjustment of P/E ratios by current levels of interest rates paints a very different picture of the stock market. Adjusted for current levels of real interest rates, P/E ratios tell us that the stock market today is on the cheap side relative to previous similar phases of the business cycle.

Antonio Fatás

on October 17, 2016 |   Edit