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October 30, 2013 8:33 am
The recent buoyancy in global equities has raised fears that the markets have entered a major bubble, driven by the unprecedented expansion in central bank balance sheets.
To the extent central bank asset purchases have reduced government bond yields, they have certainly brought forward returns from the future into the present, thus reducing expected returns on both equities and bonds. But this is normal in a period of monetary easing, and it does not automatically mean that markets are in a bubble.
Bubbles exist when market prices become substantially divorced from the behaviour of underlying fundamentals. For equities, the most important fundamental to watch is the expected growth of profits, discounted by the required rate of return.
Many investors are concerned that the recent strong performance of profits in the developed economies cannot be sustained in the future, because it has been based on an abnormal rise in the share of profits in GDP, and a corresponding decline in the share of wages. Over very long periods, the profit share has tended to revert to its mean, and a repeat of this tendency would substantially reduce the growth of corporate earnings in the next few years.
The effects could be large. For example, in the US case, a return to normal for the labour share in national income, from 59 to 62 per cent, could reduce the return to shareholders (domestic corporate earnings after depreciation and interest payments) by more than 25 per cent on a permanent basis, a change which current equity valuations could not possibly survive.
But why should this happen? The rise in the profits share has been a pervasive feature throughout the global economy since the mid-1980s. It has occurred in almost all countries and industries, so particular explanations based on statistical quirks or national policy differences, though widely discussed, are not likely to prove sufficient.
Recent economic research shows that several powerful factors have been at work. The least controversial is the economic cycle. Profits normally do well when economies begin to recover from recessions, because firms’ pricing power increases, while high unemployment rates hold down labour compensation. A strong global recovery from now on would be expected to reverse these cyclical effects, but the depth of the Great Recession could mean it takes far longer than usual for the wages share to rebound. Five years after the crisis, there is no sign of it happening.
Turning to secular forces, the nature of technological progress seems to have changed. Economists have for many decades designed their growth models so that they would produce a constant profits share, which Keynes, Samuelson and Kaldor all said was a stylised fact from economic history. But a 30-year trend decline in the global profits share has changed all that.
In more recent growth models, technical progress can be “capital augmenting”, which means it can enhance the productivity of the existing plant and equipment. Technology can be substituted more easily for labour in the production process. The IT revolution since the 1980s may be having these effects and they may be increasing the return on capital.
Globalisation has also been another major secular factor. As international trade and investment has grown, the effective labour supply in the productive sector of the world economy has vastly increased.
The International Monetary Fund estimated that the effective labour supply engaged in the global economy increased from about 500m in 1980 to about 2,000m in 2005, a development which has clearly reduced the wage share in developed economies. It is true that future growth in the global labour force may be slower than before, and its impact may be reduced by increases in real wages in the emerging world. Nevertheless, with projections suggesting the global labour force may double again by 2050, it is another force which is unlikely to reverse anytime soon.
Other explanations for rising profits include the decline in unionisation in the major developed economies, and the rise of “financialisation”, which has increased the incentives on management to maximise the return on capital for themselves and shareholders. Empirical studies find some role for these factors, but generally agree that they have not been as important as the two great forces which have characterised the last three decades, the technology revolution and globalisation.
There is an active dispute about which of these has been the more important, but in some ways this does not matter for investors. Both of them are unfinished revolutions, showing little sign of reversing in the near future. If that proves correct, the high profits share may provide fundamental support for equity valuations for longer than is generally expected.
Gavyn Davies is chairman of Fulcrum Asset Management and writes an FT blog
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