Recently emerging trends in the U.S. equity markets reveal three key shifts in the structure of the U.S. economy: the rise of uncertainty, as opposed to volatility, as the core driver of the markets valuations; growth in importance of the pro-cyclical fiscal policies in replacing monetary policy easing as the key policy driver for the continued economic expansion; and the uninterrupted rise of investors’ over-confidence as the psychological force sustaining continued inflation of the already historically unprecedented financial assets bubble.

Taken together, all three form a logical denouement to a decades-long process that fueled the transformation of the U.S. economy from the one driven by free enterprise and innovation into the one dominated by the rising monopolization, oligopolization and the growing reliance on state supports and rent seeking.

The full range of implications of these developments is yet to be felt by the global markets. But what these promise for the years ahead should worry every investor around the world.

The rise of uncertainty

While markets volatility, especially measured by the widely traded VIX and VXX indices, has enjoyed a period of historical lows in the run up to the February 2018 U.S. equity markets ‘wobble,’ equities and broader markets’ uncertainty gauges have been trending sustainable above their pre-2008 averages ever since the end of the Great Recession.

Since the end of the global financial crisis, indices for economic policy uncertainty indices, as well as the largest emerging markets have been averaging well above levels consistent with past economic expansion cycles.

These indices generally reflect news-reported sentiment about the uncertainty in the direction and impact of current economic policies and environments, and as such underpin longer term trends in key economic fundamentals that serve as major determinants of the long run equity and bond markets valuations.

Similarly, the index of VIX volatility (VVIX), a measure of more definable, Knightian uncertainty that reflects the degree of instability in market volatility itself, was on the rise long before the onset of the most recent equity markets correction.

Beyond this, a range of academic studies have shown that other indirect gauges of uncertainty have been singling trouble ahead for the financial markets. In simple terms, volatility (or measurable risk) has been trending down, just as uncertainty (a deeper source of future instability) trended up.

The nirvana state of complacency, exhibited by the markets, investors and traders prior to February 2018, has come to an abrupt end when VIX spiked to its highest level since August 2015 (when a China stocks correction triggered contagion to other markets around the world). Although the market recovered from the February correction rather quickly, there was no return to the pre-correction trends. Instead, markets continued to trade sideways, with volatility remaining at elevated levels and volatility of volatility continuing to trend above historical norms (See Chart A).

Source: Bloomberg and author own calculations

As shown in chart A, even allowing for the latest markets correction, the linear trend in VIX has been sharply downward over the period of January 2010 – February 2018, in contrast to moderately positive trends in uncertainty (VVIX) and intraday markets volatility, and strongly positive trend in actual measured markets volatility.

In reality, as reflected by broader market uncertainty, the environment has been at odds with the markets perceptions of volatility – a clear-cut sign of sustained behavioral disconnect between the valuation fundamentals and the investors’ sentiment.

The short-term optimism over never-ending easy investment and credit conditions, fueled by monetary and fiscal excesses across most larger economies, is contrasted by the elevated unease about the longer-term direction of the global economy lacking sustainable and resilient growth drivers. The former propels excessive investors’ optimism, reducing expected volatility; the latter sustains deep sentiment of structural uncertainty and a threat of a systemic crisis in years to come.

The rise of the state economy

This behavioral divergency between expected volatility, realized risk and longer-term concerns with uncertainty rests on the foundation of recent macroeconomic policies. Since the start of the global financial crisis in 2007-2008, worldwide monetary authorities have deployed an unprecedented – in volumes of funds involved and in ranges of instruments used – wave of mentally easing.

At the end of February 2018, U.S. Federal Reserve, ECB and Bank of Japan combined holdings of assets amounted to $14.6 trillion, up from about $3.2 trillion back in the first half of 2007. The Peoples’ Bank of China balance sheet adds another $5.6 trillion. At the end of 2007, the Big 4 central banks asset holdings amounted to roughly 8 percent of the global GDP. By the end of 2017, the number was just under 25.5 percent.

This monetary activism sustained an unprecedented Bull run in equities and bonds, which, in turn, drove investor exuberance. If core metrics like revenues per share, earnings per share and profit margins are anything to go by, S&P 500 investor expectations for improvements in corporate financial performance outpaced actual outruns in almost every quarter since at least 2011.

