Tuesday, June 30, 2015

The era of idiosyncratic risk?

Previously, I referenced this blog post by Aswath Damodaran.  He was discussing the effect of cash holdings on the PE ratios of firms.  This first graph was from that post.  One of IW's perceptive readers noticed that the Damodaran chart seemed to imply a much higher level of cash holdings than seemed feasible.  Damodaran clarified that the chart included financial firms, which can have very large cash and cash-equivalent holdings, which did inflate the difference, relative to non-financial firms.  But, he noted that the trends were the same.

Since then, he has added another post, where he has included the effect of debt on PE ratios, and he also posted his data from the first graph, which includes non-financial firms and also separates the data between profitable firms and all firms (including those with losses).  His first graph only included profitable firms, because PE ratios can become incoherent when earnings are very low or negative.

I have used his data to create this second graph, which has PE ratios (both unadjusted, and adjusted for cash) for only non-financial firms.  Also, I have included the PE ratios for both all firms, and for only profitable firms.

I think there are a couple of interesting things to consider, here.  First, we can still see Damodaran's original point, though to a lesser extent.  For non-financial firms, this is inflating the aggregate PE ratio by about 2 points, and it is generally a new phenomenon of the past 15 years or so.  I suspect this is largely due to the large cash holdings typically seen in the tech sector.

But, possibly the more interesting issue to note here is how much of a difference it makes to filter out the unprofitable firms.  This is also a recent phenomenon, although it goes back more like 25 years.  I suspect this is also related to the digital revolution.

This suggests that before 1990, there were very few unprofitable firms.  Scott Sumner and I touched on this in our National Review article.  There is widening inequality among capitalists.  The digital revolution has created a winner-take-all dynamic that creates a much wider set of outcomes for firms than traditional industries experienced.  This also means that organizational life cycles have been shortened tremendously, and losses incurred by new entrants are at larger scales.  Think of the record-breaking IPO's in the 1990s of firms that don't even exist any more.

Returns to risk and variability of incomes have risen, globally, and among both human and physical capital.  Returns to a college education continue to rise, even as college attendance expands.  Super-firms like Apple have high returns based almost entirely on intangibles.  This is much more of a product of an emergent technological context than it is of some left-vs-right policy shift or tax regime.  One idea I hope to look at some more is the idea that increased variance and returns to risk may be an ingredient in the persistently high equity risk premium, low risk free rates, and high home prices.  In this context, safety demands a premium.  Could variance in capital outcomes become large enough that frictions in markets prevent the practice of efficient modern portfolio theory?  So, non-corporate low-risk securities take on more importance when diversification of equity portfolios is more difficult?  Could the inherent inability to diversify our human capital be a reason that American students seem to under-populate many STEM fields, in spite of their higher compensation potential?  Could it be that American students who can earn higher incomes in more generalized fields aren't willing to take on the high risk of the human capital imbedded in technical fields, but the payoff to foreign students with lower alternative income options is worth the risk?  The two trends themselves - significant numbers of firms with negative earnings and high levels of cash holdings - are probably also related.  Firms facing extreme levels of idiosyncratic whisk may be taking on large risk-free asset positions, within the firm structure, for the same reasons that savers are taking on large low-risk asset positions outside of firms.

Here is a chart of the number of profitable and non-profitable firms from Damodaran's data.  Today, profitable firms represent 86% of market capitalization, but only 39% of firms.  The total number of firms and the total number of profitable firms peaked in the late 1990s.  This seems like potentially bad news.  I would speculate that some of the increase in small, unprofitable firms could be due to changes in firm structure, so that modern financial innovations are allowing more early R&D to be done in new, small firms, instead of being incubated within large conglomerates.  But, if that were the case, I would hope that the total number of firms would be growing.  But this does suggest that we are in a stock picker's paradise, where there are thousands of potential turnarounds and home runs to find.

Recent research has found that "much of the 1970s-2010s increase in earnings inequality results from increased dispersion of the earnings among the establishments where individuals work. It also shows that the divergence of establishment earnings occurred within and across industries and was associated with increased variance of revenues per worker".  And, boy, doesn't this graph point to an obvious source for this change?  How many of those unprofitable firms are populated with development staff loaded up with stock options and working for the big payoff?  No wonder households want to load up on treasuries and real estate.

Even among profitable firms, there has been a re-characterization.  Compare Apple today to GM 50 years ago.  Apple has outsourced and offshored all the capital intensive, standardized, low-risk portions of its business, leaving high value-added, high payoff, high risk positions in the US within its corporate identity.  This is why Apple is practically nothing but intangible value.  They have only retained the pure value-added portion of the firm, and sent the rest of the business to the developing world that now has a competitive advantage in capital intensive production.

These sorts of optimizations can create benefits for everyone when there aren't frictions to obstruct them.  Our history of functional commercial institutions has created a context of relative safety and high incomes.  The developing world is improving its commercial institutions, but they aren't there yet, so wages are still low there, but rising quickly.  An interesting question for us to ask is, if variance in incomes is increasing, why aren't more Americans students majoring in fields with higher wages?  Maybe the impediments are too complex for us to solve.  Does more education funding solve the problem?  There appear to be opportunities in these fields that are going unclaimed now.  One solution to this is to import skilled technical labor help create America's technical advantage where we don't have local skilled labor to do it.  But, if that's a trade for a more efficient global economy, the other side of that trade isn't going to happen.  Low skilled laborers from the US aren't going to emigrate to Malaysia to find factory work.

These are all speculative ideas, but regime shifts like this could be creating many of the trends in investment and consumption that seem baffling or nefarious when viewed without accounting for changing context.

Thursday, June 25, 2015

Higher asset prices are not a Wall Street giveaway.

The value of a financial asset is the present value of future cash flows.  That value can generally be simplified to (1) current cash flows, (2) the growth rate of future cash flows, and (3) the discount rate applied to future cash flows.

I have been arguing that, for corporate assets, at least (of which equities are our proxy), the discount rate tends to be fairly stable over time, and most of the cyclical and secular changes in equity values are from changes in cash flows.

There seems to be a widespread belief in the idea that balance sheet expansion at the Fed has injected cash into asset markets, and has been a "bailout" of financial interests.  This is usually paired with the idea that the alternative would be some sort of fiscal injection or Federal transfer. In effect, the idea is that fiscal injections would increase consumption (ergo, current cash flows) while monetary injections increase asset prices instead of consumption (ergo, decrease the discount rate).

What if I am wrong about the relatively stable discount rate, and monetary injections are just inflating asset prices (reducing the discount rate)?  This is still not a "giveaway" to Wall Street.  Asset prices resulting from changing discount rates are simply a transfer from new owners to current owners.  Cash flows have not changed.  In the end, after all cash flows have been received, the only difference will have been that an owner that sold at t=0 would have received a one-time transfer from the new owner.  So, to the extent that this transfer leads to consumption from asset holders, there would be no net wealth effect, all things considered.  There would only be a transfer of consumption from the future to the present.

Now, I don't believe this is the primary result of monetary injections.  It certainly wasn't the case in the one undisputed period of loose monetary policy - the 1970s.  Both monetary and fiscal injections increase current corporate cash flows.  We can argue about which is the best policy and which types of injections do the best job of maximizing future growth while mitigating short term dislocations.

But, without getting into all of that, I am just pointing out that if any policy is a Wall Street giveaway, the interpretation of events that does not describe a Wall Street giveaway is the one where monetary injections "artificially lift asset prices" above the "fundamentals".

This is how some people characterize the housing boom of the 2000s.  I agree that there was a wealth effect during that period (although I disagree that it was artificial or based on a deviation from pricing fundamentals).  But, notice how in that scenario, where middle class households are the protagonists in the narrative, the narrative treats the wealth effect as a transfer through time, that had to be matched with reduced consumption in the bust.  But, when the narrative has "Wall Street" as the protagonist, the wealth effect is treated as a giveaway, or a bailout.

We like to populate our narratives with dupes and villains - "smart money" and "dumb money".  I think these sort of preordained narrative biases become self-fulfilling, leaving many with an attitude that there is some greatly over-estimated cabal of financial power mongers who have a "heads I win, tails you lose" stranglehold on the economy.  The erosion of trust this sort of narrative building creates leads to so much poor public policy, such as the supply constrictions I have been discussing in housing.

