Germany’s tough choices amid the global disorder

Some three decades after the Berlin wall fell, history did not end and now the Republic must take sides

Philip Stephens 

     © Ingram Pinn/Financial Times

Germany has prospered through the best of times. Now, it must navigate what are shaping up as the worst. Next month it celebrates the 31st anniversary of the fall of the Berlin Wall. Amid a rising sea of international discord, Germany’s peaceful reunification has been a triumph for liberal democracy and an anchor of political stability. Now, the global order that made it possible is disappearing over the horizon.

Cast around for descriptions of today’s Germany and responses usually include “prosperous”, “steady”, “moderate”. Some may add “smug”, and there will always be some UK Brexiters who live the nightmare of a fourth Reich. In troubled times, however, Europe’s most powerful nation is defined by its stability — a national resilience rooted in rejection of extremes.

Of course, Germany has its dark corners. It has not been immune to the economic and social divisions challenging political elites across Europe. It has its own populists — Alternative for Germany on the far-right, Linke on the far-left. Those who assumed German capitalism always played by the rules have been startled by the environmental frauds perpetrated in its legendary car industry. Admirers of its unmatched engineering prowess struggle to explain a crumbling national infrastructure.

By the same token, reunification has thrown up disappointments. The vast investment poured into the former German Democratic Republic has not erased the line between east and west. Leipzig and Dresden have been reborn as great cities, but the east has failed to attract self-sustaining private businesses. The best and brightest head west. A generation of “left-behinds” still hanker for communist certainties. Ostalgia, it is called.

All these challenges are relative. Most other European governments would not hesitate to swap Berlin’s problems for their own. In an era of popular disenchantment, what stands out is the high level of trust in Germany’s political and civic institutions — trust that underpins a capacity to absorb unexpected shocks.

The opening of the borders in 2015 to 1m migrants from Syria and beyond looked for a time as if it might overwhelm Chancellor Angela Merkel’s administration. The far-right in the shape of AfD gained a firm foothold in the Bundestag. The subsequent process of integration has not been perfect, but the crisis has long passed — smothered by the high levels of civic engagement that mark out Germany’s federal system.

The response to the Covid-19 pandemic has illuminated the same careful proficiency. Responsibility has been shared between the various tiers of government. Citizens have been engaged. Germany’s infection and mortality rates are the lowest of Europe’s big countries.

So why fear the worst of times? For over three decades, history was on Germany’s side. Now, the external stability on which it built domestic success has been replaced by the most significant geopolitical uncertainty of the postwar era. 

The US presence in Europe guaranteed the continent’s security. The wisdom of Bonn’s political leaders in facing up to the horrors of Nazism created a shelter behind which Germany could rebuild its economy while entrenching democracy.

Franco-German reconciliation and the creation of the EU pulled in the same direction towards a rules-based system in which the social market economy flourished. The bargain suited all sides. Fear among neighbours of German rearmament left responsibility for security — and the burden of defence spending — to the Americans, the French and the British.

For more than a decade after the wall fell, Germans could tell themselves that this conjunction would last for ever. The German model of normative power would serve alongside US military might as a guardian of unification. As former chancellor Helmut Kohl used to remark: “For the first time in our history we are surrounded only by friends.”

This was the walled garden behind which the republic flourished. To be fair, Germans were not alone in thinking the world had reached the end of history. Never mind. Real life has turned out otherwise.

Vladimir Putin’s Russia has re-emerged as a revanchist power, seeking to redraw national borders by force. China has repudiated the western model in favour of state-directed capitalism attached to political repression. The US has turned inwards as China pushes outwards. Nationalism has returned to Europe. This is the world of 19th century power plays rather than the co-operative internationalism of the second half of the 20th.

Germany’s leaders have mostly understood this. Frank-Walter Steinmeier, the former foreign minister and now federal president, has spoken eloquently on the need for Germany to take on its share of the security burden. The ultra-cautious Ms Merkel habitually offers a rhetorical nod in the direction of a bigger German role in upholding the rules-based order.

