Back in January, we described ways in which the world has changed since the last secular bull market. Among the wonderful features of that Goldilocks era were the consistency of high equity returns and the calmness of markets. Well, as Hugh Grant said in his memorable British-Brooklyn accent in Mickey Blue Eyes, "Fuggedabout it!" Volatility is back, it's brash and it's here for the duration. If we understand what's causing this volatility, we can learn to work with it.
It starts with a jockeying for capital. Around the globe, securities markets are struggling with an increasingly boisterous clash over it between governments and the private sector. This public-private competition for scarce capital is a headline-grabbing, market-moving reality in socialist Europe, in the largely free-market America, in Islamist theocracies, in communist China and even in those Latin American economies fumbling for a place in the eco-political spectrum. The world over, this contest influences everything, and investors lose sight of it at their peril.
Here in the U.S., in just three years total government spending as a percentage of gross domestic product has been catapulted from 35% to a stunning 45%! It doesn't look temporary, either (www.usgovernmentspending.com), and that's upsetting the markets. This is the new nail-biting reality to which economists, business people, voters and investors are struggling to adapt.
Why is this government/private ratio so important? Three years ago, the cash-generating, job-creating, productivity-enhancing private sector accounted for 65% of GDP, and government for the remaining 35%. The private two-thirds of the economy threw off almost enough cash to support both itself and the government part.
I say almost enough, but not really enough because the private sector was spending every after-tax dollar it earned (i.e., saving almost nothing) and meanwhile the government sector was spending more than it took in from the private sector. And now the part of the economy that has to support the whole system has shrunk to just 55% of the pie. Is it any wonder that the securities markets are stressed about how all the bills are going to get paid?
Neither in Europe nor here in the U.S. has the government spending surge been funded by an increase in tax revenue. Rather, the government's employees, vendors and dependents have been paid from the proceeds of massive sovereign debt issuance. For this reason, the government-private sector struggle for capital has so far played out in the credit markets of the world and inevitably shaken currencies and the price of gold. The uneasiness of lenders is beginning to migrate to our stock markets, and for good reason.
Until there's broader confidence that we're in a self-sustaining, job-creating recovery, we'd be naive to think politicians will risk their re-election on spending cuts; after all, that might tip the economy back into recession. So if the spending cuts are unlikely, the only way to reduce the government deficit would be to increase tax revenue. Yet higher tax rates would merely shift the government's funding pressures, since higher personal taxes would crimp consumer spending, and higher corporate levies would reduce net profit margins.
Investors are keenly aware that capital is a finite resource; it's especially in short supply where populations are aging and savings are slim. Whatever capital governments need must be commandeered from the private sector. And if the government deficit is not going to shrink, we should expect the cost of capital to rise. We would see the higher cost of capital in higher interest rates and more discounting for sovereign default risk and inflation risk. We would also see it in lower P/E ratios, either because of competition equities face from bonds with higher yields and/or because rising tax rates imply slower growth and smaller corporate profits.
Mutual fund flows out of equities suggest that the public, disillusioned by two market crashes in one decade, never bought into the 80% U.S. rally of 2009-2010. Perhaps individual investors (a.k.a. owners of capital) are beginning to suspect that our best economic growth years are already in the record books now that government spending is approaching one-half of GDP.
The recent huge uptick in market volatility is our clue that a serious adjustment in valuation is in the offing.
Learning To Cope
By definition, a market is a mechanism for figuring out prices, especially in the classic examples of stock and bond markets, where buyers and sellers of securities process information about traditional economic variables affecting interest rates, credit risk and all the ordinary inputs that influence companies' prospective cash flows. Of course, it's hard to tell how things such as raw material costs and new products will affect any market. But investors can rationalize away these uncertainties, make estimates off them, set prices and diversify the risks.