I usually try to start my first column of a New Year in a positive mood – unlike the Grinch who stole our Christmas and New Year parties – but, putting the best spin I can upon it, I still feel an overwhelming need to caution readers that there is a dangerous bubble waiting to burst out there in the global marketplace.
In justification of that claim, consider the graph below which tracks the price earnings ratio of the world’s single most important share index, the S&P500. As you can plainly see, it is already at its third highest level in its entire history since they began plotting it in January 1871 – at 38.83 it’s twice its mean level of 15.87.
There is, however, another valuation method which market professionals have long come to trust. It is known as the Shiller PE ratio or the Cyclically Adjusted PE Ratio (CAPE Ratio). Here, instead of dividing by the earnings of one year, this ratio divides the price of the S&P 500 index by the average inflation-adjusted earnings of the previous 10 years in order to eliminate the obvious distortion of historic data due to the inevitable upward creep of inflation which strips money of its buying power. But here you need to recognise that I, and many other observers, believe that the way the US officially calculates its inflation rate effectively understates the true number which might lower that peak somewhat. Nevertheless, the CAPE Ratio graph below makes it clear that, other than the 2000 “Dot Com” bubble, Wall Street has NEVER been as expensive. It is, as the red band indicates, officially in an “extreme bubble”:
Inevitably then, it has to burst sometime in the future and, depending upon the severity of that burst, the economies of the Western world will probably be plunged into an even more dire recession than they are already in. The only question is when?
Now, it is important to recognise that world governments are all in outright war mode. That is, they have pulled out every stop to keep their economies afloat while we collectively fight, what is arguably the worst pandemic this planet has ever experienced. During a war, nations habitually mobilise every resource that they can, regardless of the cost, because the first objective is to defend themselves. But afterwards they have to count the cost.
To fight this debt, the world’s already deeply-indebted, governments have nevertheless binged on even more debt on a previously unimaginable scale as my next graph illustrates. Global debt was on track to exceed $277-trillion in 2020, or 365 percent of global GDP. Excluding the financial sector, debt will be a slightly more modest $210-trillion, but that is still 274 percent of global GDP and massively up from an already huge $194-trillion last year when the figure stood at 240 percent. On its current trajectory it is likely to surpass $360-trillion by 2030!
Now you need to recognize that before anyone can borrow money, the money itself has to actually exist. So, in the obvious absence of significant GDP growth – i.e. as a result of the collective labours of mankind, where is this extra money coming from? Well the plain answer, of course, is that the world’s central banks have collectively thrown caution to the wind and have been “printing” the stuff on a scale never before seen even during the two world wars. Usually this would result soon afterwards in a surge of inflation but they have been printing so much money that even inflation is being dampened down along with economic growth. But it cannot be dampened forever and, once it starts it’s likely to be a runaway event…and it has already started!
So the obvious question is whether governments are the only ones taking up all of this debt? Well the next graph on the right makes it clear that everyone is taking advantage of the situation. The natural laws of supply and demand ensure that if you increase the supply then the commodity becomes cheaper, and so money has understandably never been as cheap as it is now. Understandably too, many borrowers are busy re-arranging their debt burdens by substituting low-cost money for older higher-interest debt and that is an obviously sensible thing to do. But it is so cheap that they have also been buying things they would previously not have afforded and that might also be fine from the borrower’s point of view if the interest rate is contractually pegged at the current low rates. But most small borrowers; like householders who are also currently bingeing on mortgage debt to fund home purchases that they ordinarily could not afford, are simultaneously creating a bubble in the housing market.
Ben Aris, writing for BNE Intellinews, notes that the surge in borrowing has been led by the Developed Markets which saw debt surpass 432% of GDP in the third quarter of 2020, up by half from a year earlier. The US accounted for nearly half of the rise, with total debt on track to hit $80 trillion in 2020, as the IIF reports, up from $71 trillion in 2019.
Government borrowing accounted for most of the increase, with general government borrowing up $3.7-trillion and non-financial sector corporate borrowing up $1.7 trillion. The Eurozone also borrowed heavily, adding $1.5-trillion to government debt to bring the total outstanding debt to $53-trillion in the third quarter of 2020, although this is still a bit less than the all-time high of $55 trillion set in the wake of the last crisis in the second quarter of 2014. Debt in other mature markets rose by over $3.7-trillion to $65-trillion in the first three quarters of 2020. However, the Emerging Markets have also been piling on debt as chart 3 on the right illustrates – with South Africa a significant inclusion in the list – debt is fast approaching 250% of GDP, up from 222% in the fourth quarter of 2019 to reach 248% in the third quarter of 2020.
Most of the EM debt is dollar-denominated and worth $76 trillion, although countries like Russia have moved to reduce the share of dollar-denominated debt and have been trying to promote the settlement of international trade contracts in other currencies.
Most of the rise was driven by a surge in non-financial corporate debt in China. Excluding China, the dollar value of EM debt declined from $31 trillion in the fourth quarter of 2019 to $29.3 trillion in the third quarter of 2020. The fall in the debt had more to do with exchange rate dynamics and widespread devaluations vs the dollar than to deleveraging in EMs.
So, in the light of this background, what does the recent share market surge mean for the immediate future? Well, they printed so much money last year that after everyone else in the line of borrowers had taken a dip, there was still a whole lot more available and, as always it flowed directly into the world’s securities markets. Thus the good news is that the Wall Street’s S&P 500 Index rose more than 14 percent in November and December, ending a tumultuous year at a new all-time high of 3,756.07 — gaining a total of 16.3 percent in 2020.