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If discount rates are stable, then Wall Street gains from the other interpretations of cyclical policies are mainly the result of broad-based expansion of spending across the economy and higher expectations of future broad-based expansion.  Looking at profits + interest income + proprietors' income, total returns to corporate and non-corporate capital only have cyclical fluctuations of 2% or less, and haven't moved outside of a band of 4% since WW II.  In other words, even if all of the fluctuations in capital income were a product of some pro-Wall Street cyclical policy, it could only amount to a total capital price appreciation of about 10% between valuation bottoms and tops.

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In fact, even that small amount of fluctuation is almost entirely the product of corporate profits recovering from the dislocation created by the contraction.  Once this dislocation is reversed, long term levels of capital income appear to be a very stable product of complex social inputs.

I have been commenting on the unusually high corporate earnings, relative to valuations, in the 1970s.  In the first graph here, we can see total capital income share bottoming out in 1970, after the long period of cyclical stability in the 1960s, and growing until it peaks in 1984.  But, even here, we are looking at an increase in share of GDI to capital of only 4% over a period of 15 years.  And, this was during a period of very low equity valuations.  The secular growth in capital income share during that period was more likely a product of slowing growth expectations associated with pro-consumption policies, a poor capital environment, and some amount of misattribution of the inflation premium portion of interest income.  (The inflation premium of nominal interest payments on corporate debt causes interest income to be overstated and profit to be understated.  On mortgage debt and consumer debt, the inflation premium overstates interest income and understates real savings for households.  But, the overstatement of interest income due to mortgage and consumer debt should tend to amount to less than 2% of GDI, with relatively little fluctuation over time.)

There is simply no modern era evidence of massive relative income grabs by capital.  It is probably impossible, or at least highly unlikely, for that sort of income transfer to take place in a modern liberal society.  Except for the exceptional burden equity holders accept of absorbing negative cyclical shocks, long term growth in capital income is a reflection of the rising tide of abundance.  We are the 100%.

Wednesday, June 24, 2015

The end of QE and the first rate hike

Since we hit the zero lower bound, there appears to have been a basic rule of thumb regarding forward interest rates.  When QE's have been in effect, the date of the initial rate hike has been stable.  When QE's have not been in effect, the expected date of the first hike has generally moved forward in time.  So, when QE3 was terminated while we were still firmly at the zero lower bound, one question I had was whether this pattern would continue.

So far it seems like it is continuing.

Now, there is something arbitrary about this, because it looks like the Fed will use interest on reserves to raise short term rates while there are still significant levels of excess reserves outstanding.  I presume that this will cause short term rates to rise more swiftly than if they were planning on simply raising rates with  open market operations.  I think there would be some deflationary effects of open market operations, even at the zero lower bound, as the balance sheet would be reduced.  Please correct me in the comments if I have this wrong.

In any case, even given the monetary tactics that have been proposed, which will begin with a hike in the policy rate target while there are still large quantities of excess returns, the expected date of the first hike has begun to move ahead in time as QE3 was tapered, and then finished.

In the second graph, which covers the time since the beginning of QE3, we can see that,  in February of 2015, the expected rate of the first hike was around 5 months away, in June 2015.  That's about when the expected date of the first rate hike was when QE3 began.  The expected first rate hike is still about 5 months away - in November 2015.

Before the taper began, the expected date of the first rate hike moved around quite a bit, even though it basically ended up where it began.  So, this idea isn't exactly pristine.

So, it will be interesting to see what happens over the next few months.  Will the expected date of the first rate hike stabilize?  Or, come December, will we be debating about whether the first hike will be coming in the summer or fall of 2016?  This will be data driven, as the Fed says.  One curiosity will be if Core CPI inflation moves up to around 2.5%, but this is composed of, say, 4% shelter inflation and 1.5% non-shelter inflation.  Will the Fed consider this a signal to raise rates?

Of course, I see mortgage expansion as the key, and if we see mortgage expansion then I think we will be very likely to see the date of the first hike stabilize.  The expected slope of rate increases is also near the low levels we saw at the beginning of QE3.  (The red line in this last chart is the slope of the yield curve - the rate of future rate increases.  The blue line is the expected date of the increase.  It is an inverted version of the green line in the chart above.)  If the expected date continues to move forward in time, I expect that the slope will continue to fall, as doubts build about the possibility of leaving ZLB.  The effect of a positive surprise in interest rates will probably mostly play out in an increase in the slope of the yield curve, and this is probably still the factor to watch on a speculative short bond position.  If mortgage levels continue to limp along without some sort of monetary stimulus or revolutionary change in the way we fund the housing stock, then interest rates and real GDP growth will continue to muddle along.

Tuesday, June 23, 2015

The difference between taxes and bonds, fiscal stimulus, and the 1970s equity puzzle.

In the previous post, I included this graph comparing the federal budget deficit with GDP growth over time.  And, it got me thinking more about the puzzle of low P/E ratios in equities in the 1970s.  In this graph, you can kind of visually see how high inflation can ease fiscal constraints.  Even though budget deficits were large in the 1970s, nominal GDP was growing fast enough to compensate.  The deficit didn't grow that much in the 1980s, but the end of high inflation policies meant that the nominal economy wasn't keeping pace any more, so public debt grew relative to GDP.

One issue I have been touching on lately is the extremely low P/E ratios of equities in the 1970s.  From a discounted cash flow perspective, equity values are a product of current earnings, earnings growth expectations, and the discount applied to those earnings.  These low valuations appear to have been related mostly to low growth expectations.  But, I don't see an obvious reason in the data why growth expectations would have been low.  (The mood of the time certainly conveyed low expectations, however.)

The effect of such high inflation on de facto tax rates could explain some decline in expected earnings growth, since firms would expect to be paying future taxes on what would amount to inflated return of invested cash.  But, I think this only explains a small portion of the unusual valuations.

I wonder if some of the dislocation of the time could be related to inflation in another way.  I find the debate over public deficits to be a little bit unsatisfying.  To me, when all is said and done, the main question at any point in the business cycle regarding public spending is, "Is it useful?"  I don't see much difference between tax-supported expenditures and bond-supported expenditures.  In either case, cash is being taken from the private economy and applied to some public expenditure.  In the case of the bond, I think this is most clearly thought of as a combination of two transactions.  The first transaction is the equivalent of a tax.  Cash (representing use of scarce resources) is transferred from private investment to a public expenditure.  The bond represents a promise of a future transfer.  If the government defaults on the bond, then we are left with just the tax, and the transfer is cancelled.


In the case of an inflationary policy, the bonds are paid back with devalued dollars, so it is, in effect, a partial default.  So, compared to the original set of promises, in the inflationary scenario the government is engaging in public consumption, investment, or transfers with funds that had been earmarked for capital repayment.  This could represent a significant negative shock to the capital base.  In effect, the government had pre-committed to re-injecting cash into capital markets, but ended up only injecting a portion of that capital into those markets.

A 20 year bond purchased in 1965 would have only received about 60% of its expected value back in real terms.

Since the inflationary policies of the late 1960s and 1970s reduced the expected commitment of repayment, they were like a one-time tax on capital.  It would take a lot of work to figure out treasury holdings by duration, inflation expectations, etc., to come up with a good estimate of the total, so I'm not sure I will get past the theoretical here.


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Corporate enterprise values were stagnant during this period, both because of the very low equity capital levels and because of slower growth of debt capital.  We also see a sharp uptick in dividend yields in the 1970s, which we might associate with lower reinvestment and lower growth expectations.

But, on the other hand, private fixed investment was relatively high in late 1970s.  I don't have an explanation for that.


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When corporate profits are taxed directly, the consequences are more subtle.  After tax profits are a product of complex social inputs which will tend to find their equilibrium, so higher universal corporate taxes tend to mostly lead to higher corporate pre-tax profits.  Here, we can see how after tax profits have been fairly stable over time (except for the large bump in the 1970s), while pre-tax profits have fallen as corporate tax rates have declined.  I think a similar outcome is true in terms of profit as a proportion of GDP, but to see it capital movement between proprietor and corporate, debt and equity, and domestic and foreign all need to be accounted for.