Yet there is little sign yet of a corresponding change in the national mindset. At times of crisis, Germany’s first instinct is to mediate. In a world where too many others prefer to shoot first, that is no bad thing. But whether it is Russian aggression, Turkish adventurism or Chinese expansionism, the new global disorder presents unavoidable choices. There are times when nations — Germany included — have to take sides. 

Putin offers Trump one-year extension to nuclear arms treaty

Russian leader’s overtures to save bilateral accord would offer US president a foreign policy victory as election nears

Max Seddon in Moscow and Katrina Manson in Washington 

Russian President Vladimir Putin attends a meeting with the members of the Security Council via video link © Sputnik/AFP via Getty Images

Russian president Vladimir Putin has offered to extend a crucial nuclear treaty with Washington by one year in a move that could hand Donald Trump a foreign policy win before the US presidential election.

Mr Putin told his security council on Friday that “it would be exceedingly sad” if New Start, a 10-year bilateral accord that limits US and Russian nuclear warheads, were to expire on February 5.

“I have an offer: to extend the existing agreement without preconditions for a year at least, in order to have the possibility to hold constructive negotiations on all parameters of the issues regulated by such agreements,” Mr Putin told foreign minister Sergei Lavrov. “Try to get some sort of coherent answer out of them as soon as possible.”

The Trump administration had refused to accept Russia’s earlier offer to extend the treaty for five years without preconditions, terms that are acceptable to Joe Biden, Donald Trump’s Democratic opponent. If elected at next month’s polls, Mr Biden would take office in January with little more than a fortnight to negotiate and sign a five-year extension, however.

The Trump administration is seeking to rack up foreign policy wins in the final stretch of the campaign before the November 3 election as US president tries to narrow Mr Biden’s lead in national polls.

Mr Trump said this month that US troops “should” return home from Afghanistan by Christmas, and claimed last month that “five or six” more countries were ready to strike US-brokered deals to normalise relations with Israel, following in the steps of the United Arab Emirates and Bahrain.

However the Trump administration has been unwilling to extend the treaty with Russia without extracting an agreement from Moscow to freeze its entire nuclear arsenal, including smaller tactical nuclear weapons that are not covered by the agreement but make up as much as 55 per cent. The US also wants to include China in nuclear accords.

Alexandra Bell, senior policy director at the Center for Arms Control and Non-Proliferation, said a short extension of the treaty would be “infinitely preferable” to expiration. But it would be better for both sides to extend the treaty for a full five years to “provide a more secure environment for Washington and Moscow to create new and expanded agreements,” she added. 

Marshall Billingslea, presidential envoy for arms control, did not immediately appear to respond to the offer. State Department did not immediately respond to a request to comment. 

Mr Lavrov said US intransigence over “quite a large number of [US] preconditions that go beyond both the treaty itself and our competence” had led to a “critical situation” where “work on extending the treaty without preconditions that are not contained in it has basically not even begun.” 

He warned that Russia would be left without “any sort of other instrument that ensures any kind of joint approaches to strategic stability” after US withdrawal from a series of other treaties. “Everything else has either already been destroyed or the Americans are offering to end it,” he said.

Mr Putin said Russia was willing to discuss China’s involvement and restrictions on new Russian hypersonic weapons, as well as Moscow’s own concerns over US missile defence and a conventionally armed long-range strategic cannon.

“In previous years New Start has worked faultlessly by fulfilling its fundamental role to limit and contain the arms race,” the Russian leader said. “Obviously, we have new weapons systems that the American side doesn’t have, at least not yet. But we are not refusing to discuss that side of the issue either.”

US national security adviser Robert O’Brien revived talks when he met his Russian counterpart Nikolai Patrushev in Geneva this month. The encounter was followed by talks in Helsinki between Mr Billingslea and deputy foreign minister Sergei Ryabkov.

The gap between the two sides was evident on Tuesday after Mr Ryabkov said the US stance was “unacceptable” — hours after Mr Billingslea said the US believed there was “an agreement in principle at the highest levels of our two governments”.

