Returns on capital are deteriorating
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.