But, the tax burden of high inflation could not be passed on.  The terms of nominal repayment had been set by bondholders when the bonds were purchased.  This was a case where capital could be taxed without the ability to pass the cost on.  It seems plausible that this could be a significant factor in the high capital income levels of the time, relative to valuations.  There was simply a dearth of capital to re-invest.  And, this coincides with a period of low GDP growth per worker.

And, I suppose the opposite effect happened 20 years later when persistently lower inflation led to excess gains for treasury bond holders, and there was a period of unusual growth expectations.


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There appears to be a correlation of high government expenditures with low real growth rates, over time in the US as well as across countries.  Outside of short run effects and adjustments, I doubt that it matters much whether this spending is funded through taxes or deficits.  But, to the extent that it is funded through fixed rate, nominal bonds, I think regime shifts in inflation levels might be correlated with a similar and significant change in growth rates that is not as easily noticed.

It is interesting that the positive (negative) inflation shock was associated with low (high) growth expectations, low (high) real interest rates, and high (low) equity risk premiums.  It might have been reasonable to expect real interest rates to increase in the high inflation 70s.  There was a real income shock in the low risk, fixed income market.  So, we might have expected to see capital pulled from risky investments like corporate equity, to rebalance portfolios, but not completely, because of frictions in asset allocation adjustments.  This would leave bond and real estate prices low (real yields high).  But, the rebalancing included an over-correction, so in the 1970s, portfolios included less equity and more fixed income. Albeit, rebalancing that went into housing did provide an inflation hedge that would have had value at the time.

The opposite happened in the 1990s, where the fixed income windfall didn't lead to an excess of fixed income investment.  Real interest rates were high and housing price/rent ratios were low in the 1990s.  Not only did some of those gains go into investments with cash flow risk; apparently all of the gains and more went into investments with cash flow risk.

And, given this over-rebalancing, we might expect that total required returns on corporate capital (the risk free rate plus the equity premium) would have gone up during the 1970s (down during the 1990s), as the dearth (excess) of risk-seeking capital would have bid down (up) corporate assets.  We do see valuations move down (up) relative to earnings, but the change in valuations appears to be explained by changing growth expectations, not changing total expected returns.


The over-rebalancing may be due to the possibility that low risk investments are a sort of financial Giffen good.  As the price of homes and fixed income securities rise, relative to their cash flows, demand for them increases.  Since rent and supply are relatively stable in housing, this happens naturally in home equity and mortgage levels as implied yields change.

Maybe, thinking in terms of low risk interest rates as a sort of discount from a relatively stable at-risk required rate of return, there is a sort of market segmentation, and there is a relatively inelastic demand for a set amount of low risk real income.  When the relative rate of low risk income declines, this segment of the market has to swap more capital with the risk-taking segment in order to maintain its level of income.

Maybe the transfer of capital from private markets to public expenditures, either through the inflationary fixed income shock or through changes in relative Federal spending levels, change growth expectations, and this is what causes valuations to fluctuate through growth expectations instead of through at-risk return requirements.

As usual, please post references in the comments if you know of good literature on this idea.

Friday, June 19, 2015

The 2013 Austerity Debate

Scott Sumner went into the issue of the 2013 austerity debate some more, at Econlog.

Here is some of what, Russ Roberts, Simon Wren-Lewis, and Paul Krugman, have added.  Others have weighed in.

This whole episode began in early 2013, when Krugman said:
...as Mike Konczal points out, we are in effect getting a test of the market monetarist view right now, with the Fed having adopted more expansionary policies even as fiscal policy tightens... Sorry, guys, but as a practical matter the Fed - while it should be doing more - can't make up for contractionary fiscal policy in the face of a depressed economy.
This was in response to the sharp fiscal consolidation that was legislated in late 2012.  Here is a letter, signed by 350 economists at the time, which included the following comments:
As Great Britain, Ireland, Spain and Greece have shown, inflicting austerity on a weak economy leads to deeper recession, rising unemployment and increasing misery....Public outlay for jobs and recovery come first, growth is restored, and revenues follow...We can also stimulate recovery without increasing deficits by increasing taxes on the wealthy and pumping the proceeds directly into the economy...At the end of the year, we face a congressionally-created "fiscal cliff," with automatic "sequestration" spending cuts everyone agrees should be stopped to prevent a double-dip recession.

Suffice it to say, after significant fiscal consolidation was indeed put in place, economic and employment growth in 2013 pushed ahead at about the same pace that they had been.  The market monetarists took a victory lap.  But, Krugman's response was:
Incidentally, these other factors are why I don’t take seriously the claims of market monetarists that the failure of growth to collapse in 2013 somehow showed that fiscal policy doesn’t matter. 
In Krugman's latest post on the matter, he says:
And while it’s true that there was limited direct evidence on the effects of fiscal policy 6 or 7 years ago, there’s now a lot, and it’s very supportive of a Keynesian view.
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Here is a close-up graph of the periods, using Quarter-over-Quarter GDP growth (annualized).  Below is a picture of long term GDP growth (real and nominal, Year-over-Year) and the Federal budget deficit.  One can easily see how worrisome the 2013 budget would be to anyone who believed that it would have a strong effect on growth.  Many of the changes in the fiscal budget in the past have been the product of shocks in GDP.  It looks to me like this is an unprecedented incidence of a sharp contraction in the Federal budget during a period of stable GDP growth.  And the contraction was, indeed, very sharp.

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The quarter-over-quarter numbers are a bit noisy, so there has been some argument over start and end times, but, basically nominal GDP growth had been between 3 1/2% and 4 1/2% since 2010 and has continued at that pace during and since the sharp consolidation period.  Krugman implies that there was some exogenous factor that would have made growth in 2013 more like 5% to 6 1/2% in 2013, which I guess implies a multiplier of about 0.4, since the consolidation was about 3.5% over 2 quarters.  Actually, annualized GDP growth was around 5-6% in 2013 3Q and 4Q, but as I said, the quarterly numbers are noisy.

Wren-Lewis produces this chart, where the "no austerity" counterfactual is based on 2% growth in federal expenditures, and he assumes a multiplier of 2, which produces a hypothetical growth rate similar to the pre-recession level.  Presumably, this means that Wren-Lewis thinks that NGDP growth would have jumped to 11% in 2013, if not for the sharp fiscal consolidation.  (edit: Wren-Lewis has a new post up, calling Sumner a liar.  It looks like Wren-Lewis is using a multiplier of 2 for government consumption and investment, and a 0 for taxes and transfers.  That's why his counterfactual looks so straight through 2013.  So, by this model, there was nothing special about 2013, since most of the consolidation was from transfers and taxes.  So, I guess Wren-Lewis' position is that "austerity" in 2013 was not really any different than the previous couple of years.  This would seem to be a third position, different from both Sumner and Krugman, since by this measure, there wouldn't be anything particularly definitive about 2013.  So, Wren-Lewis would apparently object to some taxes on fairness grounds, but not on cyclical grounds.)

Much of the consolidation was from tax increases.  So, maybe those who think the test failed don't think that tax increases are as damaging as spending cuts.  But, then, why were they so worried to begin with?

But, keep in mind, on the argument of federal expansion vs. contraction, this suggests that both spending and tax changes are subject to monetary offset.

If we look at inflation over the post-recession period, it seems to corroborate the monetary offset point of view.  During QE1 and QE2, treasury rates rose as QE was implemented, mostly due to higher expected inflation.  Then, with some lag, consumer inflation would also rise.  Then, as each QE was phased out, inflation, expected inflation, and treasury rates would subside.

I was taking a short bond position when QE3 was implemented.  But, I didn't fully account for the effect of austerity.  Here we can see how fiscal consolidation might explain the difference between QE3 and the earlier QEs.  Inflation expectations rose during QE3, pretty much as they had with QE1 and QE2, but actual inflation was flat, and treasury rates remained flat until 2013 Q3, when treasury rates suddenly rose.  That just happens to be when consolidation stopped and the federal deficit settled in at the new, lower level.  The missing inflation during QE3 is right about 1.5-2% compared to QE2, which is about how much of a fiscal drag Krugman seems to have been expecting.