A ten percent or more gain in the final two months of the year has led to a higher S&P 500 the following year every single time since World War II. “In fact, January was also higher every single time as well. On the five previous occasions the index has climbed more than 10 percent in November and December: 1954, 1962, 1970, 1985 and 1998, the S&P 500 has gained an average of more than 18 percent the following year. The index also climbed in all five Januarys, rising an average of 3 percent.
The below chart shows what a year typically looks like after a 10 percent or more November/December rally.
Sooner or later, however, the party has to end and the first sign will logically be an up-turn in international interest rates. Thus, even though interest rates are still at historic lows, they have in fact been rising steadily throughout 2020 as my next graph of US 30-year sovereign bond yields shows:
Over the past quarter century, US long bonds have fallen from a peak yield of 7.17 percent in April 1997 to a low of 1.18 percent on August 7 last year. But note that, since that low point, the yield has already risen by 47.46 percent and it is showing no sign of slowing.
If that looks like a small blip on the chart, just pause to consider what a 47.46 percent increase in the cost of a household mortgage would do to the local housing market where bonds currently cost 6.85 percent for borrowers with the best credentials. Care to do the maths and you can see the increase would be to 10.1 percent. On the current median house price in South Africa, that implies that the mortgage interest alone would rise from R5 606 a month to R8 266.
Given a median South African salary of R21 432, that implies that for the average South African the monthly cost of a roof over his head would rise from 26.16 percent of gross salary to 38.6 percent. It has shattering implications for the inflation rate for a start. And remember this is only the beginning!
The big question is how will it all end? So readers need to recognize that there is only one way governments have ever been able to clear their accumulated debts without resorting to punitively taxing their people and that is by allowing inflation to erode the face value of their issued bonds. So it is obviously in the interest of heavily-indebted governments like ours to fan the flames of inflation once the pandemic is behind us. So, with vaccines rolling out everywhere, it is arguably safe to say that the pandemic will be behind us sometime later this year and then most world government priorities are likely to begin to focus upon the next big problem: DEBT.
So, to take one of the world’s biggest borrowers, the USA with an average 2020 inflation rate of 2.29 percent – already up 20 percent on the 2019 figure of 1.91 percent, the graph below illustrates how inflation peaked at 13.29 percent in 1979.
As the next graph illustrates, South Africa has tended to be rather more volatile in its inflation history, having endured a series of much higher peaks and valleys. From an historic low of 1.22 percent in 1959, it rose successively to peak at 15.28 percent in 1981 before falling back briefly to 11.5 percent in 1984 but by 1986 it was back to 18.66 before sliding back steadily to a historic low of -0.68 percent in 2004. But by 2008 it was back at 10.04 percent and then began an erratic decline to its present 3.24 percent.
Since investors always require a “real” return on a bond investment i.e. a yield greater than inflation, the consequence for SA sovereign bonds was to climb to a peak yield of 18.38 percent in September 1998 before retreating once more and reaching a record low of 6.09 percent in May 2013. The graph below tracks our 10 year bond yields since January 1997 during which the yield fell from a September 1998 peak yield of 20.51 percent to an April 2013 low of 6.01 percent before heading up again to its current 8.69 percent:
Now you need to recognise that the cost of money to fund your mortgage or your business overdraft ripples directly from the interest rate government is forced to pay to attract loan capital to fund those day-to-day operations which exceed what it is able to raise through taxation. It is thus easy to understand why both monetary inflation and the creditworthiness determinations of the Ratings Agencies together determine the sovereign bond rate, also directly impact ordinary citizens. These two sovereign bond rate drivers are, in fact, the direct drivers of a hidden tax upon citizens!
To put that simply, if the Government mismanages its spending and thus has to borrow in the sovereign bond market, ordinary householders end up paying more for their household bonds and their car hire purchase agreements just to name a few of the many ripple effects.
Now you need to further recognize that South African interest rates behave like a snake in a tunnel. Internal issues might determine how the snake writhes within the tunnel, but the tunnel itself writhes according to the dictates of the global debt situation. So, imagine if you wish, what will happen when global debt becomes so intolerable that the major nations are obliged to act in concert to try and manage indebtedness downwards! Furthermore, you also need to recognize that our own sovereign situation is already in crisis. Stemming from the ANC Government’s inability to live within its means, our sovereign bond rate has risen inexorably such that the rate we currently have to pay is already the world’s third highest.
It, in part explains why our share market has so underperformed the rest of the world in recent years. When investors try to determine the fair price of a share they always look at the “Total Return” that it offers, i.e. the sum of its dividend yield and its average price growth in recent years. In the absence of dividend growth, the share price must thus logically fall in order to offer a higher dividend yield to equate with higher bond yields.
So, for proof of this phenomenon please note my comparison graph below which illustrates how the JSE All Share Index has been falling at compound 2.8 percent a year since January 2018 while Wall Street’s Nasdaq has been rising at compound 20.6. Of late, of course, this situation has worsened because local investors have lost patience with our poor market prospects and have increasingly begun sending their investment capital offshore! Do note, however, that the red trend line of the upper graph has recently been penetrated on the up-side suggesting that an improvement might be on the way.
Now, to go back to my example of the impact upon household bonds, readers need to recognise what the consequence might be for the household bond payments of Mr Average South African if the sovereign bond rate should climb again to something like the September 1998 peak yield of 20.51 percent.
It would imply that the average mortgage rate could easily rise to 24 percent and Mr Average, who now earns R21 432 and lives in a house that cost R982 000, would find himself having to pay R19 640 in interest alone on his mortgage.
