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posted on 28 January 2017

How Lowered Return Expectations Can Improve Economic Growth

by Gene D. Balas

One puzzling issue about the economic expansion so far is the tepid investment by businesses in new plants and equipment. Not only is business investment a direct ingredient in economic growth, but it has downstream effects as well: more efficient technologies and systems can boost productivity. And productivity is an essential ingredient in allowing corporate profits to grow at the same time wages might increase.

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Businesses are actually optimistic

But why has business investment been lacking in the economy? Is it because companies don’t have faith in the recovery? Well, no, because surveys of corporate executives don’t yield such pessimistic results. Consider, for example, the Business Roundtable survey of big companies. In the press release accompanying the CEO Economic Outlook Survey for the fourth quarter 2016, we see that the very first sentence reads, “CEOs report higher expectations for sales and hiring over the next six months, but lower expectations for capital investment." A more detailed explanation follows, “CEO expectations for sales over the next six months increased by 4.5 [percentage] points, and expectations for hiring increased by a more robust 14.8 points over last quarter. However, CEO plans for capital expenditures fell by 5.4 points relative to last quarter."

1_18_2017_image1.png

And then consider a similar monthly survey from the National Federation of Independent Businesses, which shows smaller companies are more optimistic about the future, but also are reporting softer investment in their businesses. Consider the press release of the latest survey of small companies, which notes, “The percent of owners planning capital outlays in the next 3 to 6 months fell 3 points to 24 percent….Seasonally adjusted, the net percent expecting better business conditions rose 19 percentage points to a net 12 percent. Expectations for economic improvement and sales growth made significant gains, but plans for capital spending did not follow, declining after the election."

Examining the “hurdle rate" for returns on new investments

Well, if it isn’t optimism, what is it? It might come down to math. Companies must please shareholders and must pay interest to bondholders. While the rate of interest they pay on their bonds is straightforward, their return to shareholders is less so. It is implicit in their cost of capital, which is an indirect way of saying what returns their shareholders might expect (in theory, at least) on the value of their investment in a company’s shares.

Investors have come to expect returns on stocks to be as high as, say, 8% (or even more), though every investor has different expectations. So, to deliver that type of return, a company must earn that same hypothetical 8% (or whatever the number happens to be at a given company) on its invested capital, known commonly as return on equity, or ROE. Very simplistically, it might be thought of as the income generated by a project divided by the amount invested. If a proposed investment can deliver at least that hypothetical return, then the company will invest in that project. If not, it won’t, figuring it can simply return those funds to shareholders through share repurchases or dividends.

Share repurchases and dividends may be pleasing to some shareholders, but they don’t directly affect economic growth. A company investing those funds, however, would augment output, as a new factory, office or store would be built, replete with new equipment and technologies - not to mention any hiring such expansion might produce.

What might reasonable expectations be?

But what if people - both investors and business executives - are simply expecting too much? After all, the real rate of interest is quite low, and while inflation and the real rate of interest are increasing, they are unlikely to return to previous levels seen in prior decades. Why this is so matters a great deal, as it influences investment returns across asset classes.

First, consider what is realistic for economic growth. Potential GDP is basically the sum of productivity gains - how much each worker produces per hour - and the increase in how many workers there are. With an aging population and the influences of many technologies already incorporated in business practices, the growth of both the labor force and productivity may be lower than what it was in the past.

Add to that inflation, which the market expects to be about 2% over the next ten years (based on pricing in the TIPS market) and you’re left with the nominal potential GDP growth of about 4%, which is a downtrend from what we’ve seen in previous decades. (Note that the potential rate of GDP growth is forward looking, and is the rate of economic expansion where inflation would remain stable. It is not the same as actual, backward looking GDP growth.)

With lower potential GDP growth, perhaps it is to be expected that the real rate of interest would also be lower, as we see in the nearby graph that compares the relationship between nominal potential GDP growth rate and inflation-adjusted bond yields. Since the return on stocks depends on the risk-free interest rate plus a premium for the risks of investing in stocks, a lower real rate of interest means we might expect a lower return on stocks going forward.

1_18_2017_image2.png

Conclusion

As business executives similarly conclude that their shareholders no longer might demand that projects exceed that ephemeral 8% (or whatever the number happens to be at a given company), then their hurdle rate goes down. And when the hurdle is lower, more projects clear it - and companies then invest more in their businesses, rather than return that cash to shareholders. And that is how lowered return expectations can improve economic growth.

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