Bernanke's Easy Money Death Spiral

On the Road to Zero Growth

By Vince Foster

It seems that big sucking sound signaling a precipitous drop off in the demand for money that I have been warning about for a few weeks is starting to get some more attention. This past Monday, the Wall Street Journal ran a front page story headlined Investment Falls Off a Cliff:  US Companies Cut Spending Plans Amid Fiscal and Economic Uncertainty. According to the article:

Nationwide, business investment in equipment and software -- a measure of economic vitality in the corporate sector -- stalled in the third quarter for the first time since early 2009.

Corporate executives say they are slowing or delaying big projects to protect profits amid easing demand and rising uncertainty. Uncertainty around the US elections and federal budget policies also appear among the factors driving the investment pullback since midyear.

Companies fear that failure to resolve the fiscal cliff will tip the economy back into recession by sapping consumer spending, damaging investor confidence and eating into corporate profits.

The consensus would have you believe that this hunkering down by corporations is solely a function of fears of the current dysfunction in Washington. But upon further investigation, it appears that this decline in capital expenditures is more secular in nature.

Esteemed value investor Jeremy Grantham of privately-held GMO, one of the largest investment firms in the worlds with nearly $100 billion in assets under management, explores this reduction in capital spending in his quarterly letter to investors released this past week. In a sobering dissertation titled On the Road to Zero Growth, Grantham goes through the many drivers of a structural decline in US economic growth capacity. Citing the "Bonus Culture," a term coined by his economic consultant Andrew Smithers, Grantham explains why today’s CEOs are averse to capital investment.

Now, in the bonus culture, new capacity is regarded with great suspicion. It tends to lower profitability in the near term and, occasionally these days, exposes the investing company to a raider. It is far safer to hold tight to the money and, when the stock needs a little push, buy some of your own stock back. This is going on today as I write, and on a big scale (approximately $500 billion this year). Do this enough, though, and we will begin to see disappointing top-line revenues and a slower growing general economy, such as we may be seeing right now.

Grantham, it should be noted, has made several significant market predictions including the bubble in Japan's stocks in 1989 and also in US stocks in 2000. In his recent letter to investors, he posts a chart of US Capital Formation as a ratio to GDP that shows a severe decline that began in 2000 with the flowering of Bonus Culture. About the chart he says:

Mostly the data in Exhibit 5 reflects a lower capital spending rate responding to slower growth. The circled area, though, suggests an abnormally depressed level of capital spending, which seems highly likely to be a depressant on future growth: obviously you embed new technologies and new potential productivity more slowly if you have less new equipment. This currently reduced investment level appears to be about 4% below anything that can be explained by the decline in the growth trend. If this decline is proactive, if you will, and not a reflection of earlier declines in the growth rate, then based on longer term correlations it is likely to depress future growth by, conservatively, 0.2% a year.

This decline in capital spending isn’t just about fears of the fiscal cliff. This has been going on for over a decade. This got me thinking about what the roles are that interest rates and monetary policies play in this secular change. Last week in How QE Is Impeding Economic Growth, I cited a speech Chairman Bernanke had delivered in the prior week where he extols the benefits of low interest rates (emphasis mine).

At the Federal Reserve, we have sought to support the economic recovery and maintain price stability -- the two goals given to us by the Congress -- by keeping both short-term and longer-term interest rates historically low. Low interest rates reduce the cost to households of buying homes, cars, and other consumer durables while increasing the attractiveness of new capital investments by firms.

Do low interest rates increase the attractiveness of new capital investment?

I ran my own chart on Bloomberg of capital expenditures as a ratio of GDP to see if I could find a positive correlation between low interest rates and higher capital investment. Using the Federal Reserve’s own Flow of Funds data I plotted the Nonfinancial Business Capital Expenditures Fixed Investment divided by nominal GDP.  After overlaying the chart with a couple of different interest rate relationships both real and nominal, I found a pretty tight inverse correlation with the slope of the yield curve going back 40 years. When the curve flattened, capital expenditures tended to rise; conversely, when the curve steepened, capital expenditures tended to fall.

In order to explain why this correlation might exist, I want to drill down a bit deeper and explore two different decades: The 1990s, which can be generally characterized as a period of tight money, and the 2000s, which generally has been considered a period of easy money. 

In 1992, the Fed funds (US Department of Treasury) rate was 3% and the spread between the daily 5-year (5YR) and 10-year yield (10YR) curve rates was 100bps. When Greenspan began normalizing monetary policy after the recent recession, the curve flattened from 100bp to 0bps as he took the funds rate to from 3% to 6% by 1995. Basically, between late 1994 up until the tech bubble imploded in 2000, the Fed funds rate remained relatively stable at 5.50% plus or minus 50bps. Over that same time frame, the yield curve measured by the 5YR/10YR spread was equally as stable, trading between 0bps and 25bps until going negative in 2000 as Greenspan tightened into the tech bubble.

As you can see on Grantham’s chart over that time period, capital investment as a percent of GDP rose from 5% to nearly 10% in 2000. 