Even if there was monetary offset here, a question might be whether the Fed would have done QE3 anyway.  So, maybe we are seeing monetary offset, but if the fiscal consolidation hadn't taken place, we would have been looking at 5-6% NGDP growth in 2013 and 2.5% rates on 5 year treasuries.  Maybe we would be off the zero lower bound by now, if that had been the case.  Sumner points out that the Fed is tightening now, even in the face of recently declining inflation and GDP growth, so it seems unlikely that they would have continued with a strong QE3 policy if NGDP had risen above 5%.  Home prices were appreciating by 5% to 10% annually during QE3.  If fiscal accommodation would have pushed that up higher and if consumer price inflation had been higher, it seems likely that they would have pulled back on monetary accommodation sooner.

Could the outcome here have been any more in line with market monetarist expectations?  And, looking at the first large graph above, is there any justification for saying that holding the fiscal deficit at nearly 10% for 5 full years as an economic stimulus has undeniable empirical support?

Here are two posts by Mark Sadowski on the issue, and some more of his analysis, via Scott Sumner.  A while back, I looked at some IMF data that suggested the main issue regarding the fiscal balance was having a positive budget level before the recession with a follow up showing the difference between Euro countries and the rest of the developed world..

Thursday, June 18, 2015

May 2015 Inflation

It looks like CPI measures across the board took a breather this month.  Year-over-Year measures are moving generally sideways.  Core inflation is at 1.7%, which is a combination of Shelter inflation running at about 3% and Core-minus-Shelter inflation, running at about 1%.

This has been the pattern since the mid-1990s, except for the 2003-2005 and 2012-2013 periods, which were the only periods where aggregate housing supply was expanding strongly enough and monetary policy was accommodative enough for housing inflation to fall and non-housing inflation to rise to the ostensible target of 2%.

Constrictions on building in the major California and Northeastern metropolises mean that target-level monetary policy is associated with significant home price appreciation (10% and higher).  It seems to me that until the large metro areas fix their housing problems, it will be difficult for monetary policy to hit our targets over the objections of those worried about home prices.

Wednesday, June 17, 2015

Housing Tax Policy, A Series: Part 40 - Yellen on 2004-2006 and More Notes on Rent Inflation

From the Dow Jones news feed from today's press conference:

Federal Reserve Chairwoman Janet Yellen said Wednesday it's possible the central bank might have needed to raise rates more quickly in the 2004-2006 period to prevent overheating in housing and financial markets. "Conceivably I think with the benefit of hindsight it might have been better to raise rates more rapidly or more during the 2004 to 2006 cycle.
You know, I'm not certain of that judgment but I think there is a case to be made." Ms. Yellen said during her press briefing.
That was a shift in tone for the chairwoman, who has previously dismissed claims that low interest rates helped fuel the housing bubble and subsequent crash.

By the end of 2006, the Fed Funds rate was 5.25%, the 10 year treasury rate was at 4.56%, and YOY currency growth was falling below 3%.

In the inflationary 1970s, forward rates would tend to rise along with short term rates.  After the 1990 contraction, rates again followed the same pattern, but the upward movement during the recovery was weaker than the downward movement had been during the contraction.  Inflation remained low as the yield curve flattened in the last half of the decade.  But, after the 2000 contraction, while long term treasury rates began to rise, in anticipation of Fed rate hikes, the forward rates failed to show a consistent move upward.  So, instead of seeing rates move up with the Fed Funds rate, across the yield curve, short term rates were moving up but long term forward rates were stagnant.  By the time the Fed started moving the target rate up in 2004, forward rates were declining.  As far as I can tell, there isn't a precedent for this.  Forward inflation expectations were stable during this time.  This was a decline in real long term forward rates.

I wish that forward rates were more commonly used and tracked.  Looking at forward rates makes it much easier to separate long term expectations from the effects of short term target rate behavior.

My poor-man's estimate of the forward 7 to 10 year treasury rate in this Fred graph fell from 5.6% in June 2004 to 4.6% in February 2006, while the Fed Funds rate rose from 1% to 4.5%.  All rates then moved together as the Fed Funds rate rose to 5.25% by July 2006, after which the yield curve inverted and 7 to 10 year rates fell back to around 4.6%.
Source

In the next graph, I have pulled future expected rates from the Office of Thrift Supervision Asset and Liability Price Tables , which I think are only available from 1997 to 2011.  I have just shown the numbers here for June 30 of each year.  (I included rates up to 360 months, but 30 year treasuries weren't issued from 2002 to 2005, so the 360 month number from those years may have a wider potential error.)  This also shows falling forward rate trends for the entire period, including the period where the Fed Funds rate was rising and the Fed was supposedly dangerously accommodative.

As Scott Sumner points out, the Fed has just been following economic consensus, and in the quote above, we can see Yellen being pulled in this direction.  Is there any basis for claiming that monetary policy is accommodative during a period where long term inflation expectations are level and forward real rates are declining?  Yet this is what everyone claims.  Even those who are with me in fingering monetary contraction as the cause of the financial crisis and most of the housing default crisis tend to accept that there was some period where the Fed was imprudently accommodative.

The singular source for this idea seems to be the strong price appreciation in housing.  I had originally suggested that it was the long-running trend of tight monetary policy that had caused home prices to accelerate in the 2000s by pulling down long term interest rates.  Low real long term rates were increasing the intrinsic value of the homes while low inflation expectations were lowering the monthly payment on mortgages and removing an obstacle to demand.  During the housing "bubble", those real rates were probably mostly an exogenous factor, but at this point their continued decline is a product of market distortions coming from the crisis and disastrously tight policy.

But, as I have proceeded through my series on housing, I have been coming more to the point of view that our housing supply problem is mostly to blame.  In this graph, I constructed a simple model of home prices based on actual rent inflation and interest rates, and compared that to counterfactuals with stable inflation and real interest rates.

All the indexes begin in 1995 at around 80.  In 2006, the Case-Shiller National Index had grown to 184 and the 10 city index had grown to 225.  My modeled home price indexes (based only on rent levels, rent inflation, and real interest rates) tend to be a little noisier than the Case-Shiller indexes, and they come in a little low in 2006, at 173 and 196.

The counterfactual home price index with stable real interest rates and no excess rent inflation (rent inflation equal to core inflation ex. rent) rises to 99 in 2006, and the counterfactual that uses actual real interest rates but without the excess rent inflation rises to 116.

That suggests that only 1/4 of the price increases during the boom were related to low real interest rates.  Three-quarters of the excess price increases, according to this model, were related to rent inflation - to the housing supply problem.  (A small amount may also have been related to lower barriers to home buying demand because of the low inflation premium on mortgage payments, but I think this was small compared to the other effects.)

So, the housing supply problem has caused consensus demand for tight monetary policy because it has caused inflation to be higher due to persistent supply problems.  But, indirectly, it has led to a consensus for tight money because of the tendency to blame the home price "bubble" on speculative demand.  If the house price "bubble" was largely a supply phenomenon, the evidence overwhelmingly points to a general position of tight monetary policy throughout this period.  As I have pointed out, Core CPI inflation less Shelter has been consistently below 2% since 1998.  Currently Shelter inflation is running at 3% and Core minus Shelter inflation is at 1%, YOY.

Since the crisis, the low real rates that have been created by the crisis have become the overwhelming factor in pushing up the intrinsic value of the national housing stock.  But, this is a disequilibrium.  If we allow the home market to recover, rates will rise.  The supply problem will not be solved, so the prices paid in the 2000s will be vindicated.

The question is, how many decades will it be before we stop calling it a bubble?

Tuesday, June 16, 2015

Looking some more at an at-risk based interest rate model.