You might ask yourself what, in this scenario, would be the future of an already increasingly unpopular ANC government in an up-coming election? Meanwhile, just to rub salt into the wounds of local investors who have seen their JSE-invested capital shrink, you might be interested to see how the portfolio my ShareFinder system created for those of you who have been prepared to send their money offshore. From an initial investment of $977 506 in December 2019 it has grown to $1 838 410 at today’s date. My next graph shows that performance.
You need not feel all that bad, however, if you have regularly followed the choices I have made for my Prospects portfolio. Since we launched it in January 2011 it has risen in value from R1-million to R4.2-million at a compound annual average rate of 17.6 percent and, happily is also well above its last January level of R3.617-million.
The final word, of course, is where do you put money in order to escape the ravages of an economic crisis? Well every single time that has happened, blue chip shares have held out the best in the medium to long-term. But when you fear a share market crash, cash in a savings account is the best way to ride the storm. However, if an inflationary wave follows, get out of cash and back into Blue Chips as fast as you can!
South Africa remains one of the most unequal countries in the world in terms of income distributions. Post-Apartheid government efforts at stimulating inclusive growth, while having reduced racial inequality, seems not to have achieved much in terms of curbing overall income inequality. The growing income gap between the rich and the poor is well documented. What remains less explored is the related issue of wealth inequality and the feasibility of wealth tax as a policy option. More recently, however, both international and domestic developments have ignited discussions around wealth taxation.
Internationally, the global financial crisis, Piketty’s seminal work on the extent of wealth inequality and substantial improvements in international cooperation and tax administration constitute the main driving forces. Domestically, the need for additional tax revenue to curtail rising deficit and government debt and the country’s persistent reputation as an economically unequal society are the main factors inspiring renewed interest in wealth taxation (DTC 2018; Arendse & Stack, 2018; Orthofer, 2016).
Wealth inequality in South Africa is extremely high. Based on recent Gini coefficient estimates of 0.9, not only is wealth inequality higher than income inequality (with Gini coefficient of 0.67) but also higher than the global wealth inequality estimate (Orthofer, 2015; Orthofer, 2016; Mbewe & Woolard, 2016). Orthofer (2016), for instance, reports that the top 10 percent of South Africa’s population owns more than 90 percent of the total wealth with virtually an absence of a ‘middle class’.
Further, the richest 0.1 percent of South Africa’s population owns a quarter of overall household wealth. Even worse, massive wealth inequality exists both between and within races. Mbewe and Woolard (2016), for instance, estimate that the average wealth of an African household constitutes less than 5 percent of that of white households.
Currently, wealth taxes in South Africa are in the form of Transfer Duty, Estate Duty, and Donations Tax. These taxes, however, are ineffective in reducing wealth inequality, enhancing fairness and generating revenue as they raise a very small amount of tax revenue and constitute a very small proportion of overall tax revenue in South Africa (DTC 2018).
It is against this background that a debate on the feasibility and practicality of introducing a net wealth tax has emerged. For proponents, wealth tax has can reduce wealth inequality while also diversifying the sources of much-needed government revenue. For opponents, a net wealth tax is costly to administer and has the potential of causing capital flight. In light of these contrasting positions, this paper assesses the feasibility of introducing personal net worth tax as part of South Africa’s tax mix.
International Experience with Wealth Tax
Amid policy debates on the feasibility of introducing a net wealth tax in South Africa, and evaluation of whether South Africa should introduce an annual tax on personal wealth as part of its tax mix requires careful considerations. Interests in wealth taxes, internationally, have waxed and waned over time.
Presently only four OECD countries still maintain net wealth tax compared to about 12 countries in the 1990s (OECD, 2017). Countries abandoning net wealth tax include Denmark (1995), Germany (1997), Finland (2006), Sweden (2007), Spain (2008), and more recently India (2015).
Table 1 below shows countries that have had annual personal wealth taxes in Europe. European countries’ experience with annual wealth taxes on individuals Source: OECD, 2017 Reasons for repealing wealth tax among the eight others include administrative and efficiency concerns as well as the failure of net wealth taxes to meet their redistributive goals (DTC 2018). More recent developments on the international landscape such as Piketty’s seminal work on the extent of wealth inequality and advocacy and progress in international cooperation in tax administration have, however, raised the prospect of taxing wealth more effectively and reignited interest in addressing wealth inequality via wealth tax. Broadly, a cross-country synopsis of the international experience of levying wealth tax points to several useful lessons that can inform the wealth tax debate in South Africa.
Starting with the reasons for abandoning net wealth tax, it emerges that factors such as increasing the cost of classifying and measuring net assets, structuring the tax collection system and more importantly, accounting for global assets are what necessitated the repeal of wealth taxes (Arendse & Stack, 2018). Secondly, the need for exemptions on net wealth taxes often creates an avenue for coordinated lobbying and can effectively corrupt the asset evaluation and tax collection process (Edwards, 2019). Thirdly, a narrow wealth tax base implies levying a higher tax rate if sizeable revenue is to be generated. This has the effect of burdening taxpayers disproportionally for those unable to exploit loopholes in the tax system (DTC 2018).
Fourthly, there is the risk that wealth tax would be paid mainly by the fairly wealthy or the middle class whose wealth is mostly residential properties, leaving out the very rich whose assets are diverse and difficult to tax (Boadway et al., 2010).
Finally, there is evidence to the effect that wealth tax promotes tax avoidance and capital flight or tax migration to neighbouring countries (Saez & Zucman, 2019). There is no contradicting that after 25 years of democracy, economic inequality manifesting in income, consumption and wealth disparities remains a pressing issue in South Africa. Various attempts at inclusive growth have achieved little. For instance, progressive income taxes geared towards redistribution have not contributed much as the income gap between the rich and the poor continues to widen.
