By Paul Cantor
The world of investing is one in which there is an endless stream of information. Curiously, it is also a world characterized by increasing degrees of uncertainty. Investment professionals and laymen alike are tasked with sifting through this maze of often contradictory material in order to make profitable long-term decisions. Some address this process by utilizing rigorous mathematical models which attempt to balance risk, reward, and probability of disparate outcomes. Others count on expert insight, experience, and simple common sense to shape their decision-making process. We are currently facing one of the most uncertain investing environments I’ve seen in my 30-year career as an investment professional. This article recounts my research on leading academics regarding the potential empirical impact of uncertainty. In plain language, the question posed is: “Has there been significant academic work done on the subject of investing with uncertainty and, if so, what are the conclusions?”
The sources of this uncertainty are fairly obvious but I believe it is currently extreme. The first level of uncertainty is political. In the U.S., we have partisan politics at such extremes that we are bordering on a dysfunctional government. Governing by response to extreme crisis only opens up the possibility of many negative left tail events. The inability of government to address structural issues in both revenues (tax code) and spending (entitlement programs) creates the probability that the U.S. could become the next Greek Tragedy. This is not an overnight outcome. Rather, it most likely plays out several years from now. Occupy Wall Street, a U.S. debt downgrade, and strident partisan politics are but the early warning signs.
In addition to U.S. political malaise, there are pending major elections and potential political change in numerous important countries. They include 2012 scheduled elections in Russia, India, Mexico, France, South Korea, Iran, and Venezuela. China and North Korea will go through leadership transitions. Italy, Greece, and Spain are already under new governments and will continue to address their own issues. To postulate that some of the outcomes on this matrix could be deleterious to world economic growth seems more than credible.
A second area of uncertainty stems from monetary policy, both in the U.S. and abroad. The paramount economic issue distilled to its most basic level is one of excessive debt worldwide. The policy responses have been competitive currency devaluations, the transfer of debt from the private to the public sector, manipulation of debt curves, monetary largesse in the form of ballooning central bank balance sheets, and excessive degradation in the quality of those balance sheets. The ability of central bankers to effectively normalize these issues appears questionable. Further, the ability to react to additional stresses from any left tail type events is highly diminished. The governmental quiver is largely empty. To date, the results have been sub-par GDP growth in the U.S. during the past three years, a depression in Greece, and the beginnings of recessions in other parts of Europe. The upside is that we have so far avoided absolute fiscal and economic calamity.
As one might expect, the relationship between investment and uncertainty has been a primary focus of much academic research during the past 50 years. There is an enormous amount of material to research, of which I only cite a few studies to give a general sense of direction. So what do the experts think uncertainty means for economic growth? Is there an empirical answer to the question? In a recent paper (Oct. 2011) by Baker, Bloom, and Davis (the former two academics of Stanford University and the latter of the University of Chicago Booth School of Business), they constructed a new index of policy-related economic uncertainty.
Essentially, they conclude that “VAR (vector autoregressive models) estimates show that an increase in policy uncertainty equal to the actual change between 2006 and 2011 foreshadows large and persistent declines in aggregate outcomes, with peak declines of 2.2% in real GDP, 13% in private investment, and 2.5 million in aggregate employment.”1 They further summarize some of their findings as follows: “According to our news-based approach, economic uncertainty is considerably higher in the past 10 years than in the previous 15 years. Second, policy-related uncertainty increased more sharply than overall uncertainty. As a result, it accounts for a larger share of economic uncertainty in the past decade – more than 60% since 9/11 and a remarkable 77% in the 2010-2011 period. Third, policy uncertainty accounts for 8% of the high-frequency movements in economic uncertainty since 9/11, a much larger share than in earlier periods. These results imply that policy-related concerns are an increasingly important aspect of overall economic uncertainty, and that they account for most of the movements in overall economic uncertainty in recent years.”2
Whether one agrees with the magnitude of the outcomes or the methodology utilized in their study, it seems likely that the direction of the conclusion is correct. When one considers all the tangential elements of potential uncertainty such as geopolitical tension, energy policy or the lack thereof, environmental issues, European economic stability, and China’s growth and policy directions, it seems viable to assert that future economic growth and incumbent investor returns are highly uncertain. While a case can be made that current U.S. equity valuations are not egregious by historical standards, it seems prudent to be a bit conservative when looking forward.
