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Wednesday, November 19, 2014

Equities Are A Burden On Future Generations

One corollary of the analysis in my recent article is that government bonds are not the only source of potential inflationary pressure that is inherited by future generations – corporate equities also have the same effect. In fact, they would appear to be an even greater “burden” than government bonds. Although we see “(government) debt clocks” ticking away, warning us about government debt, the risk posed by the equity market attracts no hand-wringing.

The justification of my argument is straightforward, and matches economic and financial theory as well as empirical data.

The concept of a portfolio dominates modern thinking about securities; we cannot isolate single instruments and think about them isolated from wider markets. Additionally, we realise that all entities within a modern economy are portfolio investors. At the minimum, the entity holds ‘cash’ – either bank deposits or government money – but the reality is that most assets are held by investors within diversified portfolios. Even “nonfinancial” corporations optimise their treasury operations if the corporations are of significant size.

Therefore, when thinking about my example of the long-term real effects of debt, one realises that the same scenario could play out with corporate equities replacing the government bonds. After all, it appears most households hold equities and bonds through intermediaries – mutual funds or exchange-traded funds (ETF’s).

If I sell financial assets to finance a Christmas shopping spree at Acme Inc., I am largely indifferent to whether I sell units in my equity or bond fund; I will rebalance the portfolio to meet my risk objectives sooner or later. And my selling of financial assets does not destroy them; all that happens is that it initiates a chain of transactions that exchanges financial assets amongst portfolios, with one of the consequences being that at some point Acme Inc. increases its cash holdings, possibly only temporarily.

In other words, all financial assets (which includes money) represent claims on present and future goods and services, and those assets need to be analysed as part of composite portfolios. All holdings of financial assets represent a potential long-term inflation risk if we assume that the propensity to consume out of financial assets may rise in the future.

Chart: Equity-to-GDP Ratio

If you are concerned about that long-term inflation risk, it is a mistake to single out government bonds. The real risk is posed by corporate equities. This is because:

  1. The equity market is much larger. The latest Flow of Funds data for the United States (second quarter of 2014) estimates that the market value of corporate equities are worth 207% of nominal GDP (chart above), which dwarfs the debt-to-GDP ratio.
  2. Dollar-for-dollar, equities pose a greater long-term risk. Financial theory argues that equities should be favoured by investors who intend to consume the proceeds in the distant future, as the near-term value of equities is volatile. The bulk of government bonds have maturities under 10 years, and are favoured by those who have near-term cash needs. This theoretical view is embedded into the portfolio recommendations of investment advisors. Moreover, the survey data that I have seen suggests that the rich are the major holders of equities, and they have a low propensity to consume out of current assets. The subdivision of fortunes amongst multiple heirs should increase the propensity to consume over time.
  3. Equities have historically outperformed government bonds over the long term, and this can be predicted to continue on the basis of modern financial theory. (Equities are riskier, and therefore should have a risk premium which raises their long-term total returns versus government bonds.) Equity returns also receive preferential tax treatment, increasing their return advantage. The demand potential of equity holdings compounds at a greater rate than for government bond holdings.

If governments were seriously concerned about the long-term inflation risk posed by equities, it would be easy to combat. Policies that reduced the value of the equity market would do the trick.

One could argue that equity investment implies greater fixed investment, hence it creates future supply to meet future demand. This would make policies to reduce equity valuations dangerous. The weak link in that argument is that the equity market is no longer a mechanism to raise capital; corporations buy back more equities than are issued. In fact, it is largely a mechanism to destroy capital in net terms, as most stock buy backs are made at the peak of the equity cycle. Fixed investment is either funded by internally generated funds, debt, or ‘private’ investment in small firms. The accounting at private firms is so opaque that they should be able to side-step policies that are aimed at reducing the market value of public firms. In any event, there is little reason to link the level of the stock market with the level of private fixed investment.

To be clear, I am not worried about the "burden" of equities or government debt on future generations (The Future Is Now, after all). Instead, I raise this point to give those who worry about government debt burdens a much bigger target to think about.

(c) Brian Romanchuk 2014

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