Perhaps the Most Important Investment Issue

Growth and productivity boomed since 1982 and really going back longer. This contributed to the boom in earnings and stock prices. Is that going to continue? This post for Philosophical Economics presents the history of the profit margin boom, attributing it primarily to technology and finance. He then presents both a bullish case (that the trends will continue for at least a while longer) and a bearish case (that the outsized profit margins from financial and technology innovation won’t continue). The discussion of the bearish case is much longer.

The result ends up being a steep curve that boosts financial sector profit margins.  But when the Fed cuts rates and keeps them cut, for a period that seems to drag on forever, because the economy never seems to get hooked into the kind of genuine inflationary expansion that would justify a tightening cycle, the market eventually figures things out. Investors realize that long-term rates need to be lower, and pulls the long-end down accordingly, at the expense of financial sector profitability.

Eventually, the Fed will raise the short-end–if not simply out of a desire to restore some normalcy to monetary policy.  When that time comes, the long end will again be slow to respond–this time slow in the opposite direction, slow to rise, given the anchoring and inertia of market participants who, by then, will have grown accustomed to the idea of secularly low interest rates.  The result will be a yield curve that gets flatter and flatter with each hike, and a financial sector whose profit margins get squeezed.  That seems to be exactly where we are currently headed, and it is not bullish.