If Hoisington is Right about Bonds
July 31, 2012
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Might today’s historically low interest rates in the U.S. persist for years to come? The latest Quarterly Review and Outlook by Van Hoisington and Lacy Hunt of Texas-based Hoisington Investment Management forces readers to consider that possibility, refuting the reversion-to-the-mean mindset that causes many people to expect higher interest rates in the not-too-distant future.
If the Hoisington model for the economy turns out to be right, the implications for the stock market are unfavorable. That may seem counterintuitive; lower interest rates, after all, generally increase market valuations. But in this case they portend a slowly growing economy, which will depress prices.
The key variable in Hoisington’s forecast of persistently low – if not even lower – interest rates is an expectation of sluggish economic growth for the next decade or so. Hoisington and Hunt cite three real-world examples and three academic studies to support the idea that the structural growth rate of a nation’s economy declines by at least one percentage point whenever countries reach a certain threshold of indebtedness. One percentage point may not sound like much, but for a mature economy like the U.S.’s that historically grows about 3.0% annually, net of inflation, it cuts growth by a third.
Citing the research of Reinhart and Rogoff, Hoisington and Hunt suggest that developed economies slip into a prolonged period of slower growth whenever government debt approaches 90% of the value of the overall economy, as measured by gross domestic product (GDP). The current government debt-to-GDP ratio in the U.S. is nearly 100%.
Hoisington and Hunt make the case that 2008 marked the beginning of a fourth episode of suppressed economic growth in the wake of over-indebtedness, following the three prior examples they cite in their report, two of which occurred in the U.S. and the other in Japan. The first was triggered by a massive debt buildup to finance the railroads in the U.S. in the 1860s-70s. The second was the period of over-investment and rampant asset speculation in the 1920s that led to the Great Depression. The third example was the debt-financed expansion in Japan that peaked in 1989. In the words of Hoisington and Hunt:
“The relevant point to take from this analysis is that U.S. economic conditions beginning in 2008 were caused by the same conditions that existed in these above-mentioned panic years. Therefore, history suggests that over-indebtedness and its resultant slowing of economic activity supports the proposition that a prolonged move to very depressed levels of long-term government yields is probable.”
The inability of the U.S. economy to reach escape velocity three years into a feeble recovery from the last recession supports the Hoisington model. If this worldview gains wider acceptance over time, it is likely to influence stock prices negatively in the decade to come. Specifically, stocks will likely be priced at a lower average multiple of earnings if investors internalize a slower expected growth rate for the economy. When combined with today’s below-average starting point for the dividend yield from stocks, a shrinking price-to-earnings ratio (P/E) would make it virtually impossible for the U.S. stock market to deliver double-digit returns over the next seven to 10 years.
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