Andrei Baklitsky, senior research fellow at Moscow’s MGIMO university, wrote on Twitter: “One thing is clear: no deal for Trump before the elections. It’s either a one-year extension of the [New Start treaty] or nothing. I almost feel sorry for [Mr Billingslea], who was telling everyone that there’s a deal agreed in principle, which will materialise within a week. Or will he simply say that President Putin is not attuned to the Russian leadership?”

Minding the Digital Economy’s Narrowing Gaps

By collapsing physical distance, the digital economy has overcome one of the largest traditional hurdles to market formation and efficiency. But data-driven digital markets come with their own unique informational challenges, demanding further innovation not just by entrepreneurs but also by policymakers. 

Michael Spence

MILAN – Informational asymmetries between buyers and sellers have long been known to impair market performance. But thanks to digital technology and the large, accessible pools of data that it generates, these informational gaps are closing, and the asymmetries are declining.

The presumption that Republicans are better than Democrats at economic stewardship is a longstanding myth that must be debunked. For all Americans who care about their and their children’s future, the right choice this November could not be clearer.

Until recently, market formation has been circumscribed by physical and geographical boundaries. A prerequisite for a market to form is that buyers and sellers are able to find each other, and this process has traditionally been accomplished in physical spaces like bazaars, stock exchanges, stores, or dealerships (albeit with intermediaries using phones and fax machines to facilitate transactions). 

Things started to change with eBay, the original model for many online marketplaces. 

Suddenly, geographical boundaries no longer operated as insurmountable barriers between widely dispersed buyers and sellers.

Arguably, freeing markets from geographical constraints has had the greatest impact on market access for remote populations. In many places globally, and for subsets of potential consumers everywhere, online channels can be the only practical option for accessing a wide range of goods and services, including primary health care and education. 

This applies to both the demand and the supply side. 

And because consumers enjoy expanded access to goods and services, sellers and producers can scale up dramatically to meet the increased demand. In China, for example, the digital expansion of the potential market for small and medium-size enterprises was a major impetus for much of Alibaba’s development, demonstrating how digital technologies, together with the rapid growth of the mobile Internet globally, can drive more inclusive growth patterns.

As online marketplaces developed, however, it soon became clear that additional information issues would need to be addressed for these markets to function effectively. 

For example, because it is difficult for buyers to detect variations in quality among sellers and among goods and services offered online, more information was needed to capture the reliability or trustworthiness of market participants. 

The problem is essentially the same for both buyers and sellers, with the former worrying about receiving what she pays for and the latter worrying about being paid.

It is precisely this kind of bilateral information asymmetry that prevents market formation or limits market exchange in the first place. Hence, a number of digital-payment platforms initially were created to address online markets’ fundamental “trust” problem. 

Following the model of escrow systems that are familiar in real-estate transactions, e-commerce platforms created intermediaries that they hoped would be trusted to collect and hold payments from buyers until delivery of the goods or services had been confirmed.

In the case of Alipay in China and Mercado Pago in Latin America, these systems were initially designed to accelerate the uptake of e-commerce platforms, but over time evolved into mobile-payments systems used offline and throughout the entire economy. 

This process is very advanced in China, while cash continues to hold on in Latin America. Not only have these systems yielded a growing trove of tremendously valuable data, but they have also allowed market-making platforms to become more powerful with each transaction, as the data accumulates.

Ratings of sellers (and sometimes buyers) and products are now a common feature of online marketplaces, and studies indicate that they are highly influential in buyer decision-making. 

But for this function to serve its proper purpose, the platforms needed to develop additional systems and safeguards to prevent ratings manipulation, and to stop banned users from reappearing under a new handle. Thus, in addition to closing information gaps, ratings also create incentives for market participants to behave better.

As more and more “stuff” appeared in online marketplaces, users starting having difficulties finding what they were looking for, because they could not browse through options in the same way that one does when shopping in a physical store. 

To address this issue, online platforms developed search algorithms and recommendation engines based not only on individual users’ browsing and purchase history, but also on behavioral data from all other users. 

These algorithms have been further improved by advances in artificial intelligence and increases in the volume and quality of data. Search and recommendation engines are a partial solution to the “matching problem,” and thus a key source of online market performance. They add value for both buyers and sellers, and boost transaction volume substantially, especially for lesser-known sellers and brands.

