Debt or equity?

One of the reasons offered by market strategists for continuing to buy equities is that the dividend yield on stocks is considerably higher than that on government bonds. It is hard to argue with this. The one-year expected dividend yield on the FTSE100, for example, is currently 4.7% versus 0.7% on a 12-month government security. Assuming that equity values remain broadly stable, it makes perfect sense to buy equities which yield a 400 basis points premium over bonds. Now imagine the choice is between corporate debt and corporate equity. From an investment perspective the same applies. But from an issuer perspective things look very different.

UK A-rated corporate debt trades at around 1.94% - more than 270 bps below the dividend yield on equities. Companies thus have an incentive to issue debt rather than equity in order to cut the amount they have to shell out each year in order to persuade investors to buy into their company. After all, according to the well-known Modigliani-Miller theorem the company’s valuation is indifferent to whether it is financed by debt or equity. To the extent that the dividend yield represents a measure of a company’s profit that is redistributed back to shareholders, there are good reasons why a company might want to reduce it – perhaps to increase the funds available for investment or simply to raise employees pay (or even simply to hike the CEO’s bonus).

There have been suggestions that this is one reason why equity issuance is beginning to dry up. The evidence is not conclusive but latest data from the London Stock Exchange does point to a reduction in equity capital issuance over the past couple of years. Based on annualised data for the first ten months of 2019, we look set for a second consecutive decline in issuance with a figure which is roughly one-third below the average of the past two decades (chart 1).

It is indeed notable that equity investors have not revised down their expected returns on stocks despite the fact that interest rates have fallen to all-time lows. We can derive this from the formulation of the dividend discount model attributed to Myron Gordon, known as the Gordon growth model. Playing around with the formula, we derive the result that the compensation demanded by the market in exchange for holding the asset and carrying the risks depends on the expected dividend yield[1] and the (constant) growth rate assumed for dividends. Since the latter is a constant, the required rate of return is a positive function of the expected dividend yield. The expectation that dividends will remain high has thus conditioned markets to demand ever-higher returns.

My calculations suggest that UK equity investors require a total return of 9.8%, which is the highest since the immediate aftermath of the financial crisis in early 2009 (chart 2). If we subtract the risk-free rate from our estimate of total expected returns, we derive the equity risk premium. On my calculations, this is somewhere in the region of 9% in the UK which is comfortably the highest rate in the 25 years over which I have calculated the data (chart 3). Back in the 1990s, I puzzled over the fact that the ERP was negative and concluded that this was flashing a signal that investors were overly complacent about market risks. This in turn prompted me to be bearish on equity trends long before the markets actually corrected (in truth I was way too early so it is no great boast). We cannot say the same today: It may be the case that Brexit-related uncertainty has prompted investors to demand a higher premium but since it has been trending upwards for the past 20 years, this is not a particularly good explanation.

But markets may still be complacent about risks, as they were 20 years ago, albeit for different reasons. In short, investors appear to expect that dividends will continue to rise. The high level for the ERP is thus a misleading signal based on the fact that expected returns are rising whilst the risk-free rate continues to fall. But investors may one day be wrong about expectations of continually rising dividends. This could certainly come about if companies decide that they are better served by issuing debt rather than equity finance, thus reducing the amount they need to pay out in dividends. Issuers do not appear to have adjusted to the fact that the traditional discount of equity dividend yields relative to bond yields has flipped and is unlikely to revert any time soon.  But company treasurers must be wondering whether now is the time to do what governments are increasingly prepared to do – use the period of low yields to issue lots more debt.

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[1] The true expected dividend yield is expected dividends relative to the expected price but the Gordon growth model depends on expected dividends relative to the current price which is not quite the same thing. For expository purposes, we nonetheless call this term the expected dividend yield.

As more evidence comes to light ...

Nigel Farage likes to claim that he is speaking for the ordinary citizen and has argued strongly against immigration, suggesting that the studies which show the benefits of immigration to be flawed because they fail to account for the cost of in-work benefits such as tax credits. But right-wing politicians are not the only ones to be concerned about free movement within the EU: One of Jeremy Corbyn’s key union supporters, Unite’s Len McCluskey, suggested this week that Labour should also take a tough line on free movement of workers. But the evidence clearly shows that both are ignoring the economic benefits of free movement to the UK and their opposition to immigration is based on a false premise.

