Why US growth is lackluster

Why US growth is lackluster

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The US economy has been growing at 2.1% per year since the Great Recession, below previous post-recession growth rates of 3% and even 4% under Ronald Reagan.  While taxes and regulation no doubt play an important role, the loss of disposable income due to falling returns on savings and the failure of the housing market to fully recover together account for the difference.  

 

Interest Income as % of Disposable Income, 1994 vs. 2014

(billion $)

1994

%

2014

%

Personal Income

          5,935

 

        14,719

 

Personal Interest Income

             794

13.4%

          1,265

8.6%

Personal Dividend Income

             235

4.0%

             861

5.8%

Personal Interest Payments

             122

2.1%

             257

1.7%

       

Source:  BLS

 

First, let’s quantify the problem with interest income.  While bank CD’s had paid a 5% return in previous economic recoveries, those rates fell below 1% after the Great Recession and have remained near 1%.  According to the BLS, Personal Interest Income on Assets fell from 13.4% of disposable income in 1994, when CD rates were 5%, to 8.6% by 2014, when CD rates were .43%.  If interest as a percent of disposable income had stayed at 13.4% through 2014, GDP would have been higher by $700 billion.  That is $2333 per capita and 4% of GDP, or .8% of GDP per year if annualized over five years (1/1/2010 to 12/31/2014) excluding compounding.

The downside effect was mitigated some by savers moving into dividend paying stocks as Ben Bernanke had hoped for.  4.0% of disposable income in 1994, dividends received had risen to 5.8% by 2014.  Accounting for a 10% increase in dividend yield over the period, the Bernanke switch offset $200 billion of the annual $700 billion hole left from lost income on savings. 

Also on the flip side, there was a savings on interest expenses, but it was small.  2.1% of disposable income in 1994, interest payments fell to 1.7% of disposable income in 2014, according to the BLS.  That’s $58 billion in savings, yet it is a savings that need not be forfeited if we find a higher yielding solution for savers. 

That solution is preferred equity.

Preferred equity was widely used for retirement income before 1979, when real returns on risk-free capital were low like today.  The oil crisis, Vietnam, and Volcker’s deregulation of bank rates in 1979, however, elevated the demand for capital so much that preferred stocks fell out of favor.  Why buy preferred equity when you could earn 5-10% risk free from a bank CD? 

The 1979-2007 period, however, was an anomaly.  Risk-free rates are not going back to 5% any time soon.  For one, inflation is subdued.   Amazonization of pricing has only just begun:  Internet commerce is still less than 5% of US GDP.  Oil prices are in for secular decline as frackers boost output and electric car sales introduce the first-ever arbitrage with natural gas, now driving 34% of power plants.  Oil has 5.8x the hydrocarbons of one million BTUs of natural gas, now priced at $3.00.  Do the math.  

Interest rates reflect demand for money, and demand for money today is minimal. The fastest growing and most valuable companies on the stock market today are digital.  They carry little or no inventory so consume no net cash. Banks are flooded with $2.5 trillion in cash from the Fed and do not need deposits.  Why will they pay for deposits when Fed money is free?

Despite this low-inflation, low-rate environment, A-rated preferred equities from high-quality companies today pay 6-7% dividends.  Why so high?  Because unlike CD’s and bonds, preferred equity does not need to be paid back by the issuer (That's why there is a liquid secondary market for it), so issuers pay more for it.  Also, issuance of preferred equity boosts the equity on the issuer’s balance sheet, unlike debt which worsens credit.  

For yield-seeking investors graduating from risk-free investments, preferred equities are the stepping stone Ben Bernanke was looking for, offering higher yields but only slightly further out the risk curve.  They offer comparable yields to pre-2007 CDs with lower risk than common stocks (preferreds are paid first), junk bonds (too much credit risk), or MLPs (commodity price risk).  However, systemic bias against them is keeping the preferred market at a small fraction of the market for common equities.   

To reinstate widespread usage of preferred equities in America, companies need to issue them, government needs to encourage them, and consumers need to buy them.  That’s a tall order.  

Corporate boards, addicted to common-stock rewards, should amend incentive plans to include preferred shares.  David Einhorn agitated for Apple to do this in 2013.   Issuing preferred equity at a 5% yield, he reckoned, would bring Apple twice the value as issuing common shares, which at the time had a 10% earnings yield, i.e., a PE of 10.  But Apple ignored him.  It will take a pioneering board to appreciate the benefit of employing the full range of their capital structure.  Hard to believe, but true.

Government, for its part, must cease incentivizing debt over equity in tax laws. Continuing to favor debt puts the country at risk of another balance-sheet recession.  Either allow deduction of dividends or, as Trump has proposed, take away the deduction of interest expense. 

The other restraint on GDP is restrictive credit policies that have succeeded too well. Housing completions peaked at 1,953,000 per year in 2005.  Today, they are still only 1,164,000, according to HUD's May 2017 projection, despite household formations exceeding new construction by millions since 2005. If annual construction returned to its previous peak at $250,000 per house, GDP would rise by $200 billion per year. That represents 1% of annual GDP or .33% if amortized over three years. 

Wide-scale issuance of preferred equity for savers and retirees across America would restore disposable income to a level that contributes its fair share to GDP without excess risk.  Loosening up severe credit restrictions imposed since then on house purchasers would be the icing on the GDP cake.

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