Moreover, because it is widely available and inexpensive to access, online information has reduced information asymmetries beyond the realm of e-commerce. 

For example, markets in automobiles, health care, and insurance have also been transformed, even in the offline world, leaving consumers better informed and more empowered vis-à-vis sellers.

A final informational challenge relates to access, specifically giving consumers accessible online identities and tracking records that signal their attractiveness as counterparties in a variety of market settings.

Credit is a good example. In the offline world, people and businesses have track records and financial histories that hypothetically could be used to underpin credit or insurance markets. 

The problem is that these offline records tend to be scattered and inaccessible, whereas in the digital economy – especially following the high penetration of mobile payments and e-commerce – they become easily retrievable and far more useful. Like knowledge, data is non-rival: using it does not diminish its value for further use or for use by multiple parties.

AI algorithms can be deployed to assess and price credit for people and businesses with no collateral and little prior contact with the traditional non-digital economy and financial sectors. As in platform-based evaluation systems, informational gaps are reduced and incentives are improved, while market access is expanded for households and small businesses.

In short, data-driven digital markets have evolved from struggling with informational gaps to having higher informational density than their offline counterparts, leaving fewer information gaps and asymmetries. The accessibility of digital data allows for new screening mechanisms and signaling behavior that are frequently missing in the offline world.

Of course, highly accessible stores of data come with own real and much discussed risks, and these must be addressed in order to achieve the potential efficiencies and inclusivity benefits on offer.

After all, the institutions (including governments) that collect data and act as digital gatekeepers must be trusted, too. At a minimum, they must be subject to enforceable regulation that provides clear definitions of individuals’ rights with respect to transparency, data use, privacy, and security. 

Here, arguably, we are making progress, but we still have a long way to go.

Michael Spence, a Nobel laureate in economics, is Professor of Economics Emeritus and a former dean of the Graduate School of Business at Stanford University. He is Senior Fellow at the Hoover Institution, serves on the Academic Committee at Luohan Academy, and co-chairs the Advisory Board of the Asia Global Institute. He was chairman of the independent Commission on Growth and Development, an international body that from 2006-10 analyzed opportunities for global economic growth, and is the author of The Next Convergence: The Future of Economic Growth in a Multispeed World. 

Demographics and Debt Hang Over Long-Term U.S. Growth

Once the Covid-19 pandemic passes, the U.S. will have to contend with weaker population growth and the drag of high debt

By Greg Ip

The 1918 flu pandemic was followed by a plunge in births. A recent report found the Covid-19 pandemic could reduce births by 300,000 to 500,000 next year. / PHOTO: JOHN MINCHILLO/ASSOCIATED PRESS

If you’re worried about the short-term economic outlook, I have bad news: the long-term outlook is worse.

That’s what emerges from the latest long-term budget outlook released by the Congressional Budget Office last week. It contained this sobering number: the agency expects annual economic growth to average just 1.6% over the next three decades—down by about a quarter of a point from its forecast a year ago—and just 1.5% by the 2040s. 

The U.S. hasn’t had trend growth that low since the 1930s. Only a bit of this is because of the pandemic. Most reflects longer-lasting forces, namely demographics and productivity.

Of course, all economic forecasts are essentially educated guesses, especially those that extend so far into the future. Many of the assumptions underlying such projections will turn out to be wrong. The CBO in particular is required to assume certain things that probably won’t happen, for example that all of President Trump’s personal income tax cuts will expire, as required by current law, in 2026.

Yet it’s still a useful exercise because the CBO systematically combines everything we know today about the factors driving growth into an internally-consistent story about the future.

That story is influenced surprisingly little by the pandemic-induced recession. CBO expects this year’s steep contraction will be followed by faster growth in subsequent years, leaving growth over the coming decade barely changed.

It’s in subsequent decades, though, the picture darkens. A big reason is demographic developments already under way today. In a recent report, Melissa Kearney and Phillip Levine, economists at the University of Maryland and Wellesley College respectively, cite research showing births decline predictably when unemployment rises. 