Additionally, a third critical area of uncertainty, that of U.S. fiscal policy, needs to be addressed. In 2011, the U.S. had revenues of approximately 15% of GDP while spending was closer to 24% of GDP. Clearly, these are somewhat worse ratios than the norm. Directionally, however, this is what the U.S. budget looks like for years to come. In fact, it gets substantively worse.
Spending on national defense has dropped from near 10% of GDP in 1970 to closer to 5% today. In the same time frame, entitlement spending for Social Security, Medicare, and Medicaid has nearly tripled to 10% today. The cause is the demographic reality of baby boomers aging into these programs, coupled with increased longevity, and increased health care costs. As the 78 million baby boomers (nearly a third of the U.S. population and a much higher percentage of the voting population) enter the rolls of these programs at an accelerating rate over the next few years, total government healthcare spending is projected to triple.
Only about one third of government spending, so called discretionary spending, is subject to annual budgets. The ‘Big Three’ entitlements are essentially on auto pilot. When looking at the political divide today, it seems benign to state that these issues will create increased policy uncertainty as the debate about how to fix the problem becomes louder and more imminent. If one assumes that the growth rate for U.S. GDP could average 3-4%, and the findings from the paper cited above are accepted, then we are likely looking at continued sub-optimal economic growth for years to come.
The elephant in the room, however, could be the price of excessive debt. Under the U.S. budget scenario, as we add a trillion dollars or so of extra debt going forward each year, the percentage of the budget which will go to pay the interest on our exploding debt will increase dramatically. In fact, the real net interest costs to the country are expected to triple in absolute dollars within the next decade. This, of course, assumes, in a quintessential Washington way, that the current interest rate will remain static. As we’ve just recently witnessed in Italy and Spain, the price of debt can change enormously, literally overnight. It would seem presumptuous to assume that we would be immune to a rising interest rate environment even as our deficits reach levels equal to and beyond the debt-to-GDP ratios currently causing severe sovereign concerns in Europe. The fact that we can continue to print money and to debase our currency is a valid argument. However, that argument should then also incorporate a discussion about inflation.
Turning to the subject of uncertainty and cyclical investment, there is a working paper for the National Bureau of Economic Research from our current Federal Reserve Chairman, Ben Bernanke. While dated at July 1980 and later printed in the Quarterly Journal of Economics in 1983, the conclusions still appear valid and may continue to inform his thinking in his current role at the Federal Reserve. The conclusion reads: “This paper has argued that when investment is irreversible, it will sometimes pay agents to defer commitment of scarce investible resources in order to await new information. Uncertainty which is potentially resolvable over time thus exists as a depressing effect on current investment. This may help explain the short-run investment fluctuations associated with the business cycle.”3
While not quantifying the effect of uncertainty, clearly he agrees that there is a probability of reduced investment and thus suboptimal economic output. His recent move to disclose Fed interest rate objectives speaks to his desire to affect investment behavior. One of the pertinent implications here is that uncertainty can create both short-term volatility in economic decision making and long-term underinvestment.
Both of these components will have negative real-life effects on our labor force and our international competitive stance. Business executives often have long lead times for planning and implementation of capital investments. If the future looks particularly uncertain, it seems feasible that growth will be deterred. Confidence is a very fragile commodity. This applies not only to business leaders, but to the consumer, to international trading partners, and to investors in the debt market. When you are a country that is dependent on investors to buy our debt in order to meet our spending requirements, having a high degree of uncertainty and a lower outlook for growth can become a very bad situation very quickly. Take note of the immediate economic reaction and consequent market reaction to the debt ceiling debate this past summer.
