Vaccine Failure, Market Expectations and Inflated Valuations

For the last year and a half the biggest sentiment driver in markets has undoutedly been COVID-19. This is perfectly reasonable as the virus is probably the biggest single driver of variables that matter in financial markets – from inflation expectations to earnings. Yet it has been striking that most financial analysts have been outsourcing their analysis of the trajectory of the virus to those in public health.

In theory this is reasonable. Many are assuming that the public health experts are, well, experts. And since financial analysts are not experts in epidemiology, deferring to those that are is a rational course to take. Yet if this pandemic has made one thing crystal clear it is that the public health experts are far from infallible.

This seems to be coming to a head this week. This week at least three major newspapers are throwing in the towel and admitting that the vaccine is not nearly effective enough to get the virus under control. The Financial Times runs the headline “Are vaccines becoming less effective at preventing Covid infection?”; the New York Times has “Israel, Once the Model for Beating Covid, Faces New Surge of Infections”; while The Times of London has “Double Covid vaccine doesn’t stop symptoms for half of Delta cases”.

The problem here for markets is simple enough: reflation and solid earnings growth was thought to be coming because the vaccine would return things to normal. Now that this looks unlikely, it is difficult to provide an alternative rational for reflation and solid earnings growth.

Are the markets waking up to this? Maybe. UK gilt yields have been tracking hospitalisations and in recent days they have ticked up.

Inflation expectations took a dip too, although they later reversed.

It seems fair to say that markets are currently attempting to process the facts as they come in. There is no way they are at the point where they are accepting widespread failure of the vaccination program, but they are starting to feel out this possibility.

This isn’t just a question of interest to traders either. Investors should pay close attention too. Stock market valuations have gone truly nuts on what we must assume are very inflated future earnings growth expectations. The Shiller CAPE is at it’s second highest point in history.

Tobin’s Q has gone totally gangbusters, now exceeding any previous peak.

Q Ratio

These are markets priced for perfection. Yet as we enter autumn/winter with a vaccine that is not keeping to the promises made on its behalf, we could be facing down another wave of the virus. This will then spur debate about more interventions that will impact the economy and with it earnings.

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Inflation, Real Earnings and Recessions

In my previous post, I laid out some issues with the methodology being used to explore the relationship between inflation and asset prices.

One issue that I raised was with respect to the observation that inflation below 1% seemed to lead to lower stock market earnings. In the previous post I pointed out that this was likely misleading: it was unlikely that the low price growth itself was giving rise to such poor earnings; it was far more likely that this was mainly being driven by recessions that in turn caused low price growth.

In this short post, I hope to be able to show this. Here we will be using a different sample due to our needing quarterly real GDP figures to do the calculations. Here is the full sample of real earnings growth categorised by inflation bucket.

Here we see much the same pattern we saw in the post-1925 sample. It shows that historically high inflation (above 5%) and low inflation (below 1%) have been associated with low real earnings growth. Now let’s strip out recessions. (For the sake of simplicity I will not use NBER recessions but rather any quarter that saw negative real GDP annual growth numbers).

As predicted, the negative real earnings growth in very low inflation regimes disappears. True, the real earnings growth in these low inflation regimes is lacklustre, but it is not negative.

In addition to this, real earnings growth in high inflation regimes has also improved on a relative basis. This means that at least some of the impact that see on real earnings during inflations is actually due to the recessions that take place in those inflations.

This is a fairly easy exercise. It was fairly obvious when given any thought whatsoever that the poor earnings growth in very low inflation regimes was probably driven by recessions. The really interest question is this: is there a variable that is not inflation that might be driving the low returns in the inflationary period we have in the sample?

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Prolegomena to a Discussion of Inflation, Asset Returns and Real Earnings

Many today are examining the impact that inflation has on asset prices. One of the best papers on the topic is by Harvey et al and it is well worth a look. What I am going to write here does not refute these sorts of analyses, but I think it raises issues that at least serve to lower our confidence in the findings.

The issues that I want to explore are as much methodological as they are empirical, but these two aspects can be approached simultaneously.

When analysing equity returns, the tendency is to examine what has happened in the past and extrapolate this into the future. There is nothing inherently wrong with this approach and it certainly gives us one window into the dynamics of asset markets, but sometimes it can prove misleading. This especially so when it comes to a very historically contigent phenomenon like inflation.

