Last year, Evidente published a report entitled The Dangers of Safety. Assets with safe haven characteristics - notably sovereign bonds, corporate bonds and low beta stocks - had delivered strong returns since the financial crisis, with bond holders doing better than shareholders. From the perspective of valuation theory, investors had lifted their expectations of future cash flows and dividends from defensive stocks relative to cyclical stocks. But the rush to safe haven attributes also pointed to lower expected returns from bonds and low beta securities.
Evidente has previously argued that a rise in the equity risk premium represents the most plausible explanation for the discount rate effect which benefited defensive stocks, because in the CAPM there is a multiplicative relationship between the risk premium and a stock's beta. So a rise in the risk premium, controlling for other factors, is associated with a lift in the expected cost of equity of high beta securities relative to their low beta counterparts.
Of course, the risk premium is not directly observable, unlike the risk free rate. But it was reasonable to infer from developments that the risk premium had risen since the financial crisis: the spread between earnings yields and government bond yields had been widening even before the onset of the financial crisis, corporate bond spreads had increased - moreso for sub-investment grade issues - and hurdle rates used by the corporate sector for the purposes of capital budgeting had remained sticky despite the decade long decline in the yield to maturity on long dated government securities and the historically high rates of return on capital.
It remains puzzling that the high profit share has not induced a capital boom. After all, the basis of capitalism is mean reversion in rates of return on capital; activities that are highly profitable should encourage an influx of capital, from both incumbents and new entrants, which subsequently erodes abnormal returns.
Network effects, high barriers to entry and capital light
Larry Summers has developed a widely known theory that seeks to resolve this puzzle. The US stock market has come to be dominated by a small number of large IT firms that have high profitability and low capex requirements, including the likes of Apple, Google and Microsoft. The benefits of first mover advantage associated with network effects has facilitated a shift towards highly profitable and capital light activities that are characterised by high barriers to entry. In contrast, the old economy firms that once dominated the US economy were typically capital intensive.
The data lend some support to Mr Summers' view. First, there has been a rising trend in the corporate profit share over the past four decades. Since the late 1980s, the cyclical peak in the profit share has continued to increase from 8% (1989), 10% (1997), 12% (2007) to 12.5% (2014). The chart below denotes the last three peaks with green circles. Despite this trend, the US economy's capital intensity has diminished since the early 2000s. The peaks in the capital cycle - denoted by the red circles - have declined from 14.5% (2001), 13.5% (2008) to 13% (2015).
A decomposition of the aggregate data on non-residential gross private domestic investment reveals an even weaker picture of 'old economy' capex. Investment in intellectual property products has expanded by almost 50% since the financial crisis to $800 billion (see chart below). In contrast, more traditional and capital intensive activities have been much weaker. Investment in equipment is around 10% higher than its pre-crisis peak, while investment in structures (eg. infrastructure and buildings) remains below its pre-crisis peak.
Despite the long-run divergence between the US economy's profit share and business investment share in recent decades, there has been plenty of cyclical variation of both series in between. Most obviously, the profit share plunged to 7% at the depth of the financial crisis. This cyclical variation provides scope for complementary or competing theories of the divergence. I believe that the lift in the risk premium that precedes the financial crisis complements Mr Summers' theory of a compositional shift towards more capital light activities associated with high barriers to entry. Mr Summers cites the low level of the VIX index of implied volatility as evidence that the risk premium has not increased. I believe that the VIX represents a poor proxy of investors' perceptions of risk.
More risk = less investment
The perception of greater risk from the perspective of a company undertaking capital budgeting decisions ought to be reflected in higher discount rates used, or the target of a higher internal rate of return (IRR) before a project is accepted. After all, a higher discount rate - controlling for a prospective project's projected cash flows - reduces its net present value. The fact that the decade plus long decline in the risk free rate has not induced a capital boom suggests that corporate hurdle rates have remained sticky. In other words, there has been a commensurate lift in the equity risk premium implicitly used by companies. The higher risk premium has therefore meant that the rising profit share and profit margins of the US corporate sector has not lifted expected risk adjusted rates of return. This represents a viable explanation for the divergence between profits and capital investment.