Another paper entitled “Corporate Investment and Cash Flow Uncertainty,” Oct. 2011, by two academics, Bhagat and Obreja, at the Leeds School of Business, University of Colorado, found the following: “We find that our measures of cash flow uncertainty have a significantly negative impact on corporate employment and corporate investment in both tangible and intangible assets. Economically, if cash flow uncertainty were to revert to levels observed back in 2005, corporate employment would increase by more than 1.89 million jobs, investment in tangible assets would increase by more than 10%, and investment in intangible assets would increase by more than 19%. Furthermore, we document that our risk measures have had a more negative impact on corporate employment and corporate investment in tangible and intangible assets during economic recessions than during economic expansions.”4
They use as examples of corporate uncertainty, with respect to policy, the implementation and time line of the Health Reform Act, environmental cap and trade reform, and corporate tax reform. They further state that: “Our numerical example suggests that corporate employment is far more sensitive to changes in cash flow uncertainty than corporate investment. This result is consistent with the idea that the average firm would rather cut labor costs than investment, when faced with increased uncertainty.” 5
Once again, academics support the common sense assumptions that one might reasonably make. It takes less than one minute to search for statements from our current cast and potential cast of government officials to find arguments for vastly changing the tax code. These are both for and against and cover the spectrum of “appropriate tax levels” for the 1% of top earners, to rollbacks of prior legislation, to changes to corporate rates, changes to deductions at both personal and corporate levels, changes to tax credits channeled toward specific industries, and changes to accounting methods for all sorts of assets.
Unfortunately, one has to view fairly massive change as a credible outcome to address in part the fiscal spending issue outlined above. At the corporate level, these potential changes will have significant impact on the cash flows a company might receive and how they are deployed. At the individual level, in a country devoid of savings, these could be life-changing decisions. Incidentally, the individual tax payer bucket accounted for 41.6% of government revenues in 2010. It was the single largest revenue pool. Payroll taxes came in at 40% and corporate tax was 8.9%. As recently as 2008, the top 1% paid 38% of all federal income taxes, the bottom 50% paid 3%, and 49% of all households paid no federal tax. This debate too is likely to be exceptionally divisive. When you add in influence peddling on the part of corporations, and special interest groups who have the ability to shape industrial and regulatory policy, there forms a truly toxic matrix of possibilities.
Given the discussion above about the current and future levels of policy uncertainty, these results imply a potentially risky investing environment during the next several years. The real world fallout of a 13% drop in private investment and 2.5 million additional unemployed people are more than just numbers. These represent people that will need support and put additional burdens on governments and the social safety net. The loss of productive investment implies diminished capital returns to businesses. Neither serves to enhance the potential return outcomes for those that are making current investment decisions.
Despite the fact that the S&P 500 Index is off to a very good start in 2012, one should remember that it had a similar start in 2011. If investing for the longer term, one needs to discount the price of uncertainty and to insure that some portion of asset allocation goes to strategies that will be able to mitigate downside risk if not perform absolutely. Timing the level of aggressiveness is exceedingly difficult to do. Thus, investors need to understand the risks they are taking as these issues come to fruition in the U.S. and elsewhere. The demographic time bomb is ticking and the price of uncertainty is likely to be high.
Paul Cantor is the co-founder and managing member of Hercules Management Group, a market-neutral U.S. equity hedge fund firm in New York.
1) Measuring Economic Policy Uncertainty; Baker, Bloom and Davis, Oct 10 2011, page 1.
2) Measuring Economic Policy Uncertainty; Baker, Bloom and Davis, Oct 10 2011 page 12.
3) Irreversibility, Uncertainty, and Cyclical Investment, Ben S. Bernanke, Jul 1980, National Bureau of Economic Research, working paper No. 502, page 23.
4) Employment, Corporate Investment and Cash Flow Uncertainty, Bhagat and Obreja, Oct 2011, page 1.
5) Employment, Corporate Investment and Cash Flow Uncertainty, Bhagat and Obreja, Oct 2011, page 4.
Additional credit to the Heritage Foundation for compiling data from the White House Office of Management and Budget, Congressional Budget Office, Internal Revenue Service, and White House Fiscal Year 2012 budget.