Returns On Capital–And Interest Rates–Will Be Low In The Future

Returns on capital have been low for most investments. Ten-year U.S. treasury bond rates averaged three percentage points above inflation from the 1950s up until the last recession started. Since the end of the recession, those bonds have yielded just one percentage point more than inflation. Stock market returns adjusted for inflation averaged lower than historic averages in the past decade. Commercial real estate cap rates have fallen. There’s good reason to expect long-term returns on capital to be lower than historic averages in the coming decade. This conclusion is somewhat speculative but one that should concern every investor in every investment class.

Economists have two words to analyze price changes, and the first is supply. The global supply of savings has been rising. It hit a low of 21.6 percent of GDP in the 1982 recession, but has recently jumped to 25.7 percent. (For this definition, we count all sources of saving: families, businesses and governments. Data are from the IMF database. ) The big change comes from the emerging countries. Their savings rates have jumped as their incomes rose. And an increasing share of global GDP is generated in these countries. Advanced economies save a lower percentage of their incomes. Thus, supply of savings on global capital markets is high and growing.

Demand for capital depends partly on the business cycle and partly on long-term trends. The global business cycle has been stable at a sub-par level in recent years, pulling demand a bit below trend. The long-run trend, though, is for less capital to be needed. Here’s a little example described in The Flexible Stance: The number of rooms or apartments listed on Airbnb for San Francisco is about three percent of the total hotel rooms available in the city. Those additional rooms came to market with virtually zero capital cost.

I pulled financials from three corporations recently, and they illustrate a stunning trend. US Steel uses $4.4 billion of physical capital to create $2.3 billion of stock market value, a ratio of roughly one-half to one. 3M, a manufacturing company known for scientific and technical innovation, creates market value equal to ten times its physical capital. Facebook creates market value about 70 times its physical capital. Which of the three companies is more typical of the future? When you see a couple of young guys or gals working in a garage on a startup, do they envision a massive factory covering 1000 acres? Or do they see an office building with data services from a cloud provider?