In the previous post, I discussed the possibility of using the at-risk rate as the starting point for discount rate models instead of the risk-free rate.  This rate seems to be fairly stable over time, allowing it to be a useful benchmark.  From this we would first deduct a "fixed income" discount.  This would get us to a simple version of the Capital Asset Pricing Model, where required returns on equity are equal to the risk free rate on long term bonds plus an Equity Risk Premium (ERP).  I would treat the ERP as a discount from the at-risk rate for avoiding cash flow uncertainty, rather than a premium added to the risk-free rate for taking on uncertainty.  This is semantic, but I think it is a first step toward a more coherent framework for thinking about market values over time.

Then, there is a further discount within fixed income for maturity, which is the discount one accepts for avoiding duration risk.


Cyclical Movements in Long Term Interest Rates

Imagining discount rates in this way gives a different flavor to monetary policy, I think.  The Fed tends to focus on short term rates.  But, if we look at, say, the iShares Core Aggregate Bond Fund, a benchmark for the high quality bond market, it has a long-running average duration of around 5 years, which is between the duration of 5 year and 7 year treasuries.  This is the duration of the typical fixed income security in the US economy.  So, the movement of rates among these durations is a more accurate measure of credit markets than movement of overnight rates.

One signal of cyclical disequilibrium is the discount accepted for avoiding duration risk.  It seems like, if we are using interest rates as a measure of monetary policy, a better signal of optimal policy would be a quickly recovering short term yield, which would be reflected in compression of rates among the higher durations.

Here is a graph of several durations of treasuries.  Note that 5 and 7 year treasuries move more closely in line with long term bonds than with short term bills.  Deviations in short term rates tend to reflect steep short-term yield curves, where rates are expected to fairly quickly recover (excepting the recent zero lower bound problem).


Before 1990, 5 and 7 year rates remained very close to long term rates throughout the cycle.  And when short term rates rose, long term rates tended to rise also.  In the 1991 contraction, we began to see periods where 5-7 year rates pulled down below long term rates, reflecting an expectation of slow recovery.  A lack of any inflation recovery during this time suggests that short term interest rates were not below the natural rate.  (It is worth noting that throughout the 1980s, the yield curve was fairly steep at the very short end, and flat at the mid and longer ranges, even while inflation was plummeting and remaining low.  Rates at the very short term range don't have that much of an effect on at-risk investment.)  But, when short term rates did rise in the 1990s, long term rates compressed and the full range of durations rose with them.

Source
In the 2000s, we continued to see these extended periods where 5 to 7 year rates fall below long term rates.  And, in the 2004 recovery period as well as today, the Fed is raising short term rates while that separation remains.  And, long term rates did not rise with short term rates.  So, compression happened, not as a function of recovered long term risk perceptions, but because of Fed tightening.  By the end of 2005, after the recovery of inflation from the very low levels of the recession, much of the excess inflation was coming from this premature tightening, which cut the bottom out of new housing starts, and sent rent inflation soaring.  Core inflation (less shelter) never crossed above 2% except for a couple brief periods in 2008 and 2010.

There is an assumption that the low short term rate was funneling cheap credit into risky investments, but a steep yield curve at short durations had been the norm for 20 years in a declining inflation environment, and, if we look at this from the long-term at-risk point of view, with discounts for risk aversion, the unusual spread between 5-7 year treasuries and long term rates was signaling risk aversion among savers.

Today is even worse than in 2004, because then the brief housing recovery did reduce shelter inflation before the tightening undermined new building.  Today we are already dealing with rent inflation and a lack of building.  A bold loosening in mortgage markets could counteract monetary policy now, but while there have been some signs of that, a full recovery of mortgage growth might require several fundamental shifts in the banking sector that would give borrowers with less than perfect credit access to the market, and this portion of the market seems totally blocked out right now.

So, looking at this from a bottom-up perspective, the Fed could raise short term rates to 2%, compressing long term rates from the bottom.  And, they could be looking at 2.5% inflation that is really 1.5% after factoring in the lack of housing supply, and they would think that low long term rates are stimulative, and high inflation is a sign of overheating.  If we are using interest rates as our monetary communication device, wouldn't it be nice if the Fed announced that they wouldn't begin to tighten until 7 year rates converged toward 30 year rates?


Secular Movements in Long Term Interest Rates

I had speculated that there could also be a secular benefit to seeing rates from this perspective, and that high long term rates and a low ERP (reflecting a low fixed income discount) would change the shape of investments, pushing investments into longer-focused, more risky projects.  Qualitatively, this seems to have been the case in the late 1990s, where a very low ERP was coincident with the internet boom.

Of course, the 15 years since then have not exactly been heralded as an era of high growth.   But, if we look at real GDP / Labor Force growth, there is actually a seemingly tight relationship between stock returns and GDP/LFP growth.

My proxy here for bond returns is based on the interest rate of Moody's AAA corporate bond yields.  There is not a systematic relationship here because long-term persistent trends in inflation have had a large effect on the real returns on fixed rate nominal bonds.  Although, the return on real bonds doesn't necessarily look like it would have any more systematic relationship to GDP growth.

The lack of a bond relationship suggests that my speculation doesn't hold.  Even if the theory can be defended, it looks like future growth is overwhelmed by real and nominal shocks.  So, it is the real GDP growth that is the causal factor in the relationship between equity returns and GDP/LF growth.

GDP growth is on the right scale and stock returns are on the left scale.  Long term stock returns follow pretty closely alongside GDP/LF growth rates, but with a scale about 10 times larger.  Over time, equities gain (lose) from the proportional rise (fall) of GDP, but much of the gain in returns should be coming from related higher (lower) growth expectations, since required total returns are fairly stable.  Here is a graph of total required returns to equity, based on Damodaran's measured ERP.  There is a bit of a dip in the early 70s and a bump in the early 80s, but this is partly due to the difficulty of estimating real bond rates during volatile inflationary periods.  Inflation expectations would be somewhat backward looking, and would depend on expectations of Fed behavior.  I have simply deducted GDP inflation from bond rates, here.  Inflation expectations were probably a little lower than actual inflation in the early 70s and slightly higher than actual inflation in the early 80s.  So, there was probably a brief period of higher required returns in the early 1980s, but not as pronounced as it looks in this graph.

To the extent that there was movement in the required total return, a low discount rate in the 1970s would have called for a higher relative valuation and the high rate in the 1980s would have called for a lower relative valuation, so this was working in the opposite direction of equity price trends and growth expectations trends, at any rate.  The idea of a low ERP being a policy target that would raise future growth levels appears to be weak.  ERP levels appear to be a lagging indicator.  So, they tend to decline when business cycles have been long and shallow.  Low ERPs are less a guarantee that we will do well than a sign that we have been doing well.


Equity Risk Premiums and Capital Income

But, even though low risk aversion either doesn't improve our capital allocation decisions or doesn't overcome the uncertain noise of real shocks, in the here and now, where the future has not yet been manifest, it still has an effect.

"dlr" left some great comments on the previous post, and put some firm doubts on the idea that corporate income wasn't down as sharply in the late 1990s as the BEA suggests.  But, I believe that there is still evidence that stability and high real growth expectations are related to current high compensation levels.

I don't ascribe to the notion that transfers from capital to labor are something good, in and of themselves.  Labor income is measured in terms of time, but capital income is measured in terms of time and risk.  So, this is a sort of free lunch.  In times of low perceived risk, capital owners gain the same level of utility from less income.  Naional income has risen, even if we don't have a simple way of describing or measuring it, because the rise is coming from a change in capital's denominator (risk).  Some of that unmeasured extra income accrues to labor.

These are a couple of graphs that I have shown before, along these lines.

And, real wage growth moves pretty strongly with the unemployment rate.  Here are a couple of graphs comparing real wage growth and the unemployment rate, first in a scatterplot, then in a line graph.  Nominal stability leads to higher growth expectations, lower ERP, lower unemployment, and higher wages.  And, these are hourly wages of production workers, so confusion caused by stock options and returns to entrepreneurs in the 1990s should not have an effect on this measure.  In fact, I would argue that real wage growth has been understated since 1995, since some of the inflation is coming from the supply problem in housing.

