Niall Ferguson & Moritz Schularick: The sum of China and America ... Chimerica
[Mr. Ferguson is the Ziegler professor of business administration at Harvard Business School. Mr. Schularick is an economist at Amiya Capital, London.]
... The defining feature of the current world economy is not an excess of liquidity or a shortage of assets, but the gap between company profits and the level of real interest rates. This wedge between the return on capital and the cost of capital is in large measure attributable to the spectacular rise of what we call "Chimerica": the sum of China, the world's most rapidly growing emerging market, and America, the world's most financially advanced developed economy.
As is well known, the rapid integration of the biggest economies of East and South Asia into the global economy has had profound effects on the relative returns on the two main inputs of global production -- capital and labor. With two billion people entering the global work force, the pool of available labor has almost doubled. By comparison, the global capital stock has increased only by a small amount. This has resulted in a massive shift in the relative rewards to capital and labor. Company profits to GDP have risen across the globe and are at record highs in almost all markets.
The novelty is that higher returns on capital have not gone hand in hand with a higher cost of capital. On the contrary, the cost of capital, as measured by global real interest rates, has actually gone down. According to our calculations, the global long-term real interest rate has averaged around 4% since 1991. Current real rates are about 130 basis points lower. Given the recent increase in the return on capital, we estimate that real rates are between two and four percentage points lower than economic theory says they ought to be.
That the price (not the supply) of money is the real conundrum of our times is perfectly illustrated by the relationship between nominal GDP growth and the yield of 10-year U.S. bonds. Defying all that theory would lead us to expect, long-term nominal interest rates in the U.S. have been considerably below nominal GDP growth for an extended period.
Under these circumstances, it is hardly surprising that growth- and risk-sensitive assets have become extremely attractive for investors. The combination of depressed real rates and buoyant corporate profitability makes it smart to borrow money and to buy earnings streams. Small wonder we have seen record low spreads in the corporate bond market. Small wonder there has been a boom in private equity investment and leveraged buy-outs.
Of course, low real interest rates and high company profits are difficult to reconcile over the long term. This is the idea behind the "Fed model" -- the basic macroeconomic model the Federal Reserve uses to judge the information conveyed by stock-market valuation. It compares the earnings yield of the S&P 500 (the inverse of the P/E ratio) with the 10-year bond yield. Over longer time horizons, extreme divergences are corrected. The Fed model correctly indicated stock-market overvaluation ahead of the crashes of 1987 and 2001.
What the Fed model has been telling investors for some time is to prefer stocks to bonds because earnings yields are much higher than bond yields. And to some extent that advice is finally being heeded. Yet there is reason to think that the bond market may not correct by much this time around. For something is working to prevent real rates and corporate profitability reverting to their traditionally close relationship. And that something is Chimerica....
Read entire article at WSJ
... The defining feature of the current world economy is not an excess of liquidity or a shortage of assets, but the gap between company profits and the level of real interest rates. This wedge between the return on capital and the cost of capital is in large measure attributable to the spectacular rise of what we call "Chimerica": the sum of China, the world's most rapidly growing emerging market, and America, the world's most financially advanced developed economy.
As is well known, the rapid integration of the biggest economies of East and South Asia into the global economy has had profound effects on the relative returns on the two main inputs of global production -- capital and labor. With two billion people entering the global work force, the pool of available labor has almost doubled. By comparison, the global capital stock has increased only by a small amount. This has resulted in a massive shift in the relative rewards to capital and labor. Company profits to GDP have risen across the globe and are at record highs in almost all markets.
The novelty is that higher returns on capital have not gone hand in hand with a higher cost of capital. On the contrary, the cost of capital, as measured by global real interest rates, has actually gone down. According to our calculations, the global long-term real interest rate has averaged around 4% since 1991. Current real rates are about 130 basis points lower. Given the recent increase in the return on capital, we estimate that real rates are between two and four percentage points lower than economic theory says they ought to be.
That the price (not the supply) of money is the real conundrum of our times is perfectly illustrated by the relationship between nominal GDP growth and the yield of 10-year U.S. bonds. Defying all that theory would lead us to expect, long-term nominal interest rates in the U.S. have been considerably below nominal GDP growth for an extended period.
Under these circumstances, it is hardly surprising that growth- and risk-sensitive assets have become extremely attractive for investors. The combination of depressed real rates and buoyant corporate profitability makes it smart to borrow money and to buy earnings streams. Small wonder we have seen record low spreads in the corporate bond market. Small wonder there has been a boom in private equity investment and leveraged buy-outs.
Of course, low real interest rates and high company profits are difficult to reconcile over the long term. This is the idea behind the "Fed model" -- the basic macroeconomic model the Federal Reserve uses to judge the information conveyed by stock-market valuation. It compares the earnings yield of the S&P 500 (the inverse of the P/E ratio) with the 10-year bond yield. Over longer time horizons, extreme divergences are corrected. The Fed model correctly indicated stock-market overvaluation ahead of the crashes of 1987 and 2001.
What the Fed model has been telling investors for some time is to prefer stocks to bonds because earnings yields are much higher than bond yields. And to some extent that advice is finally being heeded. Yet there is reason to think that the bond market may not correct by much this time around. For something is working to prevent real rates and corporate profitability reverting to their traditionally close relationship. And that something is Chimerica....