Purgatory is preferable to hell

Another year is upon us. Notwithstanding celebrations that are routine and unthinking for the most part—since the New Year is an artificial construct—many acknowledge that uncertainties and anxieties loom large on the horizon. Barry Eichengreen, in one of his last articles in the year 2016, said he thinks that John Kenneth Galbraith would have called the 1970s the age of assurance instead of the age of uncertainty, had he had the perfect foresight about current times.

In its closing weeks before a new government takes over in the US, the Barack Obama administration has shaken the kaleidoscope so much that it might be difficult for someone to rearrange the pieces. The sanctions on Russia and the abstention in the UN security council resolution on Israel have left the world scrambling to respond. It was left to Britain—America’s natural ally—to chide its bigger brother on the other side of the Atlantic for its attitude towards a democratically elected government in a friendly nation. Well done, Britain. In years to come, the presidency of Obama would be rightly judged to be not only economically unproductive but also destructive and divisive.

In the meantime, an article in The Wall Street Journal suggests that some of Donald Trump’s appointees are in favour of rolling back regulatory constraints on the banking system in return for higher capital ratios. That is a very good start. Indeed, whether the swamp is drained or allowed to remain would be very much determined by the actions taken with respect to the financial sector. Reining in financialization is the key to tackling income and wealth inequality and distortions caused to the real economy by debt (leverage, in general) and leverage-backed surges in asset prices.

The wealthy with a guilty conscience and certitude about their answers for the world’s problems have caused more harm than good. In contrast, the rich who have succeeded, are proud of it and would work to make it possible for others to emulate them, would be a force for the good. It is hard to say whether Trump appointees belong to the second category. Tax cuts and deregulation might be what the doctor ordered for the American economy but the criteria for their effectiveness and desirability is that those who voted for Trump do not feel cheated.

Regardless of what the incoming government does, it is hard to avoid the thought that both the American economy and financial markets are enjoying their last hurrah. The current economic cycle is in its eighth year. Nothing prevents it from completing a decade. But, the last time the American economy did that, in the postwar period, it ended with a spectacular bust of the bubble in technology stocks. Before that, the longest economic expansion was from February 1961 to December 1969. Again, we know what came after that. The point is that the longer this cycle lasts, the greater the ultimate distortions and capital misallocations will be. The post-election surge in stock prices points to that.

However, in his most recent quarterly newsletter, written before the American presidential election, veteran investor Jeremy Grantham made an important distinction between the post-2009 surge in stock prices and other bubbles. Put simply, the asset price cycle since 2009 does not meet the criterion for a bubble. There has been no euphoria associated with it. More than investor euphoria, central planning (sorry, central banking) and stock buybacks have driven the rise in American stocks. Therefore, he predicts a rather slow half-death for the bubble, not a spectacular crash. That is, the bubble does not end with a bang but with a whimper because discount rates have shifted lower materially. At the same time, the brunt of the lower nominal gross domestic product (GDP) growth that lower interest rates reflect, in part, has been borne by labour than by capital. Therefore, corporate profits have held up despite declining nominal GDP growth. Therefore, elevated asset prices have been justified and discounting them using old interest rate metrics may no longer be appropriate. The past is not a reliable guide to the future, and that this time may really be different. Therefore, there may only be a two-thirds mean reversion to historical valuations over a 20-year period.

This is quite different from the investment returns in “purgatory” and “hell” scenarios that GMO official strategist James Montier broods over. The hell scenario will generate lower returns for investors over the long term but there won’t be sharply lower returns in the near future (next seven years) because of currently elevated prices.

Personally, I believe that there is rarely a good time to argue that this time is different. To assume that corporate profit margins would sustain at current elevated levels or that discount rates would remain as low as they are, for a prolonged period, might just be a case of being influenced by the present and weighting it more than long-period history. Pricing power for labour might not return because of technological developments but that would destabilize society, consigning elevated corporate profit margins and much else to history. Further, if financialization of the American economy and the global economy were to reverse, much of the speculation over this time being really different would vanish. Therefore, to allocate more to stocks after the recent stock market rally and rise in bond yields might be just the sort of mistake that retail investors have committed traditionally.

V. Anantha Nageswaran is an independent financial markets consultant based in Singapore. Read Anantha’s previous Mint columns at www.livemint.com/baretalk