The key driver of the economic cycle is, simply put, investment. Brief primer for the non-economists at the bottom of the page. It therefore falls to me to point out that this week’s investment data has been bad across the developed world. In the UK, business investment declined .7% quarter on quarter when economists had expected it to grow by 2.3%. In the US, Capital goods orders were down 1.3% annualised when growth of 1% was expected. German capital investment met expectations – and fell at a rate of 0.9% annualised. Now what does this mean? Perhaps nothing. As you can see, all of these are relatively small changes in the big picture. They are not by themselves reason to suppose that we are heading for another recession – not even close – however remember that I write from the position of a guy in financial markets, and if you look at the S&P index of share prices, the market seems to be pretty convinced the economic picture is pretty rosy – it’s risen a rather impressive 13% since January.
Let’s suppose for a second that the data is correct – that investment is tailing off. Would that necessarily correspond to lower prices in the S&P 500? Well not necessarily. Contrary to media and popular opinion, a rapidly rising stock market is not necessarily cause for celebration. Stocks rise for all sorts of reasons. Companies may use their profits to buy back their own stock, raising prices and enriching their shareholders. Investors may find other kinds of assets less attractive, and given how low the yields are on government bonds in the developed world (0.5% on 2y US, 0.5% on 2y UK etc) they may prefer to invest in equities where there is at least the possibility of some upside (buying bonds now when their yields are so close to 0 does not give much upside at all!). More generally, stocks are financial instruments – a growing stock market valuation for your company does not necessarily indicate that your company is ‘worth more’ – it just indicates that investors will pay a lot of money for it in the short run. It’s not like Microsoft or Apple could just sell itself wholesale to anyone, if you tried to sell all the shares all at once the price would collapse, there wouldn’t be enough buyers!
The thing is, an aging population means that the demand for future production is getting higher. Stocks, bonds and all financial assets (including money!) are really just deferred claims on the future production of society. Stocks going up doesn’t mean that we’re actually going to be able to produce more, it just means we’re valuing future production higher – or in other words, for every £1 we invest in the stock market today, higher prices just means that each £1 invested has less actual productive capacity backing it to ensure it can yield a return in future. Put this way, higher stock prices are a bit alarming! If stock prices are going higher, and real investment in the economy is not growing, that means all those stockholders are holding paper that entitles them to a share of future production, but future production is not growing. The economically savvy amongst you will remember that this doesn’t matter a damn if productivity (how useful each £1 of physical capital is, ie, how many widgets each of our machines can make) increases – but as has been noted by many smarter folks than me, the great economic puzzle of the last decade is… reduced productivity!
So should we be worried? In my view yes. Predictions are hard, especially about the future, but if investment does not pick up, and asset prices keep being forced higher, something will give. I don’t understand the system well enough yet (perhaps none of us ever will!) to tell you where the strain will be felt – but I get it well enough to see the strain. Low investment and high asset prices are not good for growth, or for the people relying on those assets to fund their retirements, and at some point, something will give. It could be a big correction in asset prices, or a big technological breakthrough that wholly changes how we think about all of this, or mass defaults and government bailouts – as they say, change is the only constant. What I think I can say for sure is that the system is not working. It’s never been cheaper to borrow money, easier to start a company or easier to find a technological solution to solve people’s problems – so if investment is not growing, and the stock market is telling us that people really want to save today and consume tomorrow, the system is broken.
On GDP: GDP is a measure of all the goods and services produced in an economy in a year. You can measure it via the income method as follows. National income is equal to the sum of: Consumption + Investment + (Exports – Imports). Of these, investment is the component that changes the most. For example, earlier this year, business investment in the Uk was growing at an annulised rate of 11% – whereas in the ‘double dip’ recession in 2009 it was shrinking as fast as 18% . By contrast, consumption is currently growing at 0.8% whereas in 2009 it shrank at a rate of 1.8%.