They also say uncertainty and anxiety associated with the 1918 flu pandemic coincided with a plunge in births the next year. In both cases, births aren’t merely postponed; women end up having fewer babies. Combining these results, they think the current pandemic and recession could reduce births by 300,000 to 500,000.

This is similar to the CBO’s projection that total fertility—the number of babies a woman is expected to have over her lifetime—will drop to 1.6 next year, the lowest in at least a century and well below the 2.1 rate at which each generation exactly replaces itself. Those births translate into fewer people entering the labor force 20 years later, and fewer new parents.

The U.S. could make up for falling fertility with immigration, but the CBO notes that coronavirus-related travel restrictions, reduced visa-processing capacity and fewer foreign entrants without legal status have already reduced immigrant inflows. It expects 2.5 million fewer immigrants in the coming decade than it said last year as a result.

The net result is fewer Americans: 374 million in the year 2046, 10 million fewer than what CBO thought last year and 34 million fewer than in 2012.

The CBO has had to revise down estimated population repeatedly in recent years and may have to again. It sees the fertility rate returning to 1.9 by 2026, but Ms. Kearney disagrees: “Even if there is a rapid recovery and no lingering Covid effect on birthrates, the fertility rate has generally been trending downward.” 

And while falling fertility strengthens the economic case for immigration, it doesn’t necessarily make voters more receptive, as the backlash of recent years in both the U.S. and Europe has shown.

Not only will the U.S. have fewer workers than previously projected in coming decades, they’ll be less productive: CBO has sharply revised down growth in output per worker between 2031 and 2050. Several factors are at work. One is that a smaller workforce by itself leads businesses to invest less. The CBO also thinks an aging population will want less housing and this reduces future investment and growth.

The elephant in the room is the national debt. Conventional economic models like the CBO’s say government debt soaks up saving and thus crowds out private investment, and the U.S. is about to have a lot more debt. 

CBO thinks the federal debt will soar from 79% of gross domestic product last year to 189% of GDP in 2049 compared with its forecast of 144% a year ago thanks to pandemic-related borrowing and congress’ increase in discretionary spending and elimination of the tax on high-cost health insurance.

The “crowding out” model hasn’t fared well in recent years: steep deficits have coincided with ultralow interest rates. 

This is probably because investment has been persistently weak globally relative to saving. 

Perhaps interest rates will stay low, allowing government debt to grow indefinitely with no ill effect. But in that scenario U.S. investment and productivity growth would likely be even weaker than the CBO now sees—not a future to be embraced. 

 The Fiscal Dance

Lyn Alden Schwartzer


- Household equity allocations (as a % of household assets) are near the high end of their historical range.

- An analysis of corporate capital structures in terms of equity and debt, and how it changed over time.

- Why fiscal policy is a key variable to consider within any tactical investment framework, at this particularly juncture.

This article focuses on the Federal Reserve's Sep 21, 2020 Z.1 Financial Accounts release.

The Z.1. release is a quarterly report by the Fed that accounts for the assets and liabilities for entities throughout the United States, including households, businesses, and governments. It comes out with a bit of a lag, but the abundance of information makes it a great data set for monitoring long-term trends.

Record Net Worth

U.S. household net worth reached an all-time high in Q2 2020, both in nominal dollar terms (red line below) and in CPI-adjusted terms (in blue):

      Chart Source: St. Louis Fed

Total household wealth reached nearly $119 trillion in nominal dollar terms by the end of the quarter. This new high in net worth is due to the sharp rebound in equity prices that occurred through Q2, the continued increase in housing prices, and the rapid growth of the broad money supply.

Some people are confused at why markets and overall net worth could have done so well this year so far, despite such a bad environment for employment and GDP.

The reason, of course, largely has to do with trillions of dollars of government transfer payments from April through July of this year. Due to record levels of stimulus checks, unemployment benefits, PPP loans for businesses that largely turn into grants, and corporate bailouts, personal income on a nationwide scale went up rather than down in this recession so far:

Chart Source: St. Louis Fed

More important than absolute household net worth, and a key ratio to be aware of, is household net worth as a percentage of GDP. This ratio is shown in blue on the left axis of the chart below, with short-term interest rates in red on the right axis for context:

Chart Source: St. Louis Fed

This ratio of household net worth as a percentage of GDP shot up to new record highs of over 6x or 600% this quarter (largely due to a sharp decline in GDP), after already being at record highs of nearly 550% in recent years.