Source: http://www.frbsf.org/economic-research/files/JEP-slides.pdf
The Beveridge Curve moved to the right in the 1970s and early 1980s and appears to have shifted back to the right again recently, due to persistent unemployment.  Job openings during these high ERP periods appear to remain at normal levels, but unemployment rises.  That suggests that job openings per unemployed worker is not as large of a factor in real wage growth as the unemployment rate is.

One common bit of wisdom that I think is mistaken is that low unemployment will lead to inflation from rising wages.  But, I think employers are too forward looking for this.  They don't tend to raise wage rates in an inflationary response to temporary labor supply factors.  There are too many frictions related to their many cost considerations for this to happen.  The lack of a wage response to job openings corroborates this idea.

Instead, real wage growth is related to unemployment levels because the growth in wages is coming from labor supply.  In a low risk environment, employees are more free to move to higher productivity positions and better matches for their skills and characters.  Real wage growth comes from better job matching and more fluid labor markets.  In a way, the unemployment rate is a proxy for labor's "ERP" - the Employee Risk Premium.  And, this ties into the idea that lower ERPs lead to higher wages.

Another way to look at this is to think of an employment contract as having an embedded interest rate swap, where the employer naturally takes on the residual cyclical risks.  When ERPs (both kinds) are low, the discount that employees must accept in their employment contracts is lower, and wages are higher.  But, again, this comes from a complex foundation of risks, so the higher wage it leads to is higher in real terms.  The employer does not need to compensate with higher revenues because they are being compensated through lower perceived risk.

Friday, June 12, 2015

Behavioral Finance is the wrong framing for equities

Here is a new paper, on VoxEU (HT: EV).  A key section of the VoxEU summary:
Various studies, beginning with Shiller (1981) have concluded that the volatility in the stock market is too great to represent forecasts of future dividends or other measures of cash flows of corporations. As memorably described by Shiller, the stock market appears to exhibit ‘excess’ volatility, namely volatility that cannot be attributed to rational factors and rather reflects (in the words of Keynes) the ‘animal spirits’ of investors. 
Rare disaster models offer an alternative way to understand excess volatility. Rather than reflecting the day-to-day whims of investors, stock market fluctuations could reflect investors' changing views of the probability of a rare disaster. An increased probability of a disaster implies that future earnings are likely to be both lower and more risky. These effects combine to lower equity prices, even if a disaster itself does not take place. Thus, stock returns, which incorporate these probabilities, can be far more volatile than dividends or consumption, which reflect (primarily) the disaster itself.

I think this is a much more helpful way of imagining equity behavior than behavioral explanations of cognitive biases, fickle moods of fear and greed, and wildly fluctuating required return expectations.  I also happened to see this at an interesting blog called Spontaneous Finance, written by Julien Noizet (the post I am excerpting is a guest post by Justin Merrill.):
The natural rate of interest is equal to the return on assets for corporations. Most economists that try to model the natural rate mistakenly do it as the risk free rate or the policy rate. This is a misreading of Wicksell since he identified the “market rate” as the rate which banks charge for loans, and the important thing was the difference between the market rate and the natural rate.

This all corroborates with my intuition - to begin with the required return on corporate assets and to discount from that to get to low risk securities, instead of starting with a risk free rate and adding risk premiums.  As the Vox paper points out, there are many separate issues going on with equity valuations through a volatile episode, but, the net result appears to create a quite stable level of required returns on corporate assets.  We can model equities based on (1) earnings, (2) growth expectations, and (3) the discount rate.  If the sorts of risks about future changes in income in the Vox paper are manifest in growth expectations, equity valuations become kind of boring.

The discount rate appears to be quite stable over a long period of time - around 6-8%, in real terms, depending on the range of corporations included.  And, there appear to be countervailing influences on growth expectations through the business cycle.  There is a natural tendency for mean reversion, because equity owners are the residual claimants on national income, they tend to experience extreme income fluctuations through business corrections, which are basically disequilibrium episodes.  If the economy does recovery, that disequilibrium will dissipate, and corporate income will return to its natural level as a portion of national income (which is also very stable over time).  But, as Jerry Tsai and Jessica Wachter argue in the Vox paper, risks about the reliability of recovery are especially high during these contractions.  These risks include the possibility of outlier events, and the ability of firms to handle them, that create a drag on probabilistic growth forecasts.  In practice, the added risks related to contractions appear to generally mitigate the expectation of mean reversion, so that growth rates also tend to remain fairly stable over time.


This leaves earnings as the primary source of volatility in equity valuations, and, helpfully, this is a variable that is widely measured, tracked, and forecasted.  As the chart above shows, corporate valuations and earnings move together most of the time.  Even the large swings in valuations since 2003 have largely been in proportion to changes in earnings.  There are two distinct periods where valuations were untethered from earnings.  These periods coincide with unusually low real growth expectations in the 1970s and unusually high growth expectations in the late 1990s.*  In other words, even in the cases where valuations fluctuated, a fluctuating natural interest rate (on corporate returns) is not the likely explanation.

Now, one could argue that this is simply a semantic distinction - that I am just taking "animal spirits" that Robert Shiller would identify as a fickle discount rate and re-categorizing them as deviations in the growth rate.  But, even to the extent that that is the case, this framing makes equity markets much more simple and conceptually manageable.  There is no need to endlessly argue about unidentifiable investor sentiments.  The vast majority of relative equity valuations simply comes down to earnings.  And, where there has been a persistent deviation from the expected valuation, there have been reasonably identifiable sources of deviating growth expectations.  If you take a tactical position, you don't need to put a mood ring on the marginal investor.  You just need to justify a different growth expectation.  You don't even need to think about Treasury Rates, Equity Yields, or Equity Risk Premiums.

Equity valuations, compared to earnings, are roughly at the level trend that, with a little noise on either side and two distinct deviations, has been in effect for 50 years, and corporate growth expectations, which include significant foreign revenues, are 5 1/2% - a bit less than long term NGDP growth.  A bearish position here based on "bubbles" seems wrong.  A bearish position needs to depend on extremely low growth rates or a contractionary shock.


* I admit that the very low valuations of the 1970s are a bit of a mystery to me.  An explanation that I don't quite trust, because it fits my political priors, is that this was the result of the pro-consumption public policy at the time.  High inflation, together with policies such as high minimum wage levels and new public transfer programs, were geared toward the sort of pro-consumption goals that are still associated with a Keynesian paradigm.  Possibly the result of those pro-consumption policies came at the expense of growth oriented investment.

But, what's interesting is that the low real growth expectations caused valuations to fall below relative earnings as much by pushing earnings up as by pulling valuations down.  When expected growth is low, corporations require a larger portion of current income to satisfy investors.  Future corporate growth expectations don't just create higher future incomes.  They create higher relative compensation today because corporate owners substitute expected future cash flows for current cash flows.

And, look at what happened when the Reagan era supply side policies replaced the demand side policies of the 1970s.  I think most people would be surprised to learn that nonfinancial corporate profits didn't top the 1979 level until 1992, after 12 years of the Reagan and Bush presidencies, during a decade when Democrats sponsored tax cuts and the New York Times was against the minimum wage.  And, these are nominal figures while inflation was still high during this period.  From 1Q 1979 to 3Q 1986, nonfinancial corporate earnings fell 60%, in real terms.

Part of this was due to the high inflation premium going to debt, and I have argued that when considering returns to corporate assets as a portion of national income, operating profits to Enterprise Value is more appropriate.  So, here is a graph that adds interest expense and debt to the data.  I have also adjusted the numbers with the GDP deflator.  And, even with high interest payments included, real income on corporate capital declined from 1979 to 1986 and was just above the 1979 level in 1992.

In terms of the main topic of this post, using operating profit and enterprise value still tends to show valuations and profits moving together over time, but here the lag in valuation persists a little longer into the 1980s than it did when we just looked at profits and equity values.

And, we see the same result in the opposite directions in the late 1990s.  There, the high growth expectations caused valuations to soar.  And, since so much of the value of equities was based on future cash flows, corporate owners did not require current income to justify their investments.  So, by any measure, profits were falling during the boom years of the late 1990s, well before the 2000 recession.

