Imaginary Growth Assumptions and the Steep Adjustment Ahead

Over the next several years, investors are likely to face a profound and unpleasant downward adjustment in their assumptions about growth; GDP growth, revenue growth, earnings growth, and growth in their own investments. Given that the most historically reliable measures of market valuation we identify (those best correlated with actual subsequent S&P 500 total returns) already range between 140% and 170% above their historical norms, this adjustment in growth assumptions is likely to be accompanied by one of the most violent market declines in U.S. history, even if interest rates remain depressed.

The argument that rich valuations are “justified” by low interest rates rests on the assumption that future cash flows, and their growth rates, are held unchanged. For example, if interest rates are expected to be held 3% below their norms for a full decade, but revenues and cash flows are expected to grow at historically normal rates, then the way to lower future expected equity returns to “compete” with those lower interest rates (because that’s what happens when valuations are elevated) is to raise valuations about 30% above their own historical norms (3% x 10 years). You can demonstrate this to yourself using any discounted cash flow approach.

Now, the historical fact is that prospective equity returns don’t have any such one-to-one correlation with interest rates, and the correlation actually goes the entirely wrong direction outside of the inflation-deflation cycle from 1970 to about 1997. But if one insists that low interest rates should justify elevated stock valuations, and that future economic and corporate growth rates will match their post-war norms, we can happily concede that 30% of the current 140-170% premium over historical norms may be “justified.”

The problem is that if interest rates are lower because likely future nominal growth in deliverable cash flows is also lower, then no valuation premium is justified at all. Again, investors can demonstrate this to themselves using any discounted cash flow method. Though we aren’t great fans of infinite growth models, the easiest one is certainly the Gordon growth model: P = D/(i-g), where one can easily observe that a simultaneous reduction in both (i) and (g) will leave the valuation multiple (P/D) unchanged, yet will leave you with lower future expected returns anyway.

Recall that U.S. real GDP growth is driven by the sum of two factors: growth in employment (the number of workers) and growth in productivity (output per worker). Based on demographic factors such as population growth and labor participation rates across an aging workforce, combined with an unemployment rate that already stands at just 4.3%, the employment contribution to GDP growth is likely to average just 0.3% annually over the coming 7 years; a small fraction of the post-war growth rate. On the productivity side, U.S. productivity has persistently slowed from a post-war average of just over 2% annually, to just 1% over the past decade and only 0.6% over the past 5 years. That leaves the baseline expectation for real GDP growth, even in the absence of a U.S. recession, at just 0.9% annually.

The following charts illustrate these trends. Note the persistent slowing in the contribution to real GDP from labor force growth in recent decades.

On the productivity front, booms in U.S. productivity are typically led by booms in U.S. gross domestic investment. As a historical regularity related to the savings-investment balance, such booms invariably emerge from an initial position of balance or surplus in the U.S. trade balance. Given the deep deficit at present, such a boom is not likely forthcoming. For more on these relationships, see Stalling Engines: The Outlook for U.S. Economic Growth.

The slowing of U.S. labor force growth, coupled with a gradual and persistent slowing in productivity growth, has combined produce a persistent slowing in the rate of potential and actual U.S. real GDP growth.

As for the notion of a productivity boom fueled by the tax-advantaged repatriation of U.S. corporate earnings held abroad, recall that the U.S. actually tried this in 2004, and nothing of the sort resulted. Indeed, the primary beneficiaries actually reduced research spending and cut payrolls. Is anyone really so naive to imagine that these balances are not already fully available to finance new investments by U.S. companies here? Do they think the global financial system is that unsophisticated? At present interest rate levels, a company needs only to issue debt at favorable rates in the U.S., invest the funds held abroad at floating rates, enter a fixed-floating interest rate swap, and voila, the company has access to the funds exactly as if they had been brought home. Indeed, this is just what many U.S. corporations appear to have done. So cry me some crocodile tears for companies that hold profits abroad. In my view, U.S. companies should be able to repatriate profits in a tax-advantaged way only to the extent that their actual spending on capital investments, R&D and labor compensation exceeds their own 3-year average.