All else being equal, low interest rates put upward pressure on real estate and equity valuations, which puffs up net worth relative to income and relative to GDP. As we've reached lower and lower interest rates over time, asset valuations have pushed upward. 

However, momentum and other factors tend to exaggerate this move in certain asset classes over time.

During the 2000 peak, real estate was reasonably priced compared to historical norms, but equities briefly shot up to record high valuations, which pushed up household net worth to about 450% of GDP.

During the 2007 peak, it was the opposite, with equities at historically reasonable valuations while real estate briefly soared to record high valuations, which pushed up household net worth even more to nearly 500% of GDP.

In recent years, both equities and real estate have been historically highly-valued together, as interest rates have hit lower lows, and that combination of high equity valuations and high real estate valuations has allowed household net worth to break out to record highs as a percentage of GDP, even compared to 2001 and 2007. 

We were getting close to 550% household net worth to GDP in recent years, and the decline in GDP in Q2 as asset prices went up, has briefly taken that ratio to over 600%.

Normally, a big economic shock would dislodge that and start to deflate asset valuations to some extent, but so far in this recession, record amounts of stimulus have been able to keep personal incomes and asset prices levitating through this year. And the four-decade trend of lower interest rates has been beneficial to asset price valuations.

Since August, fiscal stimulus hasn't been in effect, so uncertainty and volatility have returned to equity markets.

Equity-Heavy Household Allocations

The majority of household net worth consists of financial assets like cash, bonds, real estate, and stocks.

We all know by now that by most metrics, equity valuations are historically high. For example, based on the S&P 500 average price-to-sales ratio, or the cyclically-adjusted price-to-earnings ratio, or market capitalization as a percentage of GDP, the stock market is more expensive than most times in history. 

By some of those metrics, like the price-to-sales ratio, it is the highest in history, while in other metrics, like the cyclically-adjusted price-to-earnings ratio, it is the second-highest after the 2000 dotcom bubble peak.

On the other hand, the one key metric for which stocks are not particularly expensive, is the equity risk premium, meaning the earnings yield or dividend yield of the S&P 500 compared to an interest rate benchmark, like the 10-year Treasury rate. By that metric, the valuation advantage actually still leans a bit towards the stock market, especially if you filter out a handful of particularly bubbly stocks.

And that's what makes this environment so hard for investors. Back during the dotcom bubble 20 years ago, 10-year Treasury notes were yielding a very attractive 6%. Not only were stock valuations extremely high, but the equity risk premium was also at a record low compared to those high-yielding nominally risk-free bonds, so Treasuries were a no-brainer better alternative to stocks that smart investors could shift into.

With interest rates around the developed world all near-zero currently (or even nominally negative in some cases), and thus sovereign bonds set to produce extraordinarily low returns over the next decade, many investors are left scrambling for assets, including equities and real estate even at rather high prices.

In other words, many investors accept the prospect of long-term low returns that stock indices are likely to offer at such high valuations, because those returns could still be comparable to, or better than, the return they'll get from Treasuries over the next decade, in exchange for more volatility. Both will likely be low-returning areas, especially in inflation-adjusted terms, but which will be better is an open question.

I prefer good-quality stocks from a long-term perspective, including some foreign stocks that are generally cheaper at this time, but I do use Treasuries for some counter-cyclical defense, to buy dips and sell rips in equities and other asset classes via tactical rebalancing.

However, we have to be cautious, because equities are very popular among investors at this time. Besides the traditional stock and bond valuation metrics, one ratio we can look at is the percentage of U.S. household assets that consist of equities, from the Fed's Z.1. report.