In addition to suggesting the downward influence that growth expectations have on current capital income, this also belies the cynical myth that financial markets shortsightedly chase the next quarterly earnings report at the expense of long term value.  First, there is a consistent baseline of boring valuations that simply don't change that much relative to earnings.  But, when they do deviate, they deviate in the opposite direction from this myth.  When current profits were high at the expense of long term growth, equity values plummeted, and when current profits were low while firms plowed investment into highly uncertain long-term growth, equity values soared.

This is like one of those contradictions in consensus ideas that Marc Andreessen likes to tweet.  Everyone simultaneously knows that (1) financial markets are obsessed with short term earnings and (2) financial markets push us into recessions by throwing billions of dollars at outrageous tech. businesses that have no prayer of ever making decent profits.

Housing Tax Policy, A Series: Part 39 - Housing Values and Investment

In the previous post of the housing series, I discussed the ironic source of residential fixed investment during the housing boom.  Because our major metropolitan areas have limited the expansion of housing in their cities, households have had to substitute suburban homes in less valuable locations for homes in high value, high density cities.  The lack of housing stock in the cities that causes this substitution causes real housing expenditures to decrease while at the same time it causes residential fixed investment to rise, because those households tend to build more valuable houses on less valuable lots.  They are substituting building for location.  In other words, the high level of residential fixed investment was not a result of overconsumption of housing.  It was, ironically, a result of falling consumption due to constricted supply.

This graph might give some more clues to this issue.  As a starting point, the dark red line is the year-over-year (YOY) change in market values of real estate owned by households.  To arrive at the orange line, I have subtracted the YOY change in the S&P/Case Shiller National Home Price Index.  This gives us a rough estimate of how much of the rise in the value of residential real estate was the product of real expansion and how much was price appreciation.  The real increase in household real estate was normal or slightly low during the boom.


The dark blue line is residential fixed investment minus estimated depreciation, as a percentage of real estate market values.  This should give us the same basic result that the price corrected growth of real estate did, and in fact it does give us the same basic behavior, but with less noise.  By these measures, new investment in housing has been in decline for decades, including during the so-called housing "bubble".

Now, take a look at the light blue area.  This is residential fixed investment (RFI) as a proportion of gross rent, scaled to reflect depreciation.  It also tends to follow the same trends as the other investment measures.  But, since it has rent as the denominator instead of market values, the difference between this measure and the others is mathematically simply a reflection of changing Price/Rent ratios.  So, the three periods where RFI/Rent rises above RFI/Price are the periods were Price/Rent has been high.

A high Price/Rent ratio is caused by low long term real interest rates and high rent inflation.  Relatively stable construction costs mean that the higher price accrues to the lot.  This graph shows the replacement cost of houses as a proportion of total market value, and this declined as Price/Rent rose and as rent inflation has accumulated.

During these periods, households substitute building value for lot value.  And, if we look back at the first graph, during expansions, the price adjusted growth rate in real estate values has tended to fall below the growth rate estimated by RFI when Price/Rent (and RFI/rent) has been high.  The RFI measure is a measure of investment in buildings.  The price adjusted YOY change in real estate values is a measure of all real estate - land and buildings.  During these periods, investment in buildings rose but investment in land lagged.

After the cyclical spike in 2001, growth in real housing was low.  We were building a lot of houses where location values were low.  So, homes in the problem cities were climbing in value because of supply constraints and rent inflation - no real new housing value was created there.  And, households priced out of those markets were building "McMansions" in the hinterlands for a fraction of the price on lots with much lower values.


Economic Rents and Real Value

There is a subtle issue to think about here regarding economic rents on land and real economic production.  If we released the constraints on urban building and made it feasible for urban real estate owners to expand housing to its reasonable potential where its value is high, they would earn a large windfall as economic rents on those assets.  But, those rents wouldn't so much reflect a transfer of income as they would reflect the creation of value.  The added value provided by the higher capacity of the urban land holdings would increase real household consumption and real incomes of urban households (through falling shelter rent).  The orange line in our graph above would be higher.

Here's a funding idea for city governments in the worst cities (NYC, LA, San Diego, San Francisco, and Washington DC), if they just can't stand to see their land owners reaping a windfall.  Just go around buying up underdeveloped plots in voluntary transactions, then streamline the process for developing them and sell them to developers without restrictions on rent.  They could buy properties for a few million dollars, then allow them to have a high-rise condo building, and sell them to developers for hundreds of millions of dollars.  They could probably fund the city budget that way.  And, eventually rents will fall enough that the new condo buildings will be built for middle class households, and we won't have to keep building "McMansions" in the desert.

The only parties that will be damaged by that program will be the real estate owners who don't sell their properties to the city, and see their property values fall when rents begin to fall.  But, maybe they won't be so upset if the city has eliminated property taxes because of all the new revenue.  It's not that hard to come up with a win-win scenario when your current policy is to needlessly destroy value.


My Rent Inflation Assumption

I have been using core non-shelter inflation as the baseline to estimate the rent inflation that is caused by supply constraints.  I realize this is a little sloppy.  Even lacking regulatory constraints, no two items have the same price behavior over time.

As a general point of view, the cost of replacement graph above confirms the idea that there has been significant inflation in residential land values, above the cost of building.  Here is a graph comparing shelter prices over time to household furnishings and operations and to lumber.  In both of those cases, prices have been falling relative to core CPI, while shelter prices (mostly consisting of rent) have been increasing.  I suspect that, if anything, the use of core minus shelter CPI as a benchmark understates the level of supply-based rent inflation.

Over time, there could be some non-inflationary lot appreciation.  For instance, in fast growing cities like Phoenix, Houston, or Las Vegas, homes which were purchased and then subsequently had the city grow around them, probably experienced real value gains due to the value of living near newly developed amenities.  I don't know if the BLS accounts for that sort of hedonic adjustment or not.

On the other hand, while building in high-rise areas of core cities would be expensive even without regulatory barriers, it would generally be reflected in higher price levels, not ongoing inflation.  Skyscrapers may be somewhat more expensive than McMansions, per square foot of living area, but they aren't progressively getting more expensive over time.  So, natural price levels of housing in the cities might tend to be high, but there is not a natural reason for rent inflation to be high there.

Thursday, June 11, 2015

Mortgage trends in 2015 Q1

Why can't anything be easy?  2015 1Q Flow of Funds data came out this morning.  I have been hoping for regulatory and market adjustments to allow for more expansion of mortgage expansion, which would help to push home prices back up to intrinsic values and would provide investment demand, pulling interest rates up.  The convergence of interest rates and returns to real estate would earn profit for a position short on bonds and long on housing.

But, real estate loans retained at the banks have stalled in the past month, and while mortgage levels measured by Flow of Funds had stopped declining, they have been level.  This is a little bit surprising to me compared to anecdotal information I'm seeing in the Phoenix area.  It's a sellers market, and households with decent credit seem to be able to mortgage new home purchases.  Home price growth has started to turn up again, but it seems like there is enough activity to trigger more new building and to push mortgage levels up.

In 2015 1Q, mortgage levels actually turned down again.  But, the re-acceleration of home prices, combined with the decline in mortgage levels, caused household real estate equity to jump a full point, from 54.6% to 55.6%.  Before the real estate collapse, equity levels had been ranging between 58% and 60%.  Maybe under the new regulatory and market pressures, equity levels will tend to be higher, so that there isn't anything special about hitting that range.  But, it seems like some sort of signal of healing markets, if only because it would suggest that households would be less encumbered by negative or negligible home equity levels that prevent refinancing and home selling.

I don't have any direct evidence of a connection between foreign capital and these movements, but it does seem fitting that a large part of the decline in 2015 1Q GDP came from a larger trade deficit.  That suggests that there was a surge of foreign capital, which could be the source of price strength in housing without any domestic mortgage growth.

This complicates the housing/treasuries position.  The foreign capital will probably affect prices more than new homebuilding.  If mortgages continue to stagnate, this means that the homebuilder portion of the position will probably have a delayed reaction, and highly leveraged homebuilders like Hovnanian will need to muddle through a few more quarters before there is a positive growth surprise.  On the interest rate side, this has less clear implications than mortgage growth would have had.  New housing value grows the capital base, but I'm not sure of the effect on interest rates.  It wouldn't have as strong of an effect on the investment/savings balance as new building would.  So, I am not sure if interest rates will fall back because of the lack of mortgage growth or if they will remain fairly stable or rise slowly.  The uncertainty has pulled me out of the interest rate position, but I'm afraid that I will watch the potential profits slowly accrue to that position as I watch from the sidelines.