This expectation inflation stands out even more when one considers the impact of shares buybacks on the above corporate performance metrics. The S&P 500 Buyback Index – an index of share prices performance for top 100 S&P 500 constituents selected by their shares repurchases has notched an annualized rate of return of 13.47 per annum over the last 10 years and 19.76 percent over the last 12 months. S&P 500 total return was 4.79 percentage points below the Buyback index annually over the last decade, and 1.18 percentage points lower over the last 12 months.

Over the last 10 years, the correlation between the Buyback Index and the S&P500 Total Return Index has been a staggering 0.994, implying that a buybacks-driven credit expansion in corporate bonds markets, fueled by ultra-low interest rates, has contributed significantly to the overall equities valuations (See Chart B).

Source: data from S&P Dow Jones Indices LLC

Crucially, the same expectations dynamics are now driving the recovery from the February correction. While U.S. monetary policy is continuing to gradually drift toward a slow unwinding of quantitative easing (QE), fiscal policy has stepped in to replace the stimulative effects of the accommodative Fed. Last quarter, the U.S. unveiled a medium-term tax reforms package that attempts to stimulate private investment and aggregate demand, onshore retained profits held by the U.S. companies abroad, all while reducing incentives to raise corporate debt.

The economists are still debating the extent to which the new reforms can lift the longer-term potential GDP growth, but the markets have largely priced in all potential upside already. The S&P 500 move between December 2017 and January 2018 has been consistent with the stock markets effectively buying into the White House’s prediction of a medium-term GDP growth “in excess of 3 percent” and the long-run output effects in the 3 to 5 percent range (see Council of Economic Advisers), even as a range of economic analysts predicted a 10-year average impact of the tax reforms to range between nil and 0.17 percentage points, annualized (see Table 1).

More importantly, even assuming that the Tax Cuts and Jobs Act 2017 reform raises long-term growth rate by 3 percent, increases in annual growth rate over first decade is estimated to range between 0.05 and 0.19 percentage points. Hardly the numbers to be excited about, let alone to drive stock prices to new historical highs.

The core issue as to why the Tax Cuts and Jobs Act (TCJA) 2017 is failing to generate higher expected growth effects – the problem that the Wall Street seemed to have missed in its rosy analysis of the Act – is that while the reforms lower the effective marginal tax rate on corporate investment from just under 10 percent in 2017 to ca 6.5 percent in 2018-2021, starting with 2022, the tax rates will creep up, exceeding 2017 levels around 2026.

The bulk of corporate investment (some 50 percent of all business investment in the U.S.) falls into the shorter depreciation category, e.g. 7-year equipment, which enjoyed an effective marginal tax rate of under 8 percent in 2017.

Moving the reduced value of the depreciation schedule under the TCJA 2017, any temporary decline in the effective marginal tax rate on this type of investment over 2018-2022 will be offset by increases in the rate post 2023. By 2024, based on some estimates, the effective marginal tax rate on shorter depreciation schedule capital will rise above 2017 levels.

In fact, there is only one type of corporate capital investment that benefits from a sustained reduction in tax burden under the TCJA: investments in 39-year structures that account for roughly 25 percent of total corporate investment.

The worst part is that the TCJA dramatically cuts incentives for companies to undertake R&D investments in the U.S.

Under the act’s provisions, due to a lower debt tax shield and expensing, the current (2017) marginal tax rate on these investments (-39 percent) will shrink in absolute value to about -22 percent from 2018 to 2021 before falling further to closer to -2.5 percent during the period from 2022 to 2025. In other words, tax supports for R&D investment will evaporate.
Instead of triggering a large-scale investment boom by the U.S. corporations, the TCJA 2017 drives up fiscal supports for the American corporatocracy. Based on the analysis by the Committee for a Responsible Federal Budget and the Congressional Budget Office, U.S. Federal deficits are expected to rise to 3.6 percent of GDP in 2018, 4.7 percent in 2019, peaking at 5.4 percent in 2022. Factoring in tax extenders (continuation of existent tax provisions), and sequester/disaster relief adjustments, federal government deficits are expected to run at 4.3 percent of GDP in 2018, 5.5 percent in 2019, 5.9 percent in 2020 and 6.4 percent in 2022.

The TCJA 2017 provisions are favoring physical capital, supported by an aggressive shift in investment incentives from debt to equity. This provides support for a short-term reallocation of value from the bonds to equities, but it does not deliver a substantial support for more important – from economic point of view – incentives to invest in faster-depreciating capital and R&D. The net effect of these policy changes is likely to be a sustained wave of new share buybacks. Based on an S&P analysis through February, the markets expect S&P 500 share buybacks, led by the technology and healthcare sectors, to rise above $1 trillion in 2018, setting an all-time record.