Three months ago HMRC published data which showed the revenue and expenditure contribution of EU citizens to the UK’s tax and benefit system for fiscal 2016-17 which paints a very different picture to many of the claims made during the  EU referendum campaign. The figures show that EU and EEA citizens received around £3.2 billion in child benefit and tax credits. But they paid in £21.3 billion, meaning that they made a net contribution to the UK Exchequer of £18.1 billion. Although this figure does not include all tax and revenue streams, it is a safe bet that this these figures are a fair reflection of the overall fiscal contribution of EU citizens. To put it into context, a figure of £18.1bn is more than the current budget surplus for FY 2016-17 (£17.4bn). Without the fiscal contribution of EU and EEA nationals, the current balance on public finances would have been in deficit. 

Citizens of all EU countries made a positive exchequer contribution, with the largest net sums being paid by French (£2.9bn) and Irish (£2.2bn) nationals, with the Poles chipping in a net £2.1bn. On a per capita basis, the biggest contributors were Danish nationals, who paid an average of £25,090 followed by the French (£24,090, chart). The average European per capita contribution was £7,260 with the overall figure being depressed by the relatively low contributions made by central and eastern European nationals. The figures tell us two things: Most obviously European nationals come to the UK to work, not claim benefit as has often been claimed in the recent past. Second, the distribution of per capita contributions highlights the fact that western European nationals tend to be highly skilled and are therefore high earners whilst those from newer EU member states tend to be lower paid.

Even before the end of free movement, the UK is no longer an attractive destination

For all the fact that EU nationals make a significant contribution to the UK economy, there is clear evidence that fewer of them are entering the UK than was the case three years ago. Although the UK immigration data are subject to significant methodological flaws, they are all we have at present and they show that in the year to March 2019, a net 226k foreign nationals entered the UK compared to 311k in the year to June 2016. The net inflow of EU nationals has slowed to 59k versus 189k in the year prior to the referendum, with net outflows of EU8 citizens as many of the huge wave of migrants from Poland begin to return home. But the real kicker is that in the year to March, a net 219k non-EU nationals entered the UK compared to 171k in the year to June 2016. Recall that this is the part of immigration that the UK government can actually control, so if the electorate really does have a problem with immigration they are going to be mighty dumbfounded by the government’s current policy.

It has long been recognised that there are substantial costs associated with pulling up the drawbridge and the government appears to have quietly dropped its unrealistic pledge to reduce the net number of immigrants below 100k. But it might be too late: Large sections of the UK public sector rely on foreign labour input and there has been a 70% fall in the number of EU citizens coming to the UK to work. In the absence of a sudden surge in Brits willing and able to take on the tasks, these positions will have to be recruited from outside the EU, which may explain why the numbers arriving from outside the EU have increased.

Moreover, one of the flaws with the data is that it includes those coming to the UK to study and who make a net overall contribution to university coffers. Prior to the EU referendum roughly one-sixth of the net immigration figures was attributable to students – there has been a reduction of around 20k in new student numbers over the past three years with anecdotal evidence suggesting that many have been put off by the more hostile climate. This is certainly not a desirable outcome for universities which are seeking to expand their footprint in an increasingly competitive global education market.

Whatever one’s views on immigration, it is clear that a policy of restricting the flow of EU citizens into the UK will have economic consequences. This may only be evident initially at the margin. But it remains one of the potential underrated consequences, whose full effects will only become evident in the fullness of time.

The fiscal politics of the 2019 election

As the UK general campaign gets underway politicians have been falling over themselves to demonstrate their willingness to spend what sound like huge amounts of money in order to revamp the economic infrastructure. From my standpoint, as one who has been severely critical of the government’s fiscal stance over the past nine years, an opening of the fiscal taps is welcome. But numerous people have asked me how a Conservative government that has made such a big deal of economic austerity, can suddenly switch from fiscal famine to feast. It’s a fair question and the answer is quite simply because the Tories realise that it is a popular idea whose time has come. 

Common ground as both parties seek to ease fiscal policy 

Dealing first with the details, the Conservatives have ripped up their old fiscal rulebook in order to allow them to spend an additional £22bn (1% of GDP) per year. The Labour Party, which in 2017 campaigned on a platform of much higher spending, is committed to a plan that envisages an additional £55bn (2.5% of GDP) per year. Neither party will therefore abide by the current fiscal mandate designed to limit borrowing to 2% of GDP by 2020-21. The current framework also has two supplementary aspects: (i) to eliminate borrowing altogether by the mid-2020s (the ‘fiscal objective’) and (ii) that net debt should be falling as a share of GDP by 2020-21 (the ‘supplementary target’).