Wednesday, June 10, 2015

Housing Tax Policy, A Series: Part 38 - The World Record for Reasoning from a Price Change

As I was reading the 1000th account of our supposed pre-crisis over-investment in housing this morning, I realized that this whole chapter must be the most gargantuan example of reasoning from a price change, ever.  It wasn't the level of residential investment that triggered the panic about the housing market.  It was the change that we saw in prices.

I have argued that rising Price/Rent ratios were generally exogenous to the housing market - related to broader trends in interest rates and global capital flows.  Given the change in Price/Rent that we have seen, how would the reaction to the housing boom have changed if there were fewer constraints on housing expansion?  What if, instead of seeing higher rents on a more constrained housing supply we had seen falling rents on a less constrained housing supply?  Residential investment would have been higher, because there would have been more building.  Nominal price increases on homes would have been lower.  And, as a result of all of that extra residential investment, there would be much less moaning today about overinvestment in housing.  Reasoning from a price change leads everyone 180 degrees to the wrong conclusion.


Home Prices were high because Rent Inflation was high

In a previous post, I presented the case that the rise in home prices can be entirely accounted for with (1) the effect of long term discount rates on intrinsic values and (2) the full effect of rising rents on home values.  This is one of several graphs included in that post.

But, I neglected to take the next step in that analysis.  What would the counterfactual be if rent inflation had matched the inflation rate over this time of all the other non-rent elements of core CPI?

Next is a graph of home prices, nationally and in the Case Shiller 10 city index, along with a model of home prices based on long term discount rates, rent levels, and rent inflation rates.  And I have added the modeled national home price level, based on a counterfactual where rent inflation had equaled Core inflation (excluding rent).

How much concern would there have been about overinvestment in housing if home prices had only doubled in 20 years, instead of quadrupling (basically tracking inflation)?

Even the high real estate values that have persisted since the crisis would not have materialized, because the high intrinsic values now are a product of very low long term interest rates that are themselves the product of the collapse of real estate capital markets.


Rent Inflation was high because Residential Fixed Investment was Too Low

The amount of additional residential investment that would have been required in order to reduce rent inflation to levels to this counterfactual level would be a product of the elasticity of housing demand.  The next graph compares real and nominal housing expenditures.  Nominal expenditures have been level since the early 1960s.  (Homeownership rose after the Great Depression until it reached about 63% in the mid-1960s, which is roughly where it has remained since, except for the temporary push up to about 69% in the 2000s.)  Since 1995, when the latest period of rent inflation began, centered around the major coastal metro areas, real housing expenditures have fallen sharply while nominal expenditures remained level, as a proportion of personal consumption expenditures.  The long stability of nominal housing expenditures suggests a unitary elasticity of demand.  This is apparently slightly higher than the typical finding of slightly less than 1.  Households in the problem cities spend about 5% more of their incomes on housing than households in the rest of the country, which also suggests somewhat inelastic demand.  Possibly, national nominal spending on housing over this period increased slightly as a result of added tax benefits to home ownership.  This could explain why slightly inelastic demand hasn't led to a slight decline in nominal spending on housing as real housing expenditures have declined.

Long term elasticity of housing supply is generally found to be very high, which should make persistent rent inflation implausible.  This mystery fits well into the narrative that I am developing that regulatory limits to housing in the large metro areas is the driving factor in persistent rent inflation, and that rent inflation reflects the relative substitutability of real estate outside these areas for the preferred locations where building has been limited.

The average is mis-labeled.  It is for 1962-1995.
The next graph shows residential fixed investment over time.  When we eliminate the cyclical movements, I think this suggests that expenditures are very sensitive to small changes in residential fixed investment.  From 1962 to 1995, residential fixed investment (shown in the graph) averaged about 7.5% of GDP, and both nominal and real housing expenditures were at about the same level at the end of that period as they had been at the beginning.  From 1947 to 1962, nominal housing expenditures as a portion of PCE skyrocketed from about 11% to about 18%.  During this period, residential fixed investment was only about 1% above the 1962-1995 average.  And, from 1982 to 2007, when real housing expenditures fell, residential investment as a proportion of GDP averaged 7.3%, just 0.2% below the 1962 to 1995 average.  The secular variations in residential investment are smaller than the variations we see through the business cycle.

I have adjusted residential investment to create a counterfactual that would have led to stable real housing expenditures (and stable nominal expenditures, assuming unitary demand elasticity).  For instance, if real housing expenditures decline 0.25% in a given year, the counterfactural residential investment is adjusted upward by 0.25% of the value of residential real estate owned by households.  As the cyclically adjusted stability of residential investment suggest, it would appear to have taken a very small change in total residential investment to counter rent inflation.

Because this problem has been so persistent, it is easy to assume that rent inflation is a natural part of city dynamics.  The many growing metro areas that don't share this characteristic should serve as evidence against this notion.  And, if we look at rent inflation over time, we see behavior that appears to relate to the level of residential investment.  When building was allowed to expand, we did not have persistent rent inflation.  From the beginning of the core inflation series in the late 1950s until the late 1970s, shelter and core inflation generally moved together.  Shelter inflation first moved significantly above core inflation during the building contraction associated with the 1980-1982 recession.  Residential investment failed to move back above the long term average in the ensuing recovery, and so shelter inflation failed to recede back to core inflation levels.  Then, after the 1991 recession, residential fixed investment failed to even reach the long term average until 2003.  And rent inflation has been well above core inflation for most of this period.

The reason that this is even a topic of discussion is because nominal home prices rose to such heights.  Because practically everyone, from populist pundits to skilled economists, is reasoning from a price change, they associate the high home prices with high demand and high residential investment.  But, if only we could have had just a small amount of additional residential investment (focused in the large coastal metro areas, where the natural market supply response has been constrained), home prices would have been tame.  If only residential investment had been higher, nobody would be complaining that it had been too high!


The Substitution of Fixed Investment for Location Value

I made my own error in a recent post where I suggested that urban real estate owners were working against their long term interests by fighting against urban progressives who want to control the housing stock.  I was actually the one being short-sighted in my analysis.  Urban real estate owners do earn excess rents on the artificially high values of their actual properties.  But, they would clearly be better off in absolute dollar terms if they were earning normal returns on their potential properties.

In other words, they would earn much higher profits on their land by financing a 40 story condo building that earned 4% net returns than they earn on the same lot with a couple of duplexes that are currently earning 6% net returns plus 1% annual capital gains from rent inflation.  They are earning excess profit on the land they own, but that land is being prevented from providing the housing stock that it is capable of providing.  It is clearly in their self interest (and our collective interest) for them to develop that land further.

And, I think this adds a subtle twist to the picture of residential fixed investment in the 2000s.  Rent inflation moderated from 2003 to 2005, when residential fixed investment rose.  But, it was still running slightly higher than core inflation.  Why didn't this high level of investment cause rent inflation to fall below core inflation, reverting to lower levels?

The effect of limited building in the cities is that landlords are capturing higher rent for limited housing stock.  If housing wasn't limited, they would be capturing lower rents on expanded housing stock.  So, if housing was allowed to expand in the cities, capital income would be accruing to urban land owners, but it would be accruing to them for providing housing, not for owning an artificially scarce resource.

Now, high rents and limited housing in the cities is pushing households out to the suburbs and exurbs.  One effect of substituting lower value locations for the high value urban locations is that households purchase larger homes.  So, in the constrained context that we have created, fixed residential investment has been inflated.

Residential fixed investment never really rose above the historical range.  But, even the levels it did reach were inflated by our anti-housing metropolitan areas.

If urban development had expanded, households would have favored urban housing where more of their housing expenditures would go to rents on the land.  This is a scenario where capital income would have increased, but as a result of broad improvements in real living standards.  Lower rent on housing would mean that real incomes would be much higher.