Take the well-known correlation between energy stock returns and CPI. Analysts often take this correlation to mean that energy stocks are an inflation hedge. In assuming this they are implicitly saying something like: “Inflation is a cause of relative energy stock outperformance.” As evidence of this, they show the correlation between these two phenomena in the historical data.

But now consider this: that series is dominated by a single inflation, the inflation of the 1970s. Yet this inflation itself was in large part caused by a run-up in energy prices as the OPEC countries hiked the oil price in response to the Yom-Kippur war in 1973. The more realistic causal account then runs something like this: OPEC raised oil prices for geopolitical reasons; this gave a boost to energy stocks; it also gave rise to inflation.

The correlation between inflation and energy stocks is thus spurious. It is driven by a third variable: the OPEC price hike. All this correlation tells us is that energy stocks will do well when energy prices are hiked. Not exactly a genius-level insight.

To get a better sense of the causal dynamics we should step back. In theory, how should inflation impact stocks? Presumeably it should impact them through its effects on real earnings. If inflation hits and real earnings remain buoyant then – not to put too fine a point on it – who cares? If stock prices fall during an inflation and earnings remain buoyant investors should see that as a buying opportunity and so inflations are merely a behavioural driver of bargain basement buying periods for smart investors. So, in order for inflation to have a true negative impact on equities it should be hitting the company’s bottom-line – otherwise it is just noise.

Here is real earnings annual growth for the S&P sorted into various inflation buckets using Shiller’s data.

Now we are starting to get a sense of how inflation actually impacts companies’ bottom lines. It appears that, at least historically, high and very low inflation regimes have overlapped with periods of low real earnings growth.

Let us pause here for a moment to firm this up because in this data there are two very different inflationary regimes as can be seen below.

Up until around 1925 CPI was incredibly unstable. This was the period of flex-prices in the US. After this, prices became much stickier. So, let’s also seperate out the more sticky price regime we live in today to make sure we’re not being fooled by structural breaks in the data.

The post-1925 era is a little different to the full sample. Very low inflation/deflation is now the worst possible regime for real earnings growth historically. CPI of 1-2% is now the sweet spot, but the full sample sweet spot of 2-5% is still pretty rosy.

At this point it would be tempting to tell a tidy story about inflation and real earnings growth. But remember that spurious correlation from earlier? Let’s tread carefully.

One simple test to see whether the various levels of inflation are causing the low real earnings growth is to run non-linear regressions. If the inflation is causing the low real earnings growth we should see that relationship clearly in a regression. Since the historical data suggests that high inflation (over 5%) and low inflation (under 1%) overlaps with low real earnings growth, we should be able to fit a second-order polynomial to the data and it should look like an upside-down smile. Crucially, however, this second-order polynomial should produce a high correlation coefficient. Here is the model fitted to the data – both full sample and post-1925.

The shape of the fitted curve looks good but the correlation, well, it sucks.

This implies – implies, not proves – that there is no hard and fast relationship between inflation and real earnings growth. Thus all the historical data tells us is that, in the data sample that we have, real earnings growth were lower in both low and high inflation periods. But it seems likely that something else could have been causing the low real earnings growth.

Take the example of low inflation growth for simplicity. Why would periods of low real earnings growth overlap with periods of low inflation – especially in the fixed-price regime post-1925? A little thinking and the answer becomes obvious: these are recessionary or depressionary periods. It is not the disinflation causing the low real earnings growth, it is probably the recession/depression.

Okay, so what should we learn from all this? Others will tell you what to invest in based on previous events. I will tell you to take these analsyses with a large pinch of salt. In reality, because inflation is such an historical and contingent phenomenon, at best we will need a much, much more sophisticated analysis to determine the actual effects of inflation on equities and on equities market. We will need to control for other factors, most notably fluctuations in GDP and we would probably do better focusing on the point at which inflation may impact the bottom-line of companies – not on simple correlations with asset returns.

A negative finding, yes. But a necessary one to stomach before moving forward if we are to approach this seriously.

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Why Lower Yield Treasuries Are More Attractive Than Higher Yield

In what follows, I want to draw out some implications of an interesting post by Greg Obenshain at Verdad Capital. In the post, Obenshain laid out data showing a number of things about Treasury bonds. Most notably, that they are a great investment if you are worried about the prospect of a recession or depression – and this is so no matter at what starting yield you are investing.