While the 1990s generally saw a flat and tame yield curve the following decade would be the opposite seeing a volatile and steep curve.  Between 2000 and 2010, the Fed lowered the funds rate from 6.50% to 1.00% back up to 5.25% and down to zero in 2009.  Over the same time frame the 5YR/10YR spread was equally as volatile steepening from -25bps to 100bps back down to zero and back up to and unprecedented 125bps as the Fed funds hit zero.

Looking back at Grantham’s chart you can see this period corresponded with a collapse in capital spending as the Bonus Culture emerges. As Grantham notes, "This currently reduced investment level appears to be about 4% below anything that can be explained by the decline in the growth trend."

What is going on here? 

The term structure embedded in the yield curve is the bond market’s discount for inflation. Under tight monetary policy, the curve tends to flatten, discounting low inflation pressure; under easy monetary policy, the curve tends to steepen, discounting high inflation pressure.

In addition to discounting inflation pressures, the slope of the yield curve often manifests in the slope of the risk curve. When the yield curve is narrow, risk premiums are lower; when the yield curve steepens, risk premiums are higher. Higher inflation discounts produce lower market multiples, which translates into higher costs of capital. The market doesn’t pay a higher multiple for inflated cash flows.

The secular nature of this decline in capital investment has to be related to something that is also secular causing this risk aversion. In other words, it's not just a product of a bunch of greedy CEOs who are scared to deploy capital for fear of risking their stock options. 

I think there is a reason for the correlation between yield curve volatility and capital expenditures. I think that this era of uber-easy monetary policy driving yield curve and thus risk curve volatility is behind the collapse in capital investment due to the uncertainty in the cost of capital for which to invest.

As a corporate manager, you can’t forecast the return on invested capital if you can’t forecast the cost of that capital or don’t believe it to be stable. The immense yield curve volatility -- and thus risk curve volatility -- over the past decade has removed the ability for corporations to effectively calculate their net return on capital. Instead of deploying capital for investment in fixed assets, managers simply sit on the cash and, as Grantham notes, buy back stock or retire debt.

If that wasn’t bad enough, the returns on what little capital that had been invested appears to be peaking. I monitor two return metrics for the S&P 500 (INDEXSP:.INX): The return on assets (ROA) and the return on capital (ROC) less the Moody’s BAA bond yield. I plot the ROA over commercial and industrial (C&I) loan growth with the ROC over the S&P 500 price. The idea is that when the ROA is rising, it creates a demand for capital (loan) to invest in those assets, which in turn generates a ROC, which then produces capital appreciation (stock prices).

In late 2011, the ROA of the S&P 500 reached a post-crisis and near-decade high of 9.5%, which corresponded to double digit growth in loan demand. At the same time, the reported ROC less corporate bond yields (partly due to QE) reached a decade high spread of 11%, no doubt helping fuel the rally in stock prices. Since the 2011 peak, both return metrics have seen a notable flattening if not outright decline, with October 2012 ROA reported at 8.6% and the ROC at 10.45%. While still at robust levels of profitability, these two primary drivers of the equity market rally are starting to wane. With interest rates still at record lows, it appears the stimulative effect of low interest rates on corporate profits has reached its maximum benefit.

On November 12 in Rally Off 2009 Lows Flushes Hedge Fund Shorts, I cited two important pivots that investors should watch for the market to back test: The 1400 level on the S&P and the 150-00 level on the US bond futures contract.

The stock market has clearly done some serious technical damage, but unless we are crashing there should be an attempt to back test 1400, at the very least to work off oversold conditions.... I wouldn’t even rule out an attempt to rally back toward the old highs into Thanksgiving, however if we are putting in a cyclical top, that’s a rally you will want to sell.

or the bond market, we have a similar setup. Last week’s short squeeze was swift and severe. The US bond futures contract traded over two standard deviations above the regression line we have been following since June’s breakout rally. Traditionally that is not a move you want to buy. When the market settles down a bit, I expect a back test of 150-00. Obviously that level needs to be respected, and if we hold convincingly, you have to prepare for higher prices and lower yields.

You might expect counter-trend moves to occur during lightly participated trading sessions, and last week we saw both back test pivots hit.  During Friday’s abbreviated holiday session when no one was trading, they managed an 18-handle rally to close the S&P at 1409. During Wednesday’s equally boring session, the US bond contract hit 150-00 held and closed the week at 150-01. This week, the pros come back to work and it is make or break for the year-end trade.

Last week, I argued from a lender’s perspective that contrary to Bernanke’s assertion, QE was impeding the extension of credit by raising interest rate risk. This week, I argued from the CEO perspective that QE is impeding capital investment by raising cost of capital volatility risk. Despite compelling evidence that monetary policy is inhibiting the capital allocation process, Bernanke continues to argue as he did last week for further accommodation. 

The irony is that, if I am correct, the more easy money we get, and the longer it will take to build a sustainable recovery, which will forever prevent Bernanke from ever normalizing interest rates. We are just stuck in this never-ending easy money death spiral that only the market can end. And that probably doesn’t end well.