Recent evidence of even wider inequality in wealth distribution motivates the desirability of additional or alternative forms of redistribution. Indeed, the current pattern of wealth ownership in South African is not by chance. Rather, it is a direct manifestation of the history of colonialism and apartheid policies that cannot be undone without multiple state interventions. To put it in perspective, because wealth conveys power, wealth inequality beyond it potentially perpetuating income and consumption inequality can undermine socio-political and economic stability (Atkinson, 2015).
The high wealth inequality, therefore, is of concern and requires some form of policy response. As to whether a personal net wealth tax constitutes a justifiable policy response ought to be judged on the basis of international experience, principles of tax design, and the socioeconomic and political dynamics of South Africa.
Consider first the principle of equity. It is argued that a net wealth tax provides an opportunity to achieve both vertical equity through progressive taxation of those with wealth and horizontal equity by supplementing income tax with wealth tax to account for different forms of economic power (Chatalova & Evans, 2013). Such analysis, however, ignores the intricacies of a net wealth tax administration. The complexity of administering a net wealth tax – especially certain as certain assets are hard to measure and/or easy to conceal – is such that there are several ways it will result in inequitable tax treatment, both vertically and horizontally.
When wealth tax bases are narrowly defined, the implication would be that the rate would have to be high to generate substantial revenue. The effect of this would be discrimination between asset types. On the contrary, a wider tax base would imply the enhanced possibility of tax evasion which effectively fosters inequalities between taxpayers with different degrees of honesty (Schnellenbach, 2012). Secondly, a net wealth tax may discriminate against taxpayers like emerging entrepreneurs, subsistence farmers, senior citizens who may possess valuable properties but either they do not earn any significant income or the assets generate no income. For assets that generate no income, the inability to pay a wealth tax might imply the need to sell the property (Broadway, et al., 2010; Collocott, 2018).
Similarly, a net wealth tax implies an inequitable treatment of particularly senior citizens as net wealth tends to be higher towards retirement. Much worse, a wealth tax would be a heavy burden on the middle-class while being light on the uber-rich. For one thing, while the middle class tends to have their wealth in the form of an immobile and tangible asset (mostly residential buildings), the rich tend to have, beside immobile and tangible assets, more liquid and intangible assets which are difficult to tax. Indeed, in the absence of international consensus on a wealth tax regime, the rich are better placed to use cross-border transactions to avoid or evade wealth taxes altogether. Indeed, the fact that wealth inequality has increased in countries with many years’ experience with a net wealth tax such as France reinforces the argument that a net wealth tax is not as equitable as it might appear.
Besides equity implications, a net wealth tax is likely to contravene the efficiency principle of tax design. A counter-argument is that by imposing a tax on wealth irrespective of whether the underlying asset generates income enhances efficiency by encouraging productive use of assets (Chatalova & Evans, 2013). Such evaluation, however, fails to consider that a net wealth tax can produce unintended consequences on savings, investment, entrepreneurship and eventually on growth and hence ultimately reduce tax revenue. Firstly, to the extent that a net wealth tax distorts not only savings and investment decisions, but also decisions associated with wealth accumulation and disposal, it can hardly be efficient.
Taxpayers would be incentivised to reduce savings and reallocate savings between different investments when different taxes apply (IMF, 2013). Given that the interest earned on cash and savings in South Africa often below the rate of inflation, a wealth tax will worsen the real return and dampen further the prevailing poor savings rate (see figure 1).
Other cascading effects include increased required rate of return on investments, increased risk of investment and ultimately a reduction in investment and entrepreneurship due to reduced start-up capital and after-tax returns (see figure 2) (Hansson, 2008; Schnellenbach, 2012,)
Average self-employment rates in wealth and non-wealth tax countries, 1980 – 2003
Further, it is difficult to imagine that net wealth tax would be simple, transparent and certain. Administering net wealth tax involves complex processes such as regular asset valuation, inspection, and rules of exemption and exclusion which are by no means straightforward. This can create loopholes in the tax legislation and administration, undermine the principles of simplicity, certainty and transparency, promote coordinated lobbying and corruption of asset evaluation and impose an undue burden on taxpayers to seek advice from tax experts.
This has implications for the cost of tax collection as well as revenue generation prospects especially in the South African context where the tax authority is constrained by limited capacity (Mofokeng 2018). Also, the generally low revenue-generating potential hardly makes wealth tax viable policy response to wide wealth inequality. Arguments to the contrary that a net wealth tax can signal government commitment to redistribution are valid only to the extent that wealth tax yields an economically viable amount of tax revenue. Revenue from net wealth tax in countries applying them has generally been low, ranging from an abysmal magnitude of 0.07% to 5% of total national revenue (Arendse & Stack, 2018). The complexities in asset valuation and high incidence of evasion have been the major causes of poor revenue generation performance of wealth tax. The Swedish government, for instance in 2017 abolished wealth taxes due to disappointing performance both in terms of revenue and perceived impact on inequality (Broadway et al., 2010).
For South Africa, a wealth-income ratio of 240 percent compares less favourable to OECD countries’ measure of 400 to 700 percent. Given that a major reason some OECD nations abandoned their wealth tax regimes was low revenue generation, it is hard to imagine how South Africa can make it worthwhile.
If the revenue generation potential of net wealth tax in South Africa is limited, it is hard to expect it to contribute effectively to reducing wealth inequality. Indeed, given South Africa’s low wealth-income ratio, capital-related taxes, as Orthofer (2015) notes, would not only have lower revenue potential but can also potentially undermine capital formation and reducing reliance on foreign capital inflows.
