Wednesday, October 24, 2012

The Reluctant Recovery: Conclusions

This is the title of a presentation I gave October 10th to The Economic Club of Sheboygan. This post discusses the investment implications of the presentation. This is the fifth and final part in a series (see Part 1 here, Part 2 here,  Part 3 here, and Part 4 here).

If there is one unifying theme to my presentation, it starts with the title. I argue that the recovery has been a reluctant one, because the market has from the very beginning been reluctant to embrace the notion that the recovery was real and durable, much less robust. There are plenty of good reasons for the market to be concerned, of course: unprecedented changes in monetary policy, misguided fiscal stimulus, the deep-seated problems in the Eurozone, the housing disaster, and the huge federal deficit, among others. 

In Part 1, I show how key market-based indicators reflect a significant improvement in economic and financial fundamentals (e.g., swap spreads, real short-term interest rates, the slope of the yield curve, corporate profits), but other indicators show that the market remains very pessimistic about the future (e.g., TIPS yields, credit spreads, PE ratios, equity yields). The fundamentals have improved, but market sentiment remains pessimistic. This creates an interesting environment for investors, since it means that the bar for economic performance has been set very low: the economy only needs to avoid a recession for markets to react positively.

In Part 2, I argue that monetary policy has correctly responded to a huge increase in the demand for safe-haven dollar liquidity that followed in the wake of the Great Recession. But since the Fed's response was not only unprecedented but gigantic by historical standards, this has created tremendous uncertainty. Will the Fed be able to reverse its Quantitative Easing in a timely fashion? Should we be bracing for a significant increase in inflation? Will the dollar, already very near its weakest level ever, go down further?

In Part 3, I point out that although the federal budget is in miserable shape, there have been encouraging signs of progress. Spending as a % of GDP has declined, thanks to Congressional gridlock. Revenues as a % of GDP have increased, thanks to slow but steady growth in jobs and incomes. As a result, the budget deficit has dropped from a threatening 10.5% of GDP to now only 7%. This points to a relatively simple solution for the future: maintain spending restraint, avoid increasing tax rates, reduce tax rates as much as possible, and pay for lower rates by broadening the tax base (e.g., eliminating or limitation tax deductions and loopholes). In other words, there is a growth-oriented solution to our fiscal problem that needn't be difficult to implement. 

In Part 4, I find that although this is the weakest recovery ever, there are a number of areas in the economy that are improving, and only a few that point to further weakness. Households have undergone tremendous deleveraging, and are much more financially healthy than before. Corporations have cut costs to the bone and are now more profitable than ever. The housing market is turning up. Banks are lending more. The main obstacles to progress are the uncertainty created by misguided fiscal policy, unprecedented monetary policy, and the looming fiscal cliff.

So, the market has dreadful expectations for the economy, but the economy is displaying many classic signs of an ongoing recovery, albeit a very tepid and disappointing one. The bar of expectations has been set very low. If the economy avoids a recession and continues to recover, even very slowly, this likely would be a positive shock to the market. Investors willing to bet that we do in fact avoid a recession can therefore expect to profit by buying risk assets that are relatively cheap by historical standards.

What follows are general guidelines for investing in different asset classes.

Equities are relatively cheap, in my view, because corporate profits are very high, both nominally and relative to GDP, but PE ratios are below average. Moreover, equity yields are significantly higher than corporate bond yields (the earnings yield on the S&P 500 is currently about 7% vs. a yield of 4.5% on the average BAA-rated corporate bond), and both are orders of magnitude higher than the yield on cash, which is another way of seeing that the market expects profits to decline significantly. If profits merely stagnate, equity yields would still be very attractive compared to corporate bond yields and unbelievably attractive relative to cash. It might take an outright recession or worse to shock the equity market.

Real estate, particularly residential real estate, has fallen significantly in price, while at the same time the cost of buying real estate using extremely low mortgage rates is very cheap—historically cheap—relative to household incomes. In other words, the affordability of housing has almost never been so attractive. That's because the majority of people still expect real estate prices to decline, despite growing signs of a housing market recovery and rising prices. It's also likely that demand for housing is being suppressed because banks' lending standards are still much tougher than they were before the Great Recession. Undoubtedly there are many young homeowners who would like to buy a house but find that they lack the necessary down payment or job history. Nevertheless, "everyone knows" that there is a ton of foreclosed properties sitting on banks' balance sheets waiting to be sold, and there are millions of homeowners still underwater on their mortgages. The real estate market is still in the grips of caution, rather than exuberance.

