On the Paradox of Wealth and the Lowering of Returns on Capital, and Managing Anxiety!

From: adityarana
Date: Sat, Mar 29, 2014 at 2:13 PM
Subject: On the Paradox of Wealth and the Lowering of Returns on Capital, and Managing Anxiety!


With societies progressing economically and getting wealthier, what are the implications on the returns on capital? William Bernstein, principal of the bespoke financial advisory firm Efficient Frontier Advisors and prolific author of investment classics like "The Four Pillars of Investing" and the "The Intelligent Asset Allocator" has written a thought provoking note ("The Paradox of Wealth" published in the CFA Journal) which makes a persuasive case that the cost of living in an increasingly prosperous world, driven by the continuance of long-term trends in economic growth, is the lowering of returns on capital. To summarise:

-Pessimism about long-term growth prospects of societies has a long and ignominious history – but long-term growth is likely to continue at historical trends as a result of productivity increases driven by technological innovation built on the foundations of scientific rationalism, property rights reinforced by rule of law, modern capital markets and modern communications and transportation technologies.

-The distinguished American economist Robert Gordon has recently made the case for a significant drop-off in long-term growth rates in the U.S. due to declining productivity as we face six head winds: 1) fossil scarcity, 2) demographics, 3) education, 4) inequality, 5) globalization and 6) debt.

-Looking at productivity trends and six headwinds individually:

-The long term trend in productivity (as approximated by per capita GDP) of 1.8% seems very much intact despite periodic deviations from the trend. This feature is also observable in other advanced economies like Germany and Japan.

-The adverse impact demographic trends is undisputable – as societies age the number of individuals supported by workers will increase from 1.36 to 1.52 over the next 40 years, which will reduce per capita GDP growth by 0.3% over that period- a fall yes, but hardly the end of growth.

-The deterioration of U.S. educational standards, rising inequality and increasing debt overhang are also all true but not unsolvable as U.S. history has repeatedly shown.

-The adverse impact of globalization may already be ending as a major "insourcing" trend seems to be underway as the increasing costs (economic and cultural) of transcontinental supply chains become apparent, and advanced manufacturing techniques like 3-D printing drive manufacturing back to the U.S..

-Gordon underestimates the impact of energy technology and makes the classic mistake of assuming what cannot be conceived as not possible. Again, history is replete with examples of technological breakthroughs which were inconceivable prior to the events – modern jet transport, the Internet, instantaneous global communication to name a few.

-Optimism about the long-term growth prospects is based not just on technological progress but on deeper factors underlying modern prosperity (see chart below):

1) Scientific rationalism:

The ancient civilizations did not have what we today call science – "the rigorous, methodical collection of facts, the formulation of hypotheses and mathematical models, and the iterative testing of the latter with the former". This inductive collect-hypothesize-test cycle commenced with Francis Bacon’s treatise The New Orgamon which put to rest the predominance of the stifling, deductive Aristotelian system.

2) Property rights reinforced by rule of law:

Inventors must feel secure that they will be able to gain from at least some of the economic benefits arising from their innovations – i.e. through the implementation of property rights. While some form of property rights did exist in the ancient world – "a truly independent judiciary steeped in the tradition of equality under the law" only came into being with the emergence of English common law during the medieval period.

3) Modern capital markets:

Capital is essential to scale up production of inventions – for example Edison’s invention of the incandescent light bulb only took the form of a commercially viable business with the forming and financing of his company by the Morgan Bank.

4) Modern communications and transportation technologies:

An entrepreneur also needs to scale-up by selling his inventions across the country and globe – making the discovery of steam power and telegraph in the mid-nineteenth century essential.

The above four factors have been critical in explaining the puzzles of modern economic development:

Why did growth suddenly start in the early 19th century (see graph below)? That is the point at which the last of the four factors came about – the steam and engine. For example, prior to 1800, the Netherlands had secure property rights, advanced capital markets and a scientific environment, and while having no access to steam power or telegraph, it did have an effective canal system for inland transportation making it the "first modern economy" and allowing it to achieve a 0.5% annual productivity growth rate for three centuries prior to the Industrial Revolution.

In today’s world, secure property rights and rule of law seem to separate the rich nations from poor ones. While today most nations have reasonable access to the other three factors – lack of property law and rule of law tend to nullify the benefits of the other three.

Why did the Industrial Revolution take place in Protestant Europe? The Vatican opposed lending at interest and scientific rationalism, were concerned with only their own property rights, and so retarded economic development in the Catholic nations. This also explains why England, the home of common law, Bacon and the Royal Society, together with advances in capital markets was the epicentre of economic development.

-All these four critical factors are in ascendancy today which bodes well for future economic growth. While the track-record of long-term forecasters has been decidedly proven to be poor, it has been shown that adopting simple base-line probabilities (i.e. "there is a two out of three chance that the stock market will do well next year") and regression analysis (i.e. "stock market is historically cheap and there is a three out of four chance it will provide a positive return next year") can improve the accuracy of forecasts.

-However, despite the high likelihood of continuing trends in economic growth, the returns on capital are very likely to diminish.

-History has shown that ancient subsistence societies had a exorbitant cost of capital as there existed little excess capital and the society consumed all that it produced. As societies became more productive, wealth slowly accumulated in the hands of a few and capital became more plentiful – in absolute terms as well as relative to the demand for it. While wealthier societies do consume more capital, the supply/demand equation shifts in favour of the consumers of capital.

-For example, as calories consumed per day by the average person (as a proxy for output) increased dramatically from the stone age to ancient Mesopotamia and Greece, interest rates declined slowly from over 100% to double-digits, finally reaching a low of 4% during the Roman empire. However, after the fall of the Roman Empire and the loss of advanced civil engineering, energy consumption fell and did not recover to the levels of the Roman times until about 1700 (see graph below).