Other possible consequences of introducing a net wealth tax include capital flight and brain drain. The counter perspective here is that a net wealth tax would provide valuable information on assets and hence aid tax authorities in curbing evasion of other types of tax. The actual scenario here, however, is that since only net wealth is taxed, there would be an incentive to borrow against assets. Borrowed funds can then be invested in tax havens or assets exempted from wealth tax (Broadway et al., 2010). In France, for instance, it is estimated that about 5 billion euros of tax revenue are lost annually due to capital flight occasioned by wealth tax (Pichet, 2007).
A net wealth tax in South Africa would also crowd out the substantial revenue municipalities raise from property taxes. The effect of this on the financial position of municipalities would be dire. Besides, a new wealth tax in South Africa can be a disincentive to private giving which constitutes a source of substantial funds for social projects currently. Conclusion and Recommendations Overall, considering international experience with an annual personal net wealth tax and the present South African economic climate of low growth, it would be prudent not to introduce an annual tax on personal wealth.
Such a move risks causing harm to an already weak economy and further undermine economic growth by increasing tax avoidance, reducing savings and investment, dampening entrepreneurship, and generating capital flight. As estate duty, donations tax and transfer duty are already in existence with transfer duty doing fairly well albeit against declining revenues from estate duty, donations tax, what is required is their refinement to ensure efficiency. More importantly, there is no evidence introducing a new form of the wealth tax would contribute meaningfully to curbing the prevailing economic inequality. In the face of outrageously high wealth inequality overlaid by race, however, the need to sustain socio-political stability requires improved efforts at redistribution. Other methods of redress that can be considered and enhanced include land reforms, increased access to quality education and health for the poor. In terms of taxation, a better approach would be through consumption-based taxations that tax wealth in such a way as not to stifle savings, investment, and growth. As the conversation on possible global, coordinated wealth tax regime to curb the disturbing trend of wealth concentration, any decision on net wealth tax would require appropriate tax base, a comprehensive wealth ownership data and assessment of whether the expected revenue generation will exceed the administrative and economic burdens.
My mom called me up the other day and asked for a TV for her birthday. She wants a small 24-inch TV that she can put next to the treadmill.
I haven’t shopped for a TV in a few years. I was thinking to myself that this would be a $300 gift. Then my mom tells me that you can get 24-inch TVs for $99.
Ninety-nine bucks for a TV. I am not sure who is making money off a $99 TV. That’s incredible.
And that’s the miracle of capitalism in action…
If the government stays out of the way and does not regulate the manufacture of TVs, prices will decline over time.
I remember when I was a kid, there was a TV store in the mall. It was right by the front entrance. You could get a big tube TV, one of those wooden ones by Zenith, for $600—$600 in 1983 dollars, versus $99 in 2021 dollars. Absolutely amazing.
In real terms, the price of a TV has declined by over 90%. The Bureau of Labour Statistics says that it has declined by more than that.
BLS does this thing called hedonic adjustments. That’s where the inflation bean counters take into account the quality differences in a TV as well as the price.
Not only has the price gone down, but the quality has improved. According to the BLS, that means the price has gone down even more.
This is one way in which we systematically undercount inflation. There are other ways, but this is the biggest, at least when you’re talking about the Consumer Price Index (CPI).
Critics of hedonic adjustments say that you still have to buy a TV and you’re not getting it for 99% off. A TV is a TV.
Of course, TVs are an example where prices have declined over the years.
In healthcare and education, prices have risen, proportional to the amount of government involvement. Years ago, there was a chart going around that showed how the prices of certain goods and services had trended over the past few decades.
In places where entrepreneurs were free to innovate, prices declined the most.
Inflation is very complicated. Most macro thinkers, like I suspect you might be, look at inflation in purely monetarist terms: the supply of money and the increased supply of dollars chasing the same amount of goods.
It’s said that 35% of all dollars in existence were created in the past 10 months. Common sense would tell you that would cause inflation.
Left-wingers, generally speaking, look at the current level of inflation, which is about 2%, and say that the relationship between money supply and inflation has broken down. Milton Friedman was wrong.
Maybe not—where would inflation be in the absence of all the printing?
A pandemic is supposed to be a deflationary shock. We’re actually supposed to be experiencing deflation right now, but we’re not.
People have saved quite a bit of money during the pandemic. Once it’s over, and people begin spending again, inflation is likely to rise.
But maybe not! Technological improvements result in falling prices, but so do demographics. As the population ages, we can expect inflation to fall even further.
I like to say inflation is mostly psychological: If people expect price increases, then they will change their economic behavior accordingly. They will buy more things faster, which will cause more price increases. If people expect price declines, they will delay their purchases.
It is difficult to arrest a trend in inflation or deflation once it is in motion.
Check out this chart of corn prices, for example:
This looks like a lot of commodity charts out there right now, going from the lower left to the upper right, whether it’s agriculture, energy, metals, or soft commodities. By the way, the next time you are in the grocery store, take a look around—pretty much half the goods in the store are made of corn.
Of course, in the context of a long-term chart in commodities, what we experienced in 2020 is just a blip:
Which leads me to believe that commodity prices have a lot further to run.
I am bullish on inflation, though I acknowledge that people have been bullish on inflation since the first round of QE back in 2008, and it’s never materialized. This time, however, it’s not coming from the monetary side… it’s coming from the fiscal side.
We’ve handed out a lot of money in the last year: PPP loans, enhanced unemployment benefits, and stimulus checks. Sooner or later, this is going to find its way into the economy… right about the time that states start to ease their pandemic restrictions. This is independent of whatever the Fed does or doesn’t do.
