Re­turns on cap­i­tal are de­te­ri­o­rat­ing

Financial Mirror (Cyprus) - - FRONT PAGE - By Will Denyer

The rate of re­turn on cap­i­tal in­vested in the US has taken an­other step down. While not ter­ri­bly sur­pris­ing, this does bring the world’s largest econ­omy one step closer to the next re­ces­sion and a full-scale bear mar­ket. Nev­er­the­less, the day of reck­on­ing re­mains some way off; the cur­rent cy­cle is not about to reach the end of its road just yet.

To­wards the end of last year, I in­tro­duced a new frame­work to as­sess where the US econ­omy is in its cy­cle, the like­li­hood of re­ces­sion, and the rel­a­tive at­trac­tive­ness of risk as­sets. My frame­work is based on the sim­ple ob­ser­va­tion made by Knut Wick­sell in his 1898 book, In­ter­est & Prices, that there is a nat­u­ral up­per limit to the in­ter­est rate that en­trepreneurs are will­ing and able to bear: the ex­pected, mar­ginal re­turn on in­vested cap­i­tal (ROIC).

So the frame­work has only two parts: in­ter­est rates and ROIC. If the cost of cap­i­tal rises above its ex­pected re­turn, then en­trepreneurs will quit bor­row­ing to make new in­vest­ments. This will weigh on eco­nomic ac­tiv­ity (less in­vest­ment and fewer hires) as well as money sup­ply (a prod­uct of less bor­row­ing in a pro-cycli­cal frac­tional re­serve bank­ing sys­tem). In such cir­cum­stances, a re­ces­sion is al­most surely in the works.

While it is im­pos­si­ble to know for cer­tain what cor­po­rate man­agers ex­pect to earn on new in­vest­ments, as­sess­ing the pre­vail­ing situation can give a pretty good idea. To do this, it is nec­es­sary to com­pare re­cent prof­its on do­mes­tic cor­po­rate ac­tiv­ity with the cost of the in­vested cap­i­tal that pro­duced those re­turns—but crit­i­cally, to value in­vested cap­i­tal one should not use the his­tor­i­cal cost of cap­i­tal, but in­stead the Bureau of Eco­nomic Anal­y­sis’s es­ti­mate of the cur­rent cost of that cap­i­tal. While im­per­fect, this re­sults in a sig­nif­i­cantly more ac­cu­rate es­ti­mate of what man­agers might ex­pect to get in re­turn on any in­vest­ments they make today.

Af­ter fourth quar­ter top-down data was re­leased on Fri­day, my mea­sure of “cur­rent ROIC” (C-ROIC) fell to 5.2%, from 5.4% in 3Q. Over the course of 2015, this mea­sure fell by 80bp, from 6% to 5.2%. This is not good news. Nei­ther is it sur­pris­ing. In De­cem­ber’s Quar­terly, I ar­gued that in­vestors should be pre­pared for C-ROIC to de­cline at a rate of around 100bp per year.

Taken in iso­la­tion, the re­cent de­cline and the cur­rent level of C-ROIC looks rather “re­ces­sion­ary”—but it would be a mis­take to look at this mea­sure in iso­la­tion. There is no magic level be­low which a re­ces­sion oc­curs (in in the 1970s it would have been 7%, 6% in the 1980s and 1990s, and 5% in the last two re­ces­sions). What mat­ters is the re­la­tion­ship be­tween the re­turn on cap­i­tal and its cost. And today, de­spite re­cent de­clines, the re­turn on cap­i­tal re­mains well above its cost—how­ever you mea­sure cost. There are many op­tions, but two of our fa­vorite mea­sures of the cost of cap­i­tal are a) the sea­soned Baa cor­po­rate bond yield, and b) the Fed Funds rate with a 350bp risk and term premium added. By both of these mea­sures, there is still have a siz­able pos­i­tive spread of 200-300bp.

That means the Fed­eral Re­serve has lots of room to hike be­fore it causes prob­lems di­rectly. The big­ger con­cern is that credit spreads might blow out, putting an end to the cy­cle be­fore Fed ac­tion does so. With that in mind, the widen­ing of credit spreads around the turn of the year was alarm­ing. But credit mar­kets have calmed down more re­cently.

Still, the de­clin­ing rate of ROIC shows we are clearly in the lat­ter half of the cy­cle. The easy gains have been made, and risks abound. But over the last 50 years, there has never been a re­ces­sion while the re­turn on cap­i­tal was above the cost of cap­i­tal. So long as this spread re­mains sig­nif­i­cantly pos­i­tive, I do not ex­pect a re­ces­sion. Mar­kets should con­tinue to climb the wall of worry, even though that climb will be volatile.

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