Building Blocks Of The Future

By: Michael Ashton | Mon, Sep 27, 2010
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Volume is starting to be a real concern. While the bond market rallied (2.52% on the 10y note), inflation markets and stocks fell (-0.6%), and the VIX was slightly higher, the real story is starting to be the continued slide in exchange volumes. The 60-day average volume just fell below 1bln shares for the first time since at least 2004, which is as far back as Bloomberg has volume figures. Again, this isn't entirely surprising given the regulatory changes we've recently seen - it's just surprising that it has happened so abruptly.

But this doesn't necessarily mean the market's future is bleak. The Stock Trader's Almanac apparently just came out with a 8-year, 7-year forward forecast (that is, starting in 2017 and extending to 2025) for the Dow of 38,820.

The forward-starting forecast is creative. If the market rallies a lot before 2017, and is sitting at, say, 25,000, is the forecast for a "SuperBoom" over those 8 years also raised? If not, then it's really a 15-year forecast of 9%-per-year growth.

Mind you, that's still a fairly optimistic forecast. With 2-3% inflation, 2% dividends, and 2% real growth in GDP-per-capita (see the explanation, especially of the latter, here), 6-7% is what you'd ordinarily expect as a long-run equity return (and that assumes that we're starting from fair value, not the elevated Q-ratio of where we are). An extra 2-3% per year for 15 years is a big difference.

But since I am ordinarily playing the part of naysayer, I thought I would break form today and give a reason to be optimistic in the long run. I think that the potential future outcome is binary: there is a low but meaningful chance that our country spends the next decade or two struggling with war, inflation, a loss of confidence in the currency, civil unrest, and miserable economic performance, but there is a much higher probability that things work out okay and we come out of the current depression with bright prospects. (The chance that the best fantasies of the equity bulls come true, though, is very low).

How might things work out okay? Note that this is not my 1-year outlook. I am not particularly sanguine on the medium-term prospects, to say the least. But the view from 30,000 feet, a truly macro perspective, isn't too bad. It doesn't require blind faith in the American Way or patriotic chest-thumping that we're the Best Country On Earth; all it requires is some math, one or two good decisions from our leaders (admittedly its weak point) and one small assumption.

Let's start with this: potential GDP over time is driven by productivity growth and population growth. In Japan and in Europe's case this is worrisome since population growth is likely to be negative as the demographic bubble bursts, but one great strength of this nation is that, for all the debate about the treatment of illegal immigrants, as a nation we generally support legal immigration. Most of us come from families, after all, that were immigrants at some point in the past. So unless our leaders make a very bad decision and prevent legal immigration as well as stopping the flow of illegal immigrants, we need to make no wholesale changes to our policies to ensure that our population growth continues to be positive.

We will lead aside the productivity question for a moment and come back to it.

Now, let's look at the building blocks of GDP. The formula we all know is Y≡C+I+G+(X-M); in words that is GDP is definitionally equal to the sum of consumption, fixed investment, government spending, and net exports. We all know that recently, with consumption and investment down, artificial government spending is the only thing that kept GDP from collapsing. But let's look at the long run. The chart below shows the components of GDP in chained 2005 dollars, their proportions of the economy, and the compounded growth rate for the 10 years from 1999 to 2009 (source: BEA).

Whatever would we do without Uncle Sam??

Contributing to the blistering 1.8% growth in the overall economy was a steady rise in consumption expenditures and a rise in the size of government (especially Federal, and this obviously doesn't include the new health care entitlement and only includes part of the stimulus money).

This could make one feel afraid for the future, because the populace clearly wants the "G" number to shrink considerably. Doesn't that doom us to slower growth, if Big Brother isn't putting a following wind in our sails?

Not at all; in fact, quite the opposite is probably true. The government competes in the capital markets to fund its expenditures; because of its sterling credit, it outcompetes some investment expenditure ("crowds out" private borrowing, that is). It is interesting, although surely largely spurious, to note that over the last 10 years the increase in Federal spending has been $333bln (chained 2005 dollars) and the contraction in private investment has been $328.6bln.

Now, going back to the drivers of long-term GDP growth: which do you think is more likely to inspire productivity improvements, $300bln in federal spending or $300bln in private investment?

If, in fact, the arrow of government size is starting to point lower - and golly, it's hard to imagine how it could be pointing higher given the size of the deficit - then this is probably of long-run benefit to the economy, and the future growth rate will be higher in such a circumstance rather than lower. Admittedly, this conclusion is subject to the assumption that private investment is more productive than public investment, and some people (roughly 45% of the electorate) seems to disagree with that statement. But in my mind, it isn't such a big stretch.


Tomorrow, the economic data include the Case Shiller home price indices (Consensus: -0.1% month/month, +3.1% year/year) and the Consumer Confidence number at 10:00 (Consensus: 52.1 from 53.5). As always, watch the "Jobs Hard To Get" subindex for signs that the dip in August was a mirage and the employment picture is in fact improving. I don't entirely buy it, but we'll see.

Also tomorrow is my presentation at the New York Investing Meetup. My talk will begin at around 7pm, and the topic is "Why I Don't Worry About Deflation And Neither Should You." Go here for details. You don't have to be a member of the group to attend; attendance is only $10 to cover the group's expenses. I'd love to meet you.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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