The charts are already moving—by the time it shows up in the official statistics, it will be too late. There’s no need to run out and buy 20 bags of fertilizer at the moment, and I certainly hope that isn’t in our future.
Either way, stay tuned and I’ll show you how to play it.
Monetary stimulus would fund the vaccines we need and bolster the economic recovery.
The fiasco over the supply of vaccines reveals the vacuity of SA’s approach to Covid-19. The deposit of R283m to secure a supply of vaccines was not budgeted for because we didn’t have the funds, though money for much else was found in the adjusted budget.
Has anyone in the Treasury or the government attempted to calculate how much additional income will be lost for want of the vaccine, and how much tax revenue the Treasury will not be able to collect? It will be many times the R20bn to be spent on the vaccine, R7bn of which is to be funded by members of medical aids. A tax increase or expropriation by any other name, this is unhelpful given the state of the economy.
Yet a supply of additional money could have been made available by the SA Reserve Bank, in the same way money is being created on a large scale by central banks the world over to fund the extra spending the lockdowns made imperative. Moreover, there is little prospect of more inflation any time soon. If/when it does emerge, the reversion to normal funding arrangements would be called for, but this danger palls into insignificance compared with the current and present danger posed by the pandemic.
SA could not bring itself to think through the problem this way, led by a central bank that was able to resist the call for quantitative easing for its usual fear of inflation, with what appears to be the approval of the leaders of business and banks. The upshot is that SA lacks the essential self-confidence to do what would be right now, for fear that we might become addicted to monetary stimulation in the long run.
The money and financial market statistics are quite telling about how unready the economy is to sustain any recovery of output and employment. The supply of extra money in the form of notes and deposits by banks with the Reserve Bank — what is described as the money base or M0 — rose 8% in 2020. There was a flurry of such extra money in March and July 2020, since reversed. In the US the money base is up 43%.
The SA banking system is hunkering down, not gearing up. Bank deposits have been growing at about 8%, while lending to the private sector is up a mere 3% year on year. The banks are building balance sheet strength and raising deposits, and are cautious about lending more, relying less on repurchase agreements made with the Reserve Bank and other lenders, reserving more against potential bad debts not paying dividends, hence adding to their reserves of equity capital. All of this is growth depressing.
The financial metrics continue to paint a grim picture of the prospects for the SA economy. Long-term interest rates remain above 9% even as inflation is expected to average 5% over the next 10 years, meaning expensive capital for SA businesses, which are less likely to add to their plant and equipment. The difference between borrowing long and short remains extended, implying sharp increases in short-term interest rates to come, which is harmful to growth, and making it expensive for the government (taxpayers) to fund at the long end.
Poorly judged parsimony and monetary conservatism have brought SA great harm in the fight against Covid-19, because they have made the prospects for a recovery in GDP and government revenue appear so bleak. It is not too late to change course.
• Kantor is head of the research institute at Investec Wealth & Investment. He writes in his personal capacity.
By the time you read this, the US will likely have administered 20 million vaccinations. Add those who were previously infected, and maybe 40 million people should have some degree of immunity.
The number of new cases is dropping, as you can see in these charts from Justin Stebbing, a professor at Imperial College who sends a detailed daily COVID research summary.
New deaths are thankfully also turning.
That’s the good part, but there’s more that is less comforting. The CDC unfortunately confirmed my alarm about the UK (B117) variant strain. They expect it will account for 50% of US cases by March. This does not mean that the B117 variant will replace 50% of other cases. It means the significantly more contagious B117 will catch up through an exponential rise in the next few weeks.
How serious is this? Hard to say. How seriously will we respond, in terms of social distancing, masks, etc., in a country showing virus fatigue? How much faster can we vaccinate, given that we are already having supply problems? As I said then, I see a 40% chance of a significant uptick in cases, deaths, and lockdowns, which is a nontrivial potential. Nor is this just a US problem. The simple fact is that the world is in a race with the new B117 variant and how fast we can vaccinate the population, plus maintain safety conditions (like social distancing).
If the CDC is right about that 50% B117 prevalence, the US will face a series of lockdowns at least as intense as last spring. Do you think that is priced into the stock market? Will the stock market look past a serious uptick in cases, hospitalizations, and deaths? Along with new lockdowns? More small businesses lost?
I know that the Biden pandemic relief plan has come under severe fire for being too large. Given the sausage-making process of American politics, it is not clear what will come out of Congress. But there is a real possibility we will need more. And all that is going to merge with the other valuation/market issues we have today. Now let’s turn to the market forecast.
We all know the stock market was up significantly last year, and even more so around year-end, but you may not know how historically wild this is. Citi Research has a “Euphoria/Panic” index that combines a bunch of market mood indicators. Since 1987, the market has typically topped out when this index approached the Euphoria line.
The two exceptions were in the turn-of-the-century technology boom, when it spent about three years in the euphoric zone, and right now.
You can look at this in different ways. In terms of duration, the precedent suggests the giddiness could last another year or two. But in magnitude, the current euphoria is well above what we saw 20 years ago, and developed a lot faster.
The legendary Jeremy Grantham of GMO recently reviewed the dramatic events he observed over a 50+-year career managing money. He describes the current bubble as one of the “four most significant and gripping investment events of my life.” The others are Japan in 1989, the 2000 tech bubble, and the 2008 housing and mortgage crisis. We are in historic times.
Grantham went on:
The single most dependable feature of the late stages of the great bubbles of history has been really crazy investor behaviour, especially on the part of individuals. For the first 10 years of this bull market, which is the longest in history, we lacked such wild speculation. But now we have it.
He then described several signs of mania, ranging from Tesla’s valuation to the Buffett Indicator and Robert Shiller’s CAPE. But he comes back to the biggest disconnect.