One of the exhibits Obenshain showed, however, did not get sufficient attention. I think that it may have something to tell us about how we can start to think about his findings in an actual investment context.

Let us frame the discussion in terms of a standard 60/40 portfolio. But let us ignore the 60 for the moment and focus on the 40. Typically, the 40 can be disaggregated into cash and bonds. Usually, we are talking 30 in bonds and 10 in cash – although there are no firm rules for this.

Okay, so how might we start thinking about deciding how to allocate to cash versus bonds. One way to do this might be to take a familiar model from monetary economics and merge it with a familiar model from financial economics.

Below we have two such models. On the left, is the liquidity preference (LP) model from Macro 101. The red LP curve shows that, at higher/lower rates of interest (i) lower/higher amounts of cash (M) will be held by investors. The intuition is simple: a higher interest rate means higher return on cash savings invested, and this means less cash held.

On the right, we have something resembling a CAPM model. I have simply called it the risk-return (RR) curve and it shows that, in theory, a higher yield – in this case, the interest rate (i) as we are dealing with bonds – should compensate for higher risk measured as volatility.

When we add the RR curve to the old liquidity preference model we get what the economists call an equilibrium outcome. What we find is that a decision-maker using such a model would balance their desire for the higher yielding asset with their aversion to the higher levels of volatility entailed.

Now, here is where it gets interesting. Obenshain shows that volatility is not actually an increasing function of the interest rate. Chart below.

Instead what we see is that the one-year forward change in yields is ‘contained’ up until the interest rate rises to around 9%. After this, the market becomes more volatile. We can modify our little model to capture this.

Here I have included two seperate boxes, A and B. In box A there is no risk-reward trade-off, while in box B there is. What this means is that when we are in box A – roughly below 9% nominal interest rates on a 10-year bond – our allocation to bonds is purely driven by our desire for yield. While in box B we have to also consider volatility.

What does all this mean in plain English? We must be clear that this all rests on the assumptions embedded in the model. But if we accept them, then it means that on a purely mechanical asset allocation basis, lower yield Treasuries (sub 9%) are actually more attractive than higher yield Treasuries (above 9%).

“No way!” you might say, “When markets and/or the economy get rocky having higher yielding Treasuries are a boon because their yields will fall further and provide higher returns.” But Obenshain’s data shows that this is not the case.

Below is a regression plot of Obenshain’s two samples. The regressions shows the relationship between the starting Treasury yield and the total return in the period. The blue series are NBER recessions, the orange are S&P500 drawdowns greater than 10%. (I have removed the extreme outlier in 1981-82 as it throws the regression off).

There you have it. On a purely empirical basis we should be ‘indifferent’ to the starting Treasury yield insofar as we are seeking protection against recessions or stock market drawdowns. Yet on a theoretical basis – assuming we do not like volatility – we should be more inclined to invest in lower-yielding, sub-9% Treasuries.

It can therefore be said that it is, on balance, better to invest in lower-yielding than higher-yielding Treasury bonds. Pretty counterintuitive.

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New Review of My Book

A nice review of my book by Marc Morgan has appeared in American Affairs. Morgan works with Thomas Piketty at the World Inequality Lab at the Paris School of Economics. He is doing interesting work on profit accounting and determination.

I would also note that Morgan attended the same secondary school (high school) as me in Dublin. Apparently, Christian Brothers College, Monkstown — although not a very prominent school in any meaningful sense — is creating a lot of heterodox economists. Or, perhaps, the children of my generation found the free market nostrums they were handed by the pre-2008 politicians so nauseating that they decided to critically study economics. Who knows?

Morgan’s review is excellent and although I could pick over details, I won’t bother. I will note one thing, however. Morgan’s review is extremely extensive but, when it comes to the theoretical architecture I lay out in the book, seems to focus heavily on profits and distribution. This probably reflects Morgan’s own research priorities and there is nothing wrong with that.

That said, however, I thought that this section of the book — while important — was almost wholly derivative and widely known by people well read in heterodox and especially Kaleckian economics. Perhaps my explanation was more lucid — I should be happy if it were — but it was not any more original.

The section of the book on finance and investment, on the other hand, I thought was the most original part of the theoretical section of the book. While there is a case to be made that the theory of finance is not wholly original, resting as it does on modern finance theory, Keynes’ theory and GLS Shackle’s theory, I nevertheless think that it is an oirginal synthesis.