In simple terms, the new reforms amount to an expansionary fiscal policy at the time of low unemployment and growing economy – a pro-cyclical policy that is currently feeding the financial markets but does preciously little to lift real economic growth. This pro-cyclicality of the U.S. fiscal stance is further reinforced by President Trump’s promises to dramatically raise federal infrastructure investments.

All in, the U.S. economy is now a basket case of traditional Keynesian policies overlaying an expansionary part of the business cycle. The environment that is less likely to improve long-term growth dynamics, but more likely to fuel asset bubbles in stocks, real estate and household debt, as well as allow for greater capture of the economy by the state.

The kicker to all of this is that current, ongoing U.S. dollar weakness confirms the above story. Bigger U.S. fiscal deficits require foreign capital inflows. When hedging U.S. dollar exposures is costly, as in the present markets, this means either the U.S. runs higher interest rates (a transfer from bonds to foreign capital and equities), or U.S. dollar must fall even further to make anchoring capital into the U.S. more attractive. So far, we have both.

Captive economy

Taken together, the above factors form a logical denouement to a decades-long process that shaped the transformation of the U.S. economy from one driven by free enterprise and innovation, into one marred by the rising monopolization, oligopolization and the growing reliance on state supports.

This process, having started in the 1990s, has gained speed in the years before the global financial crisis and continued to dominate U.S. growth dynamics ever since. In simple terms, a rising degree of oligopolization or monopolization of the U.S. is responsible for

simultaneous loss of entrepreneurship and weakened innovation, the dynamics of the secular stagnation.

These, as noted in our working paper with Shaen Corbet, titled “Millennials’ Support for Liberal Democracy Is Failing: A Deep Uncertainty Perspective” (, account for the structural decline in our younger voters’ preferences for liberal values.

This is hardly surprising. The post-financial crisis recovery cycle has been led by rising stock prices and weaker wages and productivity growth. Goldman Sachs’ Wage Tracker shows that wage growth was anemic, at 2.1 percent year on year in 4Q 2017, and has been such since the end of the Great Recession.

Structurally, Goldman Sachs research attributes wage stagnation to the concentration of market power in the hands of larger multinational enterprises. And, it points to a decades-long (and counting) period in U.S. economic development in which growth has been driven by continued leveraging, not sustained by underlying income growth.

Such leveraging can only be achieved due to effective subsidies from the U.S. Fed and other central banks through ultra-low interest rates and excessive supply of liquidity.

The first point falls squarely within the secular stagnation thesis on the supply side: As the U.S. economy becomes more monopolistic, technological innovation switches to differentiation through less significant, but more frequent and incremental innovation.

The second point supports secular stagnation on the demand side. As households’ leverage is rising, the growth capacity of the economy is becoming exhausted. Longer-term growth rates contract. Leverage carries the risk of a significant underfunding of future pensions, reduced household capacity to acquire homes that can be used for cheaper housing during pensionable years and lower capacity to fund education for children, and so on.

Goldman’s research attempts to put a number on the costs of these dynamics, saying that in the longer run, rising concentration in the American private sector economy implies a 0.25 percent annual drop in wages growth since 2001. While the number appears to be small, it is significant, and exceeds the median estimates for the Government TCJA reforms impact.

From economic perspective this implies 3.95 percent lower cumulative life cycle earnings for a person starting their career.

That is a lot of money to be transferred from U.S. households to U.S. monopolies and oligopolies, and it will impact adversely long-term aggregate demand, and with it, long-term sustainability of present markets valuations. When it comes to monetary and fiscal expansionism, there is no such thing as a free lunch, and paying for the recent stock markets excesses, QEs and federal deficits will be costly.

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Constantin Gurdgiev
Adjunct Assistant Professor, Trinity College, Dublin

Trinity College Dublin

Trinity College builds on its four-hundred-year-old tradition of scholarship to confirm its position as one of the great universities of the world, providing a liberal environment where independence of thought is highly valued and where staff and students are nurtured as individuals and are encouraged to achieve their full potential.  The College is committed to excellence in both research and teaching, to the enhancement of the learning experience of each of its students and to an inclusive College community with equality of access for all. The College will continue to disseminate its knowledge and expertise to the benefit of the City of Dublin, the country and the international community.


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