There is one thing that I don’t understand in that model. A company value is it’s discounted future cash flow. If we have high rates than the future cash flows also need to be high to be attractive. Otherwise it will be crowded out by bonds. That part is clear. But the future cash flows will grow with inflation, so the crowding out only works if the real rates are high. And currently real rates are not that high.
They are - true. But this explanation is all over the internet - and they never use real rates, just the nominal rates - so I was puzzled and thinking I am missing something.
I was thinking that maybe it works like this:
If a company makes a 5% profit over the year and we have 5% inflation - then it means that the profits will grow over the year from 5% to 10%, but the average will be maybe 7.5% (or should I use geometric average here?) - so it would not beat a bond that would have 10% rate which is 5% real rate. But on the other hand the earlier profits would also need to be less discounted - because they could be invested right at the point and gather some additional profits. That gets complicated.
One reason that people have not adjusted to making calculations in real terms is that they keep assuming that inflation will revert back to the supposed "target" of 2 percent. If you believe that, then long-term real rates are in fact quite high.
Of course, I don't believe that inflation is going to settle down to that point. So in my own head I am trying to do calculations in real terms. That means both trying to guess the possible scenarios for inflation and the possible scenarios for market expectations. Gets complicated indeed.
On the topic of startups and venture capitalists, you and the bloggers to whom you link are assuredly correct. I mentioned on Twitter the other day that a perpetually high(er) interest rate environment would kill many VCs and startups. One VC responded to my tweet by claiming that for every 100 bps increase in interest rates there is 25% drop in venture capital. (https://twitter.com/jcarterwil/status/1713337562721349706). I don't know if his statistic is accurate, but even if it is directionally accurate, it spells dire times for the VC industry and the startups they fund.
A further point about startups in particular bears mentioning: higher interest rates generally will depress asset prices, including startup valuations. Which means that startup employees' equity will be commensurately less valuable. Which means, in turn, that startup employees will start to demand more of their compensation in cash, and less in equity, which in turn will increase cash demands on startups. At the same time that venture capital dollars flowing into startups is declining.
Less government debt with foreign savings coming in could do 2 things: 1) increase investments in productive private sector activity or 2) bid up asset prices. If it's 2 then you have a problem.
If domestic savings kept interest rates low in the post GFC world how did we get higher interest rates in 2022 with total domestic savings substantially larger nominally and as a % of gdp. Also why did interest rates rise from 2015 to 2019 with rising savings, both total and as a %?
Part of a VC calculation is the exit multiple that can be placed on a business which is huge variable in any DCF calculation they may do; and lower stock valuations due to higher interest rates may be a large contributor to VC fund raising and investment efforts.
I’d like to hear your thoughts on the Michael Pettus/Matt Klein thesis. I’ll probably get this a bit wrong but they believe that foreign savings/investment was exported to the US. That lowered domestic investment. So they see the post GFC period as one of weak investment concentrated in sectors like tech rather than the real economy. The pandemic stimulus reversed that but in a crazy orgy of spending not in an orderly way but real wages are finally rising. Only issue is foreign savings is still getting exported here. I’m sure I have parts of that wrong but I hope at least I got the bare bones of it correct.
If I recall, they were operating under the assumption that Investment was pretty much fixed, that there was only so much worth while investment to spend money on, and so if extra money came in it was just a question of who wanted to invest more (accept lower returns) and who would decide to spend instead.
The main problem I have with that theory is that there is a lot of investment to still be done, but I am sympathetic that much of it requires very specific knowledge that many investors don't have. The difference between putting your money in the stock market or Treasury Bills and investing in a local business that has real potential, that sort of thing. However, that still doesn't account for government deficits expanding; even with a fixed Investment level if government deficits expand that can soak up all the savings, Domestic and Foreign. If Investment is variable (it has elasticity) then deficits is the cause of drops in Investment, regardless of the Savings rates.
The constraint they saw on investment was a lack of domestic demand because of low wages. Foreigners bought domestic financial assets to keep their currencies down and remain export competitive. In that environment the only choices are higher government debt, higher private sector debt (Ala GFC), or financial bubbles with high unemployment as a result. As long as our domestic financial markets remain open, we don't really have another choice given that domestic demand is low.
I am skeptical of that view (theirs, not your summary!) in that it assumes higher government debt is necessary. If domestic savings is low (something else I am a little skeptical of, given that the savings rates of most countries are pretty similar, variant on the proportion of ethnic Chinese the country has) then investment will be low unless there is lots of foreign savings being invested in the country, fair enough. But again, government debt reduces that investment; one either buys (invests in) government debt or the private sector. In that case, government debt crowds out investment in possibly productive private activities. (I am assuming here that the marginal government spending is zero marginal product. That might be optimistic.)
In other words, investment would grow if the government stopped running deficits, but everyone seems to talk as though government debt is needed for... reasons.