As of Q2, 23.5% of household assets consist of equities (in red below), which is near the high end of the multi-decade historical range. I also included household real estate as a percentage of assets on this chart as well, which is currently at a more historically average allocation:

Chart Source: St. Louis Fed

If I plot the year-end household equity allocation percentage along with the forward ten-year percent annualized S&P 500 returns from the end of that year, it shows that periods of high household allocation to equities tend to be followed by a decade of poor annualized equity returns, and vice versa:

Data Sources: Federal Reserve, Aswath Damodaran (NYU)

When equities were over 20% of household assets in the late 1960's, the result over the next 10 years was about 2-3% annualized returns, which is not even adjusted for inflation. Then, when equities fell to cheap levels in the 1970's and 1980's, down to well below 10% of household assets, the annualized forward returns were over 15%, which even after adjusting for inflation were great.

The dotcom bubble, where equities briefly reached 25% of household assets was the worst time in modern history to buy equities, as they produced slightly negative 10-year annualized returns from there. The 2008-2010 period was a great buying opportunity, and now from 2017-2020, equities have been back up to around 25% of household assets.

This inverse correlation between household equity allocation and forward equity returns is roughly what we would expect to happen from a rather crowded trade.

To summarize here, U.S. household assets and net worth are at a record-high percentage of GDP and earned income, and equities currently represent a historically high portion of those highly-valued household assets. This combination historically doesn't bode particularly well for ten-year forward returns, especially if we adjust for inflation. As a long-term trend, however, it's not a trading signal, but rather just a "big picture" observation.

Equity-Heavy Capital Structures

Despite being highly indebted based on various metrics, such as corporate debt as a percentage of GDP, corporate capital structures are actually tilted more towards equity than average, as of Q2 2020. That's because, as previously described, equities are so highly-valued.

Specifically, at the end of Q2, total corporate equity (excluding banks) was worth $33.5 trillion, while total corporate debt (excluding banks) was worth just under $11 trillion. In other words, total corporate debt was worth about 1/3rd as much as total corporate equity shares at market value.

If we add corporate equity and debt together, the total is about $44.5 trillion, with equity accounting for about 75% of that total, and debt accounting for the other 25%. That's the current capital structure of U.S. nonfinancial corporations in aggregate: three quarters equity and one quarter debt.

Compared to history, this ratio is currently on the high end, meaning that equity value outweighs debt value by more than average. This chart shows market-value equity as a percentage of the total sum of equity and debt since 1945:

     Chart Source: St. Louis Fed

During the booming 1960's, corporate equity remained in a 70-75% band for capital structures for most of that period, with debt representing the other 25-30%.

Then, during the inflationary 1970's and 1980's, equity valuations were much cheaper, and so equities made up just 50-60% of corporate capital structures. Corporate debt was relatively low as a percentage of GDP, but corporate equity was also unusually cheap.

The 1980's began a disinflationary trend and a mega stock boom into the 1990's, with corporate equities reaching a record 78% of the total capital structure at the peak of the dotcom bubble by the end of the 1990's decade.

Then, this ratio went down and chopped along for a while after the dotcom bubble burst, and then during the 2009 market bottom, equities were very briefly back to just 60% of the corporate capital structure before quickly shooting back up.

For the past several years, since around 2014, corporate equities have once again been hovering at around 75% of the corporate capital structure, which is near the top end of the historical range.

The big caveat for this comparison of corporate capital structures, is that it's currently more top-heavy than usual. The handful of mega-cap tech and internet stocks, like Amazon (AMZN), Microsoft (MSFT), Apple (AAPL), Facebook (FB) and Alphabet (GOOGL) represent several trillions of dollars in equity market capitalization, but have comparatively very little debt. The vast majority of their combined capital structure consists of equity.

As we move down into medium and smaller companies, however, their tilting towards debt becomes a lot bigger, with lower equity valuations and higher debt loads.

Both corporate debt levels and equity valuations have been sharply rising, so corporate debt and corporate equity have both grown faster than GDP. This chart shows nonfinancial corporate equities (in blue) and debt (in red) separately, each as a percentage of GDP:

                         Chart Source: St. Louis Fed

Equity value peaked in the 1960's at around 90% of GDP, bottomed at below 40% of GDP in the 1970's and 1980's, soared to 160% of GDP during 2000, bottomed at around 70% of GDP in 2009, and now is at a record high of over 170%.