In spite of this, no one has yet assessed it in any detail.

Anyway, the review is fantastic and I recommend it to all.

The Reformation in Economics: Back to the Future

 

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How Far Can We Push This Thing? Some Optimistic Reflections on the Potential For Economic Experimentation

Readers are probably aware that there is quite a lot of discussion of Modern Monetary Theory (MMT) and the potential for fiscal experimentation batting around at the moment. Others have weighed in on this already, and I have little to add.

It is striking, however, that most of the push-back — where there is push-back — is not focused on trying to discredit the idea that we should engage in fiscal experimentation. Indeed, the notion that we should engage in fiscal experimentation seems to be, if not mainstream, at the very least part of the discussion.

Yet, vulgar strawman-style arguments against MMT aside, no one seriously disputes the fact that if too much fiscal expansion is undertaken the economy will eventually hit a hard inflation barrier, past which any increase in spending will generate inflation rather than real output expansion. Interestingly, no one seems to have tried to come up with a new framework for estimating where this inflation barrier might be and whether it is too risky to overshoot it.

So, I’ve decided to fill that gap. Linked below is a paper where I use a new capacity utilisation-based framework to provide hard, yet optimistic numbers of how far we might push the economy in the spirit of fiscal experimentation.

I find that we could probably safely increase the current US fiscal deficit by around 5% of GDP structurally — that is, from the current level of around 3.8% of GDP to around 8.8%. This would give rise to annual real GDP growth of around 6% and a once-off shot of inflation that would drive the annual growth in CPI to around 4.9%. As I say in the paper, this would then lower the private debt-to-GDP ratio from around 200% of GDP to around 190% in the first year and this decline would continue every year that the new 5% rate of inflation was maintained.

I argue that, based on a new framework I’ve developed for measuring the likelihood of sustained, runaway inflation that I call the Worker Bargaining Index (WBI), it is highly unlikely that a sustained inflation will result.

That said, after undertaking such an experiment, we would be wise to watch whether sustained, overly high nominal wage growth results and if so take action. Given the current institutional arrangement, tight monetary policy would probably be the best response but it would also be possible to tighten the fiscal stance.

So long as nominal wage growth merely kept pace with the new 4.9% rate of inflation and did not greatly outstrip it, the economy will certainly be safe from a wage-price spiral. We probably want to see some real wage growth, however. At the very least we should want to see real wage growth keeping pace with productivity growth. And given the redistribution from labour to capital in the past few decades, we may want to even see real wages outpace productivity growth, for a few years at least.

It should only be if there is clear evidence that wage growth is getting out of control that we should consider slamming on the brakes. If we start to see wage and inflation growth feed upon each other that should be our signal to act.

Here is a link to the paper:

How Far Can We Push This Thing?

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Some Reviews of My Book

I have come across two academic reviews of my book which can be found here and here. There is also a nice popular review in the Irish Times that can be found here.

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2017 Presentation on Ireland

My 2017 presentation on Ireland and the Eurozone has been uploaded to YouTube. See the previous post for the link to the full conference, which includes the Q&A.

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Presentation on the Irish Economy

On Monday of this week I gave a presentation on the current state of the Irish economy at a conference on the future of Europe at the LBJ School of Public Affairs. My presentation begins around the 33 minute mark and is followed by some Q&A. It can be accessed here:

Presentation on the Irish economy

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Book Launch in Parliament Earlier This Year

On Tuesday 16th of March 2017 Robert Skidelsky and I launched my book The Reformation in Economics in the Clement Attlee room in the House of Lords. It has taken some time to upload these videos of Robert’s and my comments. Most of the speeches were captured but I have included my own text below (I did not end up sticking to the written comments verbatim).

On a separate note, Brian Romanchuk has written a short review of the book here.

Hi everybody,

 

Thanks very much for coming. I’m pleased to see that you’ve shown some interest in the book.

I won’t beat around the bush. I’ll get right to it.

What is the key question that the book seeks to address? It is this.

To what extent is economic theory an ideology and to what extent can it be thought of as a neutral tool which can be used to explore and possibly improve reality?