The fiscal objective is a non-starter and the supplementary target will also be blown out of the water. To a large extent, the fiscal objectives had been blown off course anyway by changes to the treatment of student loans in the national accounts, which raised borrowing by around 0.5% of GDP. But on the basis of my preliminary calculations, even a modest additional £20bn per year of public investment will raise the deficit ratio to at least 3% of GDP by fiscal year 2023-24 (the March OBR projections put that figure at 0.5%).

The Chancellor Sajid Javid noted in a speech on Thursday that the Conservatives are committed to balancing the current budget on a three year horizon (i.e. excluding investment). Whilst this will leave little room for additional day-to-day spending on issues such as social care or tax cuts, this is eminently achievable on the basis of my estimates. But calculations reported in the FT suggest that the Chancellor only has around £7bn of headroom on his current spending plans, which essentially rules out big tax cuts such as Boris Johnson’s promise to raise the threshold for higher rate taxpayers.

One of the reasons the Conservatives have changed tack is that ongoing fiscal austerity is not politically popular and they risk being outflanked by Labour. I will deal with the specifics of the Labour proposals another time but essentially they involve a "social transformation fund" which would spend around £30bn per year on upgrading the social infrastructure (schools, hospitals, social care facilities and council homes) and a "green transformation fund" spending around £25bn a year on areas such as energy and transport and insulating existing homes. Labour also remains committed to a National Investment Bank in order to manage the disbursement of funds. This is not a bad idea and I looked at some of the specifics of this policy in the run-up to the 2017 election (here). 

But it will not come cheap 

The big question is how all this will be funded and the obvious answer is that it will require a huge increase in borrowing. Whilst it does make sense to loosen the purse strings at a time when interest rates are at all-time lows a huge increase in borrowing could actually force bond yields up, particularly if the UK is outside the EU which might raise the risk premium on debt anyway. Moreover, given the market’s scepticism towards Labour’s plans, particularly on tax, it is unlikely they will be able to fund the plans at anything like current market rates. In the event that a Labour government is elected (unlikely, but you never know) my guess is that they will not be able to enact a fiscal expansion on this scale. Recall that Francois Mitterrand’s victory in the French Presidential election of 1981 on a platform of nationalisations, wealth taxes and a wage increase was followed by a swift U-turn two years later as economic orthodoxy was restored. 

... and international investors may get cold feet 

The outbreak of fiscal largesse was accompanied yesterday by Moody’s downgrade to the UK’s credit outlook. My initial reaction to this was “so what.” As I have long pointed out, it is incongruous that the UK should have a lower credit rating than Germany when the UK issues debt in a currency which it controls but Germany does not. Sovereign credit events tend to occur when countries issue debt in foreign currency and run out of the necessary funds to repay creditors. Whoever is in office after the election, this is not a problem the UK will have to worry about.

But on closer inspection, Moody’s statement provided a damning indictment of the institutional framework: “The increasing inertia and, at times, paralysis that has characterised the Brexit-era policymaking process has illustrated how the capability and predictability that has traditionally distinguished the UK’s institutional framework has diminished … This broad erosion in the predictability and cohesion of policymaking is mirrored in areas of policy that are significant from a credit perspective. Most importantly, the UK’s broad fiscal framework characterized by features such as multi-year budget plans and more detailed revenue and spending decisions … has weakened.”

Politicians of all stripes want to play fast and loose with the institutional framework. Let us not forget that last year Labour wanted to expand the role of the BoE to target UK productivity growth – a ridiculous strategy if ever there was one. But since the Tories have been in office during the last three years, they deserve most of the blame for the Brexit-related policy debacle by trying to ride roughshod over parliament. From an economic policy perspective, the fiscal and monetary frameworks devised in recent years have done much to improve the transparency of policy and prevent governments from twisting it to meet their political needs. If Brexit is about a political return to the 1970s, governments seem to be doing their best to ensure a return to 1970s policy ad hocery – and we all know how that turned out.

Changing of Lagarde

Arrivederci Signor Draghi

The changing of the guard at the ECB has been well documented recently with numerous articles looking back over Mario Draghi's tenure as President. Opinions are mixed, depending on where one stands on the question of QE. A large part of the German economics profession believes he has followed an unsound monetary policy, with QE serving only to swell asset values whilst having little overall impact on the economy. A more sympathetic view is that Draghi is the man who saved the euro zone following his 2012 promise to "do whatever it takes" to support the single currency.