There is one thing that I don’t understand in that model. A company value is it’s discounted future cash flow. If we have high rates than the future cash flows also need to be high to be attractive. Otherwise it will be crowded out by bonds. That part is clear. But the future cash flows will grow with inflation, so the crowding out only works if the real rates are high. And currently real rates are not that high.
Good point, but real rates are higher than they were a couple of years ago.
They are - true. But this explanation is all over the internet - and they never use real rates, just the nominal rates - so I was puzzled and thinking I am missing something.
I was thinking that maybe it works like this:
If a company makes a 5% profit over the year and we have 5% inflation - then it means that the profits will grow over the year from 5% to 10%, but the average will be maybe 7.5% (or should I use geometric average here?) - so it would not beat a bond that would have 10% rate which is 5% real rate. But on the other hand the earlier profits would also need to be less discounted - because they could be invested right at the point and gather some additional profits. That gets complicated.
One reason that people have not adjusted to making calculations in real terms is that they keep assuming that inflation will revert back to the supposed "target" of 2 percent. If you believe that, then long-term real rates are in fact quite high.
Of course, I don't believe that inflation is going to settle down to that point. So in my own head I am trying to do calculations in real terms. That means both trying to guess the possible scenarios for inflation and the possible scenarios for market expectations. Gets complicated indeed.
On the topic of startups and venture capitalists, you and the bloggers to whom you link are assuredly correct. I mentioned on Twitter the other day that a perpetually high(er) interest rate environment would kill many VCs and startups. One VC responded to my tweet by claiming that for every 100 bps increase in interest rates there is 25% drop in venture capital. (https://twitter.com/jcarterwil/status/1713337562721349706). I don't know if his statistic is accurate, but even if it is directionally accurate, it spells dire times for the VC industry and the startups they fund.
A further point about startups in particular bears mentioning: higher interest rates generally will depress asset prices, including startup valuations. Which means that startup employees' equity will be commensurately less valuable. Which means, in turn, that startup employees will start to demand more of their compensation in cash, and less in equity, which in turn will increase cash demands on startups. At the same time that venture capital dollars flowing into startups is declining.
Less government debt with foreign savings coming in could do 2 things: 1) increase investments in productive private sector activity or 2) bid up asset prices. If it's 2 then you have a problem.
If domestic savings kept interest rates low in the post GFC world how did we get higher interest rates in 2022 with total domestic savings substantially larger nominally and as a % of gdp. Also why did interest rates rise from 2015 to 2019 with rising savings, both total and as a %?
Part of a VC calculation is the exit multiple that can be placed on a business which is huge variable in any DCF calculation they may do; and lower stock valuations due to higher interest rates may be a large contributor to VC fund raising and investment efforts.
I’d like to hear your thoughts on the Michael Pettus/Matt Klein thesis. I’ll probably get this a bit wrong but they believe that foreign savings/investment was exported to the US. That lowered domestic investment. So they see the post GFC period as one of weak investment concentrated in sectors like tech rather than the real economy. The pandemic stimulus reversed that but in a crazy orgy of spending not in an orderly way but real wages are finally rising. Only issue is foreign savings is still getting exported here. I’m sure I have parts of that wrong but I hope at least I got the bare bones of it correct.
If I recall, they were operating under the assumption that Investment was pretty much fixed, that there was only so much worth while investment to spend money on, and so if extra money came in it was just a question of who wanted to invest more (accept lower returns) and who would decide to spend instead.
The main problem I have with that theory is that there is a lot of investment to still be done, but I am sympathetic that much of it requires very specific knowledge that many investors don't have. The difference between putting your money in the stock market or Treasury Bills and investing in a local business that has real potential, that sort of thing. However, that still doesn't account for government deficits expanding; even with a fixed Investment level if government deficits expand that can soak up all the savings, Domestic and Foreign. If Investment is variable (it has elasticity) then deficits is the cause of drops in Investment, regardless of the Savings rates.
The constraint they saw on investment was a lack of domestic demand because of low wages. Foreigners bought domestic financial assets to keep their currencies down and remain export competitive. In that environment the only choices are higher government debt, higher private sector debt (Ala GFC), or financial bubbles with high unemployment as a result. As long as our domestic financial markets remain open, we don't really have another choice given that domestic demand is low.
I am skeptical of that view (theirs, not your summary!) in that it assumes higher government debt is necessary. If domestic savings is low (something else I am a little skeptical of, given that the savings rates of most countries are pretty similar, variant on the proportion of ethnic Chinese the country has) then investment will be low unless there is lots of foreign savings being invested in the country, fair enough. But again, government debt reduces that investment; one either buys (invests in) government debt or the private sector. In that case, government debt crowds out investment in possibly productive private activities. (I am assuming here that the marginal government spending is zero marginal product. That might be optimistic.)
In other words, investment would grow if the government stopped running deficits, but everyone seems to talk as though government debt is needed for... reasons.