What I mean by ‘ideology’ is not a political ideology – I’m not concerned with whether you lean Tory or Labour. Nor do I mean a worldview or Weltanschauung – such as Marxism, libertarianism or communitarianism.

What I mean by ‘ideology’ is a mode of thinking that does not seek to attain Truth – but rather seeks to attain Power. A mode of thinking that seeks to justify a certain social or economic order.

The argument that I make in the book is that a good deal of contemporary mainstream or ‘marginalist’ economics is in fact ideology in this sense.

BUT – and I hope you will have some sympathy for this claim – I also argue that there are aspects of economics that are not ideology. That is, there are aspects of economics that do in fact aim at revealing truth – rather than imposing power.

These are the aspects of economics that seek to explain the facts of the world as we see them – and, in the best instances, give us structural explanations why these facts line up in the way that they do.

If we are going to be serious, however, I think that we need to ask firmly: which is which? Which aspects of economics seek Truth and which seek Power? And in order to do this we must inevitably start with some robust epistemological questioning of economic theory.

Until now I think that economists have been somewhat cagey about discussing epistemological issues. To be frank I think that this reluctance is due to the fact that the epistemological foundations of modern economics are a little embarrassing. The “assumptions don’t matter” approach of the marginalists tends to crop up in conversation like an uninvited dinner guest or a weird uncle.

On the other hand, those that have criticised economics for being “too unrealistic” or based on flimsy assertions often seem to find it difficult to lay down clear criteria of evaluation.

This is where I hope that my book fits in. In it I have attempted to do a bit of everything at once. First, I have held what seem to me to be the major tenets of contemporary marginalist economics up to epistemological criticism. I have then – drawing on an old Prussian named Kant – laid out clear methodological and epistemological criteria to judge suitable theoretical replacements. And finally, I have constructed the skeleton of what I think could develop into a suitable alternative.

All that sounds rather grand – perhaps even tipping into the grandiose. But the book is in no way a creation ex nihilo. I have drawn on decades of excellent work by economists that have unfortunately been shunned by the marginalists.

Nor is the book an attempt at a Grand Unified Theory of everything. This is not a Book of Scripture. We have enough of those.

In fact one of the driving forces of the book is the feeling, wisdom, knowledge – call it what you will – that we can’t know everything.

We cannot, in fact, produce large-scale models of economy like the physicists do. It simply doesn’t work. Economies are too complex. They are not written in the elegant, concise prose of the Book of Nature.

If the DSGE modellers are attempting to draw up a detailed map of the economy I am merely trying to provide some directions. I call this method – following Mr Kant – the construction of ‘schema’. These schema work to try to orient us in the world of economic events and provide a firm footing.

I’ll run through the specifics of the book quickly.

Apart from this new approach to economic method the book deals with theories of money and banking; it deals with theories of profits, prices and income distribution; and it deals with theories of finance and investment – that last one I believe makes up the core of economic theory properly understood.

I hear that there is already a myth floating around out there that this is a highly abstract theoretical book with no bearing on the real world. Overuse of words like ‘epistemology’ in what I’ve just said aside, I want to dispel this myth.

Many of the aspects of theory that I discuss in the book are directly tied to key contemporary policy debates that we hear today. This is not a coincidence. I wrote it that way. I tried to avoid the more irrelevant aspects of economic theory and stick to the good stuff.

To run through a few practical examples, the chapter on money and banking has direct bearing on the quantitative easing programs that have been run by the worlds’ central banks recently – and may help to understand why these did or didn’t work as they were supposed to.

There is also a chapter on free trade that takes what seems to me a more realistic approach to the economics of trade.

I’ll briefly conclude by asking: what would economics look like after a reformation? To my mind it would be a lot more pluralistic. There would be an awful lot more debate – and by ‘debate’ I mean debate over deeply held general principles and not over whether the bell looks nicer than the whistle.

I think it would be a lot less dogmatic and people would be more willing to ask challenging questions. I think that economists would be a lot more humble with regards to what they could say with confidence. Basically I think it would look a lot more like the economics of 70 or 80 years ago.

And for that it would be a lot more exciting, a lot more engaging, and a lot more interesting. I also think that economists would develop a healthy allergic reaction to doctrinal method, gatekeepers and taboos.

I’ll leave it there.

Please enjoy drinks and conversation. If anyone has any questions about the book I’d be more than happy to answer them. Thank you for coming and have a good time.

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