Long Term Growth: Have the Facts Changed?
Posted on 12.27.13
Recent political, fiscal and economic events in the United States have changed the fundamental relationship between the federal government and its citizens. Some say the changes, and their economic impact, are permanent - the cost of capital has fundamentally changed. While that claim should be met with skepticism, if true, it has significant impact on the work of anyone who is valuing businesses, intangible assets, damages, or anything else that requires a long term “crystal ball.”
The difference between a capitalization rate, used to value a single sum, and a discount rate, used to value varying future benefit streams, is the expected long-term growth rate. While not the result of a scientific sampling, it is my impression that most valuators use historic inflation or historic growth in Gross Domestic Product as the basis for their projection. Many use both as support for their estimate. Short-to midterm expectations are that both of those measures are going to be very different than we have become accustomed to. The question is how much should you let recent developments impact your long-term growth estimate? And, what do you do when those two indicators go in opposite directions?
Gross Domestic Product (GDP) is a measure of private consumption, government spending, business capital spending, and the nation’s net exports. It is widely viewed as a measure of economic well-being and productivity. Historical growth in GDP generally ranged from 4 percent to 6 percent annually. Since 1790 the average growth in GDP has been 3.8 percent per year. However, from 2000 through 2012 the average growth has been only 1.8 percent. Some believe this is indicative of the long-term future. Significant events that cause some economists to question whether this might be the “new normal” are:
- Government spending as a percent of GDP for the last three years has been 24 percent. This is the highest level since World War II.
- Government spending is expected to grow as the demographics of this country age and more citizens are eligible for full Social Security and Medicare.
- Government spending is expected to grow as “Obamacare” is implemented over the next several years.
As government spending makes up a larger percentage of GDP there is, historically, a drag on the growth that can be expected in the private sector. Barry Eichengreen (Exorbitant Privilege, Oxford University Press, 2010) estimated that without any changes to Social Security and Medicare, government spending will reach 40 percent of GDP within 25 years. This raises the question of whether the U.S. will be able to borrow the funds needed to finance the spending. At some point the perception of risk will begin to drive interest rates higher.
Whether any, or all, of this means that expected growth in GDP will be less than the historical averages is a decision that each practitioner should evaluate. If you come to the conclusion that 1.8 percent annual growth in GDP is the new normal, than to continue using the historic 3.8 percent will result in high values.
Inflation, on the other hand, is generally defined as the sustained increase in the level of prices for goods and services. It is measured as an annual percentage change. As inflation rises, every dollar buys a smaller percentage of a good or service. This measure is used as a baseline for some practitioners in their estimate of long-term growth because if you do not at least account for inflation you are changing the premise from a going concern to a non-growth company or even one that will not grow enough to survive inflation. The US Inflation Calculator reports inflation from 1913 to 2013 of about 2.3 percent per year (average)
Several factors indicate that the U.S. economy may be entering a period of high inflation and, perhaps, for a sustained period of time:
- The U.S. government has been borrowing in excess of $1 trillion per year for the last four years and that borrowing has been used to finance consumption rather than production.
- To the extent that the holders of U.S. debt lose confidence in the fiscal policies of the country (and hence raises the risk of the debt), interest rates will be driven up.
- The U.S. government has engaged a program of refinancing debt - replacing long-term debt with shorter term instruments. If the market begins to perceive higher risk the impact on the U.S. economy will be fast and severe.
- A general economic survey is underway and could be expected to evolve into a very robust period of economic growth. This is based on the pent up demand for housing, etc. and the huge volume of cash that has been sidelined in government securities as a safe harbor.
- Federal debt has grown from $5 trillion in 2000 to about $17 trillion in 2012 and there is no projection or expectation that debt will stop growing in the next several years. The most likely way to get out from under that kind of debt is to pay back with cheaper dollars - inflation.
Historically, high inflation (in excess of historical averages) is a short-term event. Projections to the contrary are concerning but should be viewed in the context of history. In 1979 reported inflation was 13.3 percent. By 1982 the inflation rate had fallen back down to 3.4 percent.
The purpose of this article is not to make political calculations or commentary. It is designed to cause practitioners to consider how they view long-term growth and to be prepared to explain and defend their estimate. When we enter a period of high inflation there will be pressure to increase long-term growth to those apparent realities. Alternatively, if the GDP growth rate remains below historical rates there will be pressure to lower long-term growth expectations. These opposite pressures will change the current environment where the expert can base long-term growth on both inflation and GDP growth.
One of the roles of a financial expert is to understand the assumptions we are making, balance all the conflicting indications such as long-term growth, and be able to define, explain and defend those assumptions. It may get a lot more interesting and challenging in coming years.