Over the last few weeks a debate has broken out as to whether we are on the cusp of a great rotation into equities. Much of the focus of this debate has been trying to assess when yields on US Treasuries will start to rise, thus causing investors to shift their assets into equities as bond returns get depressed. However, the focus on the US Treasury market as being the potential trigger for a Great Rotation is partially misplaced as investors do not want to allocate assets to equities if they subsequently crash in value in a year’s time. This has happened twice in the last decade causing investors to prioritise the return of their capital above potential higher returns on risk assets. Hence, the more important trigger for investors to make the switch into equities will be when they become convinced that the macroeconomic environment is improving for rising corporate profits. But what signals should investors be using to guide them in this decision?
Today, far too many investors still focus on real GDP growth as a key indicator when it comes to making asset allocation decisions. Such indicators however, have not been particularly useful when it comes to signalling sustained future growth in corporate earnings and therefore asset price rises. Firstly, there is no correlation between equity returns and real GDP growth because it is possible for countries with high GDP growth to have low profits and vice versa. Furthermore, on the cusp of the last two major asset price crashes, real GDP growth forecasts were robust and hence should be treated with a great deal of scepticism by investors.
The reason why real GDP forecasts have proven to have been so wildly inaccurate is that they are based on a fundamentally flawed macroeconomic framework. This framework assumes that by minimising fluctuations in output and inflation, the economy can be maintained close to its potential output, which can sustain asset price rises. Unfortunately this framework has not been of much help to investors, with the vast bulk of funds being hit by massive losses in both the post dot com crash as well as the recent financial crisis. Fortunately there are alternative macroeconomic frameworks that do provide a great deal of insight into the general outlook for corporate earnings. These frameworks are credit-based and importantly do not assume any natural tendency towards equilibrium.
In credit-based disequilibrium frameworks as described by the great Swedish economist Knut Wicksell, what matters is the difference between the natural rate of interest and the money rate of interest. This equates to the difference between the return on capital and the cost of capital. The good news for investors is that the return on capital at the macroeconomic level is now rising in the US economy for the first time since 2010, implying that investors should have more confidence to make the switch. There are however many equity markets that are still showing falling natural rates of interest and thus should be avoided due to rising input costs causing falls in productivity and lower profits. Investors wanting to compare the different natural rates of interest across countries can do so using credit-based disequilibrium frameworks. A detailed explanation of how these frameworks can be constructed can be found in my new book, Profiting from Monetary Policy: Investing through the Business Cycle.