The strangest feature of this bull market is how unlike every previous great bubble it is in one respect. Previous bubbles have combined accommodative monetary conditions with economic conditions that are perceived at the time, rightly or wrongly, as near perfect, which perfection is extrapolated into the indefinite future. The state of economic excellence of any previous bubble of course did not last long, but if it could have lasted, then the market would justifiably have sold at a huge multiple of book. But today’s wounded economy is totally different: only partly recovered, possibly facing a double-dip, probably facing a slowdown, and certainly facing a very high degree of uncertainty. Yet the market is much higher today than it was last fall  when the economy looked fine and unemployment was at a historic low. Today the P/E ratio of the market is in the top few percent of the historical range and the economy is in the worst few percent. This is completely without precedent and may even be a better measure of speculative intensity than any SPAC.
This time, more than in any previous bubble, investors are relying on accommodative monetary conditions and zero real rates extrapolated indefinitely. [emphasis mine] This has in theory a similar effect to assuming peak economic performance forever: it can be used to justify much lower yields on all assets and therefore correspondingly higher asset prices. But neither perfect economic conditions nor perfect financial conditions can last forever, and there’s the rub.
“Accommodative monetary conditions and zero real rates extrapolated indefinitely” is a phrase I wish I had coined. It’s the best, most succinct explanation I’ve seen for this euphoria. And, as Grantham says, it’s not going to end well. But the party could continue if current monetary conditions and low rates persist.
That being said, let’s look at not only the Buffett indicator (all-time highs) he mentioned but a few more charts:
Numerous other indicators are at or close to their historical peaks. Here’s a handy list, courtesy of Doug Kass.
When we say that price-to-sales is at 100% of its historical percentile that is a little misleading. It is much higher than that in actuality:
I could easily show you a dozen more charts, all basically saying the same thing: Valuations are at nosebleed levels. You’ve seen them elsewhere so no need to reproduce them here.
The brilliant Jesse Felder illustrates the price/sales problem this way, using Tesla.
“What were you thinking?” That is the rhetorical question Scott McNealy, CEO of Sun Microsystems, asked of investors paying a “ridiculous” ten times revenues for his stock at the height of the Dotcom Mania.
The incredulity in his voice is amplified by the benefit of hindsight as McNealy gave the interview this quote was taken from in the wake of the Dotcom Bust, after his stock price had lost over 90% of its value.
Indeed, what were investors thinking 20 years ago not only paying 10 times revenues for Sun Microsystems but also paying that ridiculous multiple for 44 other stocks in the S&P 500 Index? It’s impossible to know for sure but it’s a good bet they were simply counting on the “greater fool theory” or the idea that someone will come along and pay an even more ridiculous price than they did. At some point, however, the market ran out of fools and the Nasdaq fell 83%.
It’s interesting to note that we seem to have found even more fools today than we did back then. Nearly 60 of the S&P 500 Index components currently trade more than 10 times revenues. There’s no telling when the current market will run out of fools this time but, when it’s all said and done, that last buyer may justly earn the title “greatest fool” of all time. And only with the benefit of hindsight will it really feel like the abject folly it should.
On Twitter, Jesse asked rhetorically what the McNealy of 20 years ago would think about Tesla trading at 30 times revenues. McNealy replied, “I want to be Elon Musk.”
Last year the S&P was up 18.4%, the Nasdaq 44%, and an equally weighted portfolio of FAAAM (Facebook, Alphabet, Amazon, Apple, Microsoft) plus Netflix was up 55%. The contribution of that latter group to the S&P 500’s growth was 14.35%. The “S&P 494” gained only 4.05%. (H/T Kevin Malone)
What are the chances the FAAAM+N stocks rise another 55% this year? Especially given the uncertainty and a high probability that earnings estimates will come down significantly?
Yes, the Fed will be extraordinarily accommodative, interest rates will remain low and markets will still try to “extrapolate indefinitely.” The significantly smarter-than-me people at Goldman Sachs have a much more optimistic scenario (15%+ this year!):
I will say that such optimism reminds me of the diner scene in “When Harry Met Sally.” Wall Street wishes it could have whatever they are having.
Ah, but what about earnings, you say? Think of the pent-up demand that will be unleashed on businesses when all this is over. Two responses:
First, “when all this is over” is a fact not yet in evidence. The virus still has us firmly in its grip which is, if anything, tightening. Maybe it will loosen this year, maybe not.
Second, “pent-up demand” assumes people, once liberated from virus fear, will move the money they didn’t spend during this time into the same things they would have spent it on. That’s a giant assumption. The revenue lost by service businesses is permanently gone. And the propensity to save, if you believe multiple surveys, is increasing.
The simple fact is that this period has scarred a generation, and like the Great Depression generation, they will be more financially conservative. At the very least for a while.
Nonetheless, at some point even zero real rates don’t justify holding stocks unless they produce sufficient earnings. I don’t know where that point is (none of us know the future). But we do know where earnings are. Here’s a chart from Ed Easterling of Crestmont Research.
Look at the inset chart first. It shows the progression of earnings estimates beginning two years ahead of a year-end. You see they mostly started optimistic and gradually came down (though 2012 and 2018 weren’t far off. Even Wall Street gets it right sometimes).
But look at the orange line labelled “2020F.” It was gently declining like other years, then plunged when COVID hit as analysts sliced estimates. Yet stock prices went the opposite direction, for the aforementioned monetary reasons.
Now look at 2021F. Projected 2021 earnings are almost back where 2020 was, pre-pandemic. That means analysts project US public companies will, less than 12 months from now, have fully recovered from this plague. Possible? Yes, but I think highly unlikely.