Real estate is also potentially very attractive because it has traditionally been an excellent inflation hedge. If the Fed fails to reverse its Quantitative Easing in a timely fashion, inflation could rise significantly. Incomes would also rise in that case, and the demand for housing could rise hugely. We all learned in the 1970s that real estate (and any hard asset, for that matter) is a great thing to own, especially with leverage, when inflation is rising. Today, however, both real estate and mortgage rates are priced to the expectation that inflation will remain relatively low for as far as the eye can see.

What about other inflation hedges? Gold prices are extremely high, both in nominal and real terms, and commodity prices have risen substantially. These markets arguably are priced (by speculators) to the expectation that the Fed will make a big inflationary mistake. Maybe they will, but if they don't, gold in particular could tumble much as it did in the 1980s when tight monetary policy caused inflation to fall way below everyone's expectations. It's late in the game to load up on gold, because the world has been loading up on gold for the past decade, in the expectation that inflation will rise, the dollar will collapse, and/or the global financial system will collapse. Barring any of these disasters, gold might have very limited upside but a lot of downside potential.

Treasury yields, meanwhile, are extraordinarily low, making Treasury bills, notes and bonds extraoridinarily expensive. Investors everywhere are willing to hold Treasuries at historically low levels of yield because they are very fearful of the future. With real yields on TIPS deep in negative territory, this is one more sign that expectations for future investment returns, and for real economic growth, are dismal. Thus, holding Treasuries today only makes sense if you worry about an outright depression. If the economy picks up even just a little, and/or inflation rises by even a few percentage points, Treasury yields could rise (and their prices fall) by enough to wipe out many years' worth of income.

Corporate and emerging market debt have performed very well in the past several years, because spreads to Treasuries have narrowed from very high levels and default rates have fallen thanks to an improving economy. Investment grade spreads are still somewhat wide by historic standards, but their yields have never been so low (3-3.5% currently). High quality corporate bonds still offer yields that are a few points higher than Treasuries, but if Treasury yields rise, investment grade corporate debt is going to face challenging conditions (i.e., rising yields and falling prices). In other words, current yields offer very little protection from a rising interest rate environment should the economy improve. High-yield corporate bonds offer more protection against rising yields, since their spreads to Treasuries are still relatively generous and their yields are in the range of 6-7%, but high-yield debt is no longer the slam-dunk it used to be. The current appeal of high-yield debt is that if nothing changes it offers much higher yields than Treasuries, and if yields rise, then the negative impact of rising yields would likely be offset to some degree by declining default rates and by declining spreads to Treasuries. That's because higher yields would only occur if the economy improves and/or inflation rises, and both of those conditions would make high-yield debt more attractive.


steve said...

so here's my thoughts: you are arguing that stocks are fairly cheap relative to other asset choices. the ostensible conclusion is you are attempting to time the market or at least suggest that now is an attractive time relative to others to be in stocks. A) I've been in the investment business since 1984 and I've NEVER known anyone who has a clue as to prognosticating stock prices. B) you're an economist and by therefore be definition your ability to prognosticate is effectively the same as throwing a dart.

WimpyInvestor said...

Great analysis. Would appreciate your thoughts on the relative value of US equities vs. other countries. Thanks.

Scott Grannis said...

Investing in non-dollar assets is tricky, because they have an added level of complexity: exchange rates. It's like playing three-dimensional chess. The only observation I'll make here is that the dollar is very close to its all-time lows, so that means that most other currencies are very close to their all-time highs. I think the risk-reward to non-dollar currencies is skewed to the downside (meaning the dollar is more likely to rise than to fall over the next several years). That gives me a bias to prefer dollar-based assets to non-dollar assets.

Pragmatic Investor said...

By saying PEs are low and equities are cheap, you need to demonstrate that the PE measure you are using has historically shown meaningful correlation with subsequent returns. Otherwise, it doesn't mean anything. For example, the PE ratio was at historical average in 2007 but it dropped 60% subsequently.

Scott Grannis said...

I disagree. I note that today, PE ratios are low at a time when corporate profits are at record highs. Furthermore, earnings yields are very high relative to bond yields and relative to cash. Corporate profits today are 38% above 2007 levels. Everything needs to be taken in context. And I am only saying that I think this confluence of facts, at a time when the market has plenty of things to worry about, opens up the possibility that equities have more upside potential than the market is assuming.

Benjamin Cole said...

Scott Grannis seems to be saying "buy housing" and iI gotta agree with that.

Especially for Southern California, this may been seen someday as a rare window to buy cheap, using cheap money.

Good luck everyone.

Pragmatic Investor said...

Corporate profits were also at record highs in 2007. In fact they are almost always at record highs except for the short period after recessions. PEs have been lower or just as low in the 60's and 70's. I bet if you run correlation between your PE ratio and subsequent returns, correlation is not significantly different from 0.