The great reversal
In the report The Dangers of Safety, I suggested that the at some stage, the reversal of the rising risk premium would have significant implications for stock markets as well as the divergence between profit share and capital investment. Two key financial market developments since mid-2016 suggest that this reversal is now underway.
Convergence in bond and earnings yields starts (finally)
A school of thought had emerged in the past decade that argued that stock markets were cheap because the decline in the risk free rate had not translated into lower earnings yields (or higher multiples). The earnings yield for the S&P 500 companies of around 6% at present is comparable to the level that prevailed in around 2002. Up until mid-2016, the yield to maturity on 10 year Treasury bonds has declined by over 300 basis points (see chart below). A lift in the equity risk premium that broadly offset the lower risk free rate can explain the divergence. Conversely, the earnings yield has remained little changed since mid-2016 when long term sovereign bond yields have increased by 100 basis points, lending support to the view of a decline in the risk premium, particularly given that long term growth expectations for GDP and corporate profitability have remained little changed over this time.
Lower corporate default risk
Corporate bond spreads have fallen substantially over the past year, pointing to expectations of lower default risk as well as higher recovery rates. The yield on triple A rated bonds minus the risk free rate has fallen to 1.5% from over 2%, while the spread on lower investment grade Baa rated bonds has fallen by proportionately more to 2.2% (see chart). Despite these falls, they remain higher than historical norms.
The outlook for the equity risk premium and animal spirits in the household sector
The reversal of the decade long plus rise in the risk premium is unlikely to be a linear one; asset market developments rarely are. Although Evidente has provided a framework for understanding market implications of shifts in the ERP, what remains unexplored are the underlying causes of swings in the ERP. Whatever the right theory is, the discount rates that investors use to discount future expected cash flows or dividends, and the hurdle rates used by CFOs in capital budgeting must surely be related to the discount rates that households implicitly assign to their own future expected cash flows. In other words, a plausible theory must link discount rates and risk premia across financial markets, corporate sector and household sector. It would be difficult to reconcile evidence of a lower risk premium in financial markets and the corporate sector, with a rising risk premium in the household sector.
But given that the present value of human capital (simply the sum of discounted household cash flows) is not directly observable, what can be used to infer something about the state of animal spirits in the household sector? The consumption of durable goods represents a good starting point. After all, consumers are more likely to purchase white goods and other long lasting items when they become more optimistic about their own future economic prospects. It is has been a volatile path for durable goods consumption in the United States since the financial crisis. It took five years before spending on durable goods spending returned to its pre-crisis peak and even now it is only 20% higher than its pre-crisis peak (see chart). The green circles denote the frequent episodes of either a slowdown in growth or outright contraction in durable goods consumption.
Evidente has suggested that financial market developments since 2016 point to a lower risk premium, but that it probably remains high by historical standards. The more recent reversal seems to line up with renewed growth in spending on durable goods in the past year. If the shift to a lower ERP is to continue, much will depend on the psychology of the consumer. To that end, Evidente will be closely monitoring trends in durable goods consumption.
Concluding remarks: The coming compression (and the dangers of safety re-visited)
To the extent that the risk premium continues to fall, the dangers of safety will continue to evolve. In the cross section, stocks will out-perform corporate bonds which will out-perform government bonds. Within the stock market, high beta securities will outperform stocks with safe haven characteristics, proving a challenge for systematic funds seeking to exploit the low volatility anomaly.
As far as the US corporate sector goes, a lower ERP will be associated with a revival of animal spirits amongst CEOs and CFOs. Even if hurdle rates remain sticky, higher expected cash flows and higher risk adjusted rates of return from prospective projects will usher in an influx of new capital. The subsequent boom in capital investment is likely to erode abnormal rates of return on capital. If history is any guide, episodes where a capital boom coincides with a compression of the profit share are not kind to shareholders.