For my own part, I give him great credit for his actions in 2012. Without his decisiveness, in the face of significant internal opposition, there is a serious risk that the single currency could have collapsed. Odd though it may seem now, given the relatively small size of its economy, the raging Greek debt crisis laid bare the fault lines underpinning the euro zone. Draghi was able to put a sticking plaster over the gaping wound and prevent a bad situation from becoming worse. Had he listened to other voices which argued against taking action, things could have been very different. Indeed, many have pointed out that Draghi is a very adroit politician. He did not have the policy tools to back up his 2012 promise and who knows what would have happened had markets tested him out. Indeed, it took almost three years before the ECB embarked on a policy of asset purchases.

The fact that the euro zone remains stuck in low gear reflects a combination of political intransigence on the part of euro zone governments and changed economic circumstances which have put downward pressure on global inflation, and make the euro zone economy appear more sluggish than it really is. Governments have offered the ECB no real support. The fact that they continue to sit on their hands with regard to fiscal policy makes the ECB's job harder. And as the ECB's first President, Wim Duisenberg, pointed out almost 20 years ago, governments need to do more to restructure their economies in order to remove growth obstacles. In so doing this would remove the reliance on the central bank to support growth. But aside from Germany, whose Hartz IV policies in the mid-2000s proved to be a successful package of labour reform measures, most governments have done little or nothing.

That said, the ECB's policy stance of further cutting interest rates into negative territory and continuing to buy huge quantities of government bonds are the actions of an institution that has run out of ideas. Indeed, the September decision to resume QE caused huge dissent within the Governing Council and prompted the resignation of German representative Sabine Lautenschläger. It is not the first time a German representative has quit in protest. In 2011 both Axel Weber and Jürgen Stark walked the plank. However it is significant that the most recent dissent was not only confined to German board members with French, Dutch and Austrian members expressing doubts about the policy stance.

It is well known that QE has an increasingly smaller marginal impact - the greater the volume of asset purchases, the smaller the impact. A recent research paper suggested that asset purchases produced an average increase of 0.3 percentage points in annual GDP growth between 2015 and 2018 and 0.5 percentage points in CPI inflation, with a maximum impact in 2016. Interestingly, when the working paper version was published the impacts were assessed to be rather larger. Either way, with the central bank balance sheet already at 40% of GDP it is questionable whether the benefit of increasing asset purchases is worth the cost. But whilst this is a valid concern, the simple fact is that the euro zone is still afloat because of Draghi’s actions. He has expanded the ECB’s policy toolkit and given his successor a fighting chance of moving the economy along.

Bienvenue Madame Lagarde

The appointment of Christine Lagarde as Draghi's successor was initially a controversial choice and she faces a number of challenges going forward. I have no doubts about her ability to do the job but she was clearly a political appointee, as Emmanuel Macron sought to shoehorn a French candidate into one of Europe's top jobs. As the head of an independent central bank, Lagarde will have her work cut out to maintain the impression that it is not simply an institution designed to maintain the cohesion of the EU – a view prevalent in some quarters which judges the ECB's monetary policy as a way of keeping Italy afloat.

Lagarde probably has little choice initially but to continue with the policy initiated under Draghi, but her challenge will be to keep the representatives of northern countries onside. The last thing she needs are further damaging splits amongst council members. However the fact that she represents one of the powerhouse economies means her views may carry a bit more clout. Bigger challenges will come later. It is unlikely that a loosening of monetary policy will have any significant impact on growth, and the debate is increasing likely to turn to the damaging side effects of low interest rates.

Low rates work by shifting consumption and investment patterns across time. If consumers are spending today they are not saving for later. But if they are forward looking, as modern macro theory assumes, at some point they are going to change their behaviour in order to build up precautionary savings balances - perhaps for pension purposes. Moreover since interest rates are so low, the amount they will have to save to build up a decent pension pot is likely to be quite substantial. In other words, a policy of low rates forever could start to prove self-defeating. I would not be surprised if at some point in future, the debate starts to shift towards raising interest rates in order to boost long-term growth prospects. Of course, it will not be put in such terms; central bankers will simply talk about policy normalisation.

Recent comments by Lagarde suggest that she will continue to be outspoken on policy issues. In comments earlier this week, she suggested that “those that have the room for manoeuvre, those that have a budget surplus, that’s to say Germany, the Netherlands, why not use that budget surplus and invest in infrastructure? Why not invest in education? Why not invest in innovation, to allow for a better rebalancing?” and suggested that both “have not really made the necessary efforts.” This is pretty powerful stuff and although it is unusual to name individual governments, it chimes with the view I have held for a number of years that governments need to get involved on the fiscal front. There are those who say that central bankers should focus on monetary policy issues. Whilst I respect that view, it is also the case that when fiscal inaction impacts on monetary policy they have a duty to speak out.