But if you believe both a) earnings will recover this year and b) the Fed will keep stimulating, or at least not withdraw what it injected, then today’s stock prices kind of/maybe/sort of/possibly make sense. That’s an ideal, once-in-a-lifetime Goldilocks scenario. Again, I think it’s VERY unlikely, but it isn’t impossible.
So what is an investor to do? As always, it depends on your personal circumstances. A 30-year-old with steady income and little or no debt might ride the wave for a while longer. But I think anyone in or near retirement should think very hard about how aggressive they want to be. I know it’s a tough spot. You certainly won’t make much in bonds or bank savings.
So, let me make an actual market call. With some significant qualifications.
First, anybody over 50 with substantial amounts of money in passive index investing should probably step to the side. Especially if that is your retirement money. Take profits. Go to cash.
I see too many parallels between market valuations and exposure between the year 2000 and today. Note that both in 1999/2000 and in 2006–07 I called the bear markets early. Maybe I’m early again. But I will note that my good friend Doug Kass of Seabreeze Partners issued a bear market warning this week: “My message is simple. Sell Stocks Now.” And he is a much better market timer than I am.
Jeremy Grantham points out, in the report quoted above, how investment professionals have to think not only of market risk, but career and business risk, too. They have strong incentives to stay bullish at all times. If your investment advisor has you in a traditional 60/40 portfolio using passive indexes then you should consider other options. I can’t say it any plainer than that.
Now, let me note the exceptions. If you are young and have time, as in more than 20–30 years, and can deal with the drawdown or small returns for 10 years, then be my guest.
Let’s look at this chart from my friend and business partner Kevin Malone at Greenrock Research. Note that the decade of the “aughts” had a negative (almost -1%) return. (As predicted here at the beginning of that decade, based on historical market returns from extraordinarily high valuations.) Today’s valuations resemble those of the year 2000. Why should we expect different results? The 2010s were an extraordinary bull market. You were more or less rewarded for staying in the market for 20 years, though with the smallest average annual return since 1960.
Kevin then shows what a dividend-focused strategy would have returned over the same periods. This uses Jeremy Siegel’s data, taking the 100 highest-paying dividend stocks in the S&P 500 and rebalancing every year.
I can show you any number of dividend strategies, both US and foreign, that have significantly outperformed with below-market volatility. (My good friend David Bahnsen wrote a very easy to read primer called The Case for Dividend Growth.)
So, if your advisor has you in a historically proven active strategy, there is no reason to move to the sidelines. Let me go further: There are other active stock market strategies that I would expect to do quite well, just as they did in the first decade. A diversified portfolio of hedge funds significantly outperformed in the first decade. Not so much this last decade. There are two strategies to go into in this letter today. Suffice it to say, I think the 2020s will once again be the decade of active management.
The 2020s are going to be about rifle shots, not the shotgun approach of index funds.
This will be a decade to focus on absolute returns as opposed to relative returns. Passive index investing is a relative return strategy and I think it will be a very poor choice in the coming years. As my dad used to say, every dog has its day. Passive investing had the last decade. Active investing is getting ready to take the lead.
While I’m bearish on passive index funds, my own portfolio is almost fully invested. I own individual stocks, carefully selected with a long time horizon. That’s my choice, but you and your advisor need to do your own due diligence and decision-making.
In my own portfolio, I admit the irony I am somewhat buy-and-hold. I tend to make very specific and targeted investments, and then hold them. Some are for income and some are for growth.
And even as I am saying that I think the stock market is going down, the risk profile and aggressiveness of my own portfolio is probably more than it’s ever been. I find plenty of things to be very optimistic about.
In every bear market, there are individual positions that do well. Time will tell whether my own personal convictions will prove profitable. But you cannot look at my personal investment portfolio and call me bearish. I am extraordinarily bullish, just not on passive index funds. In a few weeks, if compliance permits, I’m going to write about my personal investment philosophy and positions. There are plenty of opportunities, though admittedly more for accredited investors than those with less than $1 million, but also some for those still accumulating portfolios.
I don’t know how to be clearer. Take your profits from passive investing. Taking profits is not alarmist. It used to be considered wise advice. Just saying.
As my friend Dennis Gartman used to sign off, “Good Luck and Good Trading.”
Brexit got done, just about. But it’s not going away, and for reasons that are interesting beyond the immediate issues at stake. We’ve talked before (e.g. TiB 34) about multi-dimensional politics, with the “open/closed” culture dimension supplementing the classic left/right economic one. Crudely, Brexit worked as a bundle of policies: the novel electoral coalition of “anti-elite” voters who voted for it were willing to stomach some economic pain for a cultural victory. But that’s also precisely why Boris Johnson’s deal is unlikely to be a stable equilibrium.
The deal we have is about the hardest possible Brexit, barring “No Deal”. This creates an unusual situation. Every future UK government now has some enticing low-hanging economic fruit: increase economic integration with the EU! That doesn’t mean the UK will rejoin any time soon. I expect immigration will remain a highly salient issue that prevents the UK going even as far as EEC membership. But it’s difficult to imagine that UK governments can persistently convince the electorate that technical issues like regulatory divergence are important cultural issues when unbundled from immigration.
We only got to such a hard Brexit because of the weird sort of “iterated Hastert rule” that means tiny groups of people can exert enormous control over political parties (See this superb podcast with David Shor for examples in the US Democratic Party). But at some point this dynamic crashes up against the median voter theorem – and the median voter really likes getting richer! As such, I think we can expect the UK’s economic relationship with the EU to be a major issue – and a winning one for ex-Remainer / integrationists – for quite some time.