#MacroMemo: August 14 - 18, 2017

North Korean game theory:

• Financial markets have trembled as verbal provocations between North Korea and the U.S. mount, including threats by North Korea to target U.S. military bases on Guam and warnings by President Trump of unleashing “fire and fury.”
• These tensions are hardly new – North Korea has been a pariah state for years, long intent on developing intercontinental missiles capable of transporting a nuclear bomb and at odds with the rest of the world.
• That said, the country’s rhetoric has hardened recently, and there has been a palpable uptick in missile testing and other vexatious actions.
• During the latest U.S. transfer of executive authority, former President Obama warned current President Trump that the North Korea file would likely be his most urgent and potentially problematic.
• This is indeed proving to be the case. The latest word is that after rapid gains in missile and nuclear technologies, North Korea is now in the vicinity of achieving its longstanding goal of possessing nuclear weapons capable of reaching North America. For the first time, this puts a significant number of non-military Americans at theoretical risk. Of course, American military personnel plus the entirety of South Korea and Japan have lived with this risk for many years.
• However, it is worth reflecting on the fact that game theory firmly insists that a good Nash equilibrium still exists between North Korea and the United States that should logically preclude war. North Korea recognizes that any major military attack initiated by them would be met by an overwhelming response that would all but destroy the country and likely decapitate its leadership. Conversely, the U.S. recognizes that an attack on North Korea would prompt a last-gasp response by the regime against American allies and potentially now the U.S. itself, resulting in hundreds of thousands or even millions of allied deaths. As such, neither country should attack the other any time soon. The fact that the U.S. would “win” any such conflict is not relevant when the damage to the winner would be so great, pitted against little obvious economic or strategic benefit. If anything, the North Korean acquisition of advanced nuclear weapons should reduce the risk of conflict rather than elevate it.
• Of course, this game theory assessment presumes rationality on the part of both actors. That is not necessarily assured given the recent behavior of the heads of both states.
• However, despite appearances to the contrary, many argue that North Korea is acting perfectly rationally. To keep the Kim family in perpetual power despite atrocious economic conditions and little personal freedom necessitates a strong military and an us-versus-them mentality stoked by a constant barrage of hostile language directed at the U.S., South Korea and Japan. This antagonistic stance versus the rest of the world, in turn, requires a credible military threat such as a nuclear weapon to be sustainable.
• The assessment of rationality is a tougher call in the U.S. given the newness of the Trump presidency, his history of non-conformity, and his new approach of responding to North Korean threats with even fiercer American ones. It is unclear whether Trump is truly close to pressing the big red button or just posturing. Even if temperamentally tempted to engage militarily, one would imagine that the advisors surrounding him are advising to stick with the optimal game theoretic approach and instead exert pressure via sanctions and technological sabotage. Congress does not at present have the tools necessary to block any military strikes desired by the White House.
• All of this is to say that there is a new element of uncertainty in the mix: the intentions of the U.S. president. Despite this, the Nash equilibrium of harsh words uncoupled from military action is quite likely to persist. In turn, geopolitical risks are higher than normal – with North Korea as a key consideration – but the most likely scenario remains the avoidance of disaster.

What drove stocks higher in recent years?

•  In setting expectations for future equity returns, it is worthwhile looking back at what drove the stock market higher in the past.
• Naturally, there are many ways of answering this question, and not all yield the same conclusions. One could dwell on the underlying economic force at work, or alternately on the growing might of the tech sector. Our approach today is a little different than that, ensconced instead in the world of dividends, P/E ratios and earnings.
• We look at the U.S. S&P 500 index from March 31, 2011 (a point sufficiently clear of the financial crisis to avoid the distortions and messiness that arise during a recession) through today.
• Over that period, the total stock market return was an impressive 110.7%. Within that, a reasonable (and arguably sustainable) 26.8ppt of the return came from dividends. The big question is where did the other 83.9ppt come from?
• Alas, fully 54.8ppt of it came from a rising P/E ratio, versus only 29.1ppt from rising earnings per share. This is mostly bad news in that we would prefer if the entirety came from robust earnings growth. Instead, fully half of the stock market’s total return over the past six year has come from rising multiples. The problem with this is that this factor cannot contribute to stock market returns forever as the P/E ratio is theoretically a mean-reverting variable.
• As an important silver lining, however, the P/E ratio was arguably rising over this period from a very low level to a much more normal level (at least in the context of structurally low interest rates). The P/E gains to date probably don’t have to be given back, though one struggles to imagine that a rising P/E ratio can add another 54.8ppt to stock market returns over the next six years.
• Another stroke of bad news is that when one goes a step deeper and disaggregates the already-mediocre 29.1ppt contribution from earnings per share growth into its subcomponents, the details look worse again. Revenue growth – theoretically the primary engine of earnings growth, and by extension stock market returns – generated barely more than half of the earnings gain, at just +14.9ppt. This means that over a little more than six years, revenue growth rose at just 2.2% per annum.
• Instead, nearly half of the earnings per share growth in recent years came from two other places that are much less reliable as drivers of future earnings growth. One was the expansion of profit margins (+6.6ppt). Although traditionally a mean-reverting variable, we believe there has been a structural component to some of this increase in profit margins. That is good, but our best guess is that profit margins won’t go up much further in the immediate future given the prospect of higher wage bills and more expensive borrowing costs.
• The other contributor was share buybacks (+7.6ppt). Share buybacks will likely continue for the time being given a larger than normal risk premium between stocks and bonds and enormous hoards of idle corporate cash, but it may not be indefinite as the Fed raises rates and business investment also picks up.
• What does all of this mean for the future? Viewed through this framework, the total rate of return on equities in coming years is unlikely to be as good as the performance over the past six years. The main bad news is that there looks to be less scope for rising multiples to continue driving returns, let alone remain responsible for half of the stock market’s total gains. Secondarily, margins and share buybacks could help a hair less. To be clear, stocks are still likely to rise over time: dividend payouts can be sustained and revenue growth could even improve given the variable’s linkage to economic growth (which is itself on the upswing).

Tidbits:

• NAFTA negotiations officially begin in Washington DC next week on August 16th.
• U.S. CPI for July disappointed expectations slightly, a familiar refrain in 2017. Headline and core prices managed to rise, but by just 0.1% on the month and both now sit at +1.7% on the year. There is nothing particular problematic about this, but it is undeniable that the majority of the developed world has gone through an inflation lull lasting many months. Some of this relates to earlier commodity declines, some to structural depressants such as demographics, technological change, globalization and automation. Nevertheless, as economies tighten over time, we look for a gradual move higher from here.
• The latest U.S. employment report for July beat expectations and continues to point to a labour market nearing “full employment.”
• The latest Canadian employment report for July landed a millimeter below market expectations but shone in most other ways thanks to a plummeting unemployment rate (now just 6.3%) and ample full-time hiring. The Canadian economy is still strong.

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? RBC Global Asset Management Inc. 2017

? Published August 11, 2017