Meanwhile, corporate debt used to be as low as 20-25% of GDP, but has since nearly tripled to the 55-60% range.

Partially this trend increase is from globalization, especially if we compare the 2010's to the late 1960's. The S&P 500 is a lot more global today than it was 50 years ago, both in terms of earning revenue from abroad, and cutting expenses by building things in cheaper countries.

However, it's not all (or even mostly) from globalization. The S&P 500 used to earn a bigger percentage of its revenue from overseas ten years ago than it does lately, for example, even though the stock market capitalization to GDP ratio doubled during that time due to increases in equity valuation.

                       Table Source: S&P Global

In fact, globalization as measured by global trade as a percentage of global GDP, peaked in 2008 according to World Bank. 

This mirrors what we see from the S&P 500 foreign revenue percent table above that also peaked in 2008.

So, changes in valuation play the key role for the value of the stock market as a percentage of GDP, especially over a given decade, but that can be amplified by structural trend shifts like corporate tax cuts, globalization, and large publicly-traded companies taking market share from non-public small businesses.

Final Thoughts: The Fiscal Dance

A theme I've been framing for a while now, is that with the economy in the state that it's currently in, whenever fiscal stimulus is shut off, rising insolvency and normal recession characteristics could begin playing out.

In my previous article from August, for example, I described it like this:

However, with Congress currently in a gridlock and on recess, the economy rode off the fiscal cliff a couple weeks ago. Nearly 30 million people are no longer receiving those extra federal unemployment checks that they have been receiving for the past four months, and instead are receiving the normal level of state unemployment aid. Plus those one-time stimulus checks that both employed and unemployed people received are long-since spent.

Left unaddressed, this will eventually translate into more insolvency, such as a greater percentage of missed housing payments and a decline in overall consumer spending, and thus a possibility of W-shaped economic data, another deflationary shock, and more traditional recession effects being felt by more people.

If we look at the S&P 500, which has a lot of factors contributing to price movements, we can see how stimulus fits into the big picture as a variable.

S&P 500 Technical

If we zoom in on the 1-year chart for small caps, which are more economically sensitive and were less influenced by momentum and unusual options activity in August, it’s more clear:

Russell 2000 Technicals

The reason this current economic environment is tied to fiscal stimulus in an unusually tight way, is because of where we are at in the long-term debt cycle.

The amount of leverage and wealth concentration in the economy are both historically high, so any disruptions to broad personal income can more easily lead to systemically poor outcomes both in terms of civil unrest and broad insolvency than those disruptions could cause in a normal, healthier environment.

That will likely make the 2020’s into a particularly “macro heavy” decade, because this could very well continue to play out differently than a normal business cycle depending on how fiscal stimulus or lack thereof impacts the economy. My long-term base case is for very heavy fiscal spending, but the timing is tied to politics.

My overall process continues to be to focus on good individual stocks and ETF allocations, with a side order of precious metals. I’m using fiscal stimulus as one of my tactical risk-on and risk-off indicators, but the underlying theme is to focus on quality businesses. Unfortunately, we have to factor stimulus or lack thereof into fundamental business earnings estimates, especially for the more cyclical industries.

Personal incomes and many risk asset prices have so far defied the recession due to fiscal stimulus. But whenever stimulus goes offline, the natural tendency for an economy so indebted and impaired, is to sink into a period of disinflation and a weakening recovery. Whenever stimulus goes online (which at this point is significantly funded by permanent central bank monetization of the Treasury’s bond issuance), nominal GDP growth can be improved and risk assets have a better shot at pushing up, at the cost of higher inflation expectations and currency devaluation.

Most asset classes these days are correlated to one big theme: rising or falling inflation expectations. And these expectations are tightly tied to fiscal policy.

So, depending on their time frames, investors have that dance to play, of being more tactically aggressive or defensive based in part on fiscal stimulus being on or off, combined with whatever other indicators they prefer to use, such as fundamental valuations, oversold/overbought conditions, and technical indicators.