-But between 1200 and 1800, Europe emerged from the Dark Ages, and during this period interest rates fell dramatically as shown by the graph below. Based on the data, a rough rule shows that a society’s real investment return is approximately 5/its per capita energy consumption.

-A century ago, Irving Fisher observed that in poor nations interest rates were high while rich nations had lower interest rates. He surmised that this was so because in poor nations, a malnourished, poorly housed population with short life expectancies was "impatient" for capital and consumption, therefore making interest rates higher than in richer nations. Irrespective of the underlying reasons – it is clear that the further a country is away from its subsistence level the lower the cost of capital.

-Recent studies have also showed that there exists an inverse relationship between economic growth and return on capital. This can partly be explained by stock dilution – stable, mature nations exhibit a 2% annual stock share dilution, while nations which have undergone wartime disruption have had dilution levels of about 4%. Some recently rapidly growing Asian nations have had a stock dilution rate of almost 30%.

-Looking at 10-year cyclically adjusted price/earnings ratios (CAPE) over the last 132 years show that the earnings multiple has been expanding gradually (implying falling equity returns-see graph below) at the rate of about a point every 17 years.

-While the historical trend words cheaper capital and lower returns is clear – there have been some extraordinary fluctuations around this trend – ranging from the cost of capital in late seventeenth century England (during the English diving companies bubble) falling to levels reached during the recent tech bubble, to the entire U.K. stock market being valued (in 1974) equivalent to a few years Saudi oil earnings and the U.S. stock market being valued in single digit multiples in 1982.

-While investors with patience and discipline will certainly get opportunities to purchase assets at cheap levels in future years, it is likely that they will be more transient and fewer in number going forward.

-In summary, while technological progress will continue to make societies grow, it will also reduce asset returns by increasing societal wealth and decreasing the cost of capital, promoting enthusiasm and capital flows from gullible investors, and, by the dilution of shares required to capitalise new technologies and finance rapidly growing economies.

A fascinating tour-de-force of the factors underlying the long history of economic growth, its prospects going forward and the declining expected returns on capital. While I do not necessarily share his views on the continuance of economic growth trends (the U.S. been experiencing a subtle and clear slowing growth trend as exhibited over the last century as convincingly argued by Grantham and summarised in previous newsletters – see graph below), I do agree with his main hypothesis that we will face declining returns on capital. Indeed, higher returns (albeit more volatile) on capital will be realised from countries which are actually short of capital – i.e. current account deficit countries. The sole exception here is China, which has historically experienced poor returns on capital in conjunction with high economic growth, but with a lowering of growth it’s returns of capital are likely to catch-up and the current pessimism about China is overdone. Also be on the constant lookout for unique (and usually contrarian) opportunities to take on risk with an ample safety margin in a world of low asset returns.

Managing Anxiety:

Cam across an interesting article on recent research which shows that an imbalance between zinc and copper could be a factor behind anxiety disorders:

(Natural News -3/9/13 ):

-We all get anxious about issues now and then and tend to get over it. But chronic anxiety, or Generalized Anxiety Disorder (GAD), is both chronic and non-specific. With GAD, there are no isolated situations that warrant worry. The worry and tension are present disproportionately all the time with all situations and possibly often not even focused on any situation.

-Fortunately, this is often related to mineral and vitamin issues that can be tested and remedied. Vitamins B6 and B12 are useful for depression, while anxiety and tension issues are often remedied by increasing magnesium. But recent developments with GAD point to an imbalance of the more obscure trace minerals zinc and copper, which tend to compete with each other for absorption and receptor channels.

-A study titled "Decreased zinc and increased copper in individuals with anxiety" was conducted at the Research Institute, Illinois, and published by Nutrition and Metabolic Insights in 2011. http://www.vitasearch.com/get-clp-summary/40783

-Highly advanced technology (ICP) was used to measure trace minerals in the serum of 38 individuals with chronic anxiety and 16 in a control group without anxiety symptoms. The researchers discovered that the anxiety group had generally lower serum zinc levels compared to copper or elevated copper compared to zinc. They were treated with zinc and antioxidant supplements, according to individual parameters, and their symptoms improved significantly.

-Copper piping for water in dwellings has become the norm, and that does contribute to ingesting traces of copper beyond most diets. But raising zinc levels is a more functional factor than lowering copper levels.

-Medicinal practitioner Chris Kresser elucidates this topic further by explaining it’s the ratio of copper to zinc that determines neurotransmitter health or dysfunction. Ideally, your copper blood level should be 70% of your zinc level. Not everyone has access to ICP technology for measuring trace mineral testing, so Kresser recommends the 24 hour urine sample test, which can be more accurate than most blood tests.

-Copper and zinc tend to be antagonistic to each other. Excess copper can also invite Wilson’s Syndrome, first identified by Dr. Denis Wilson, which resembles hypothyroidism and is characterized by low baseline body temperatures and possibly low level depression.

-Food sources for zinc include pumpkin seeds, Brazil nuts, broccoli, legumes and whole grains such as brown rice. Grains and legumes also contain phytic acid that binds to zinc and blocks absorption. So it’s a good idea to soak brown rice and beans overnight in fluoride free purified water to reduce the phytic acid and free up the zinc . Of course, there are inexpensive zinc supplements available. Unfortunately, chocolate and cacao are high in copper. But the recommended focus is to boost zinc instead of reducing copper

Here’s to eating sufficient amounts of whole grains, legumes, nuts and seeds to naturally boost your zinc levels.




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