The Outlook for Returns on Investment

FOR the past six years the return which investors have been able to command for their savings has been gradually decreasing. It costs $140 to-day to buy the same bonds, yielding the same income, which could have been bought with $100 of savings in 1921. It costs $120 to buy the same bonds which could have been purchased for $100 even in 1924. This is simply another way of saying that the return which capital yields has fallen. What the investor desires to know is whether this decline in yields will continue, or whether the rise in bonds is merely an incident to general speculation in securities, which has carried stocks to a level twice as high as in 1924 and three times as high as in 1921.

There are always those who ascribe any such advance in security prices to speculation. If this were the cause of the rise, bonds would probably fall when the speculative boom had run its course. Doubtless they would not return to their former prices; neither would stocks. But there would be a material recession which would make it worth while for the investor to put his money in the savings bank and wait for lower prices.

During the period from 1920 to 1927 the investor who has been waiting for lower bond prices has lost by doing so. Only once could he have saved as much as seven points by deferring his purchases for several months. If he had waited from September 1922 to September of the following year, he could have gotten his bonds seven points cheaper. But during the greater part of the last seven years the investor who expected his capital to yield him the high return to which he had become accustomed in the years immediately following the war, and who refused to buy bonds because they were not yielding the old return, has pursued the wrong policy. His failure to diagnose correctly the underlying causes which determine the return on capital has cost him money.

What are these underlying forces which have pressed down the interest rate on the investor’s savings? Will the same forces continue throughout the next few years? Interest is the return which the person who saves and invests receives for his capital. The beginning of wisdom in discussing causes of variations in these rates is the realization of the fact that interest is a price. It is the price paid for the use of capital; and, since it is a price, the causes of its fluctuations can be grouped for purposes of analysis into those which affect the supply of capital and those which determine the demand. Nothing can change the prevailing rate unless it enters by one of these two doors of supply and demand.

During the last seven years the volume of savings brought to the investment market has exceeded the sum which borrowers with good credit were willing to take at rates which had previously prevailed. Since those who wanted capital would not take the entire supply at the old price, the competition of lenders who desired to invest their capital led them to offer it at lower interest rates. This is a phenomenon with which we had not been familiar in this country for the decade and a half which began in 1905 and ended in 1920.

The supply of capital for the nation as a whole during any period is determined by the excess of production over consumption. Whenever production is increasing rapidly, as it has been doing in recent years, there is bound to be a large supply of investment funds unless there is a rapid increase in expenditures for things which are currently used up in maintaining our standard of living. This surplus production which is not currently consumed constitutes the national savings. It is available for investment, either at home or abroad.

The supply of national savings in recent years has been large — so large that it has pressed down interest, rates in the face of an unusually large demand for capital at home and an entirely unprecedented demand for American credit from abroad. The secret of our huge savings during these last few years is to be found in the rapid increase of output which has taken place since the war. The index of industrial production constructed by the Harvard Economic Service shows an increase of 40 per cent from the years 1919 to 1926. This index includes the output of manufactures and minerals. Agricultural output has not increased much during that period, but has maintained a higher level than during the pre-war period.

With such a growth in output it has been easy to increase our savings, even though we were maintaining higher standards of living than ever before. When the present output of industry is contrasted with the period before the war, we find that the increase has been more than 50 per cent. The number of people engaged in producing these things has increased more slowly; and prices have risen less than wages. As a result the level of wages is to-day two and one fourth times as high as in the pre-war period, while the cost of living is scarcely one and three fourths times what it was then. In such a situation it is not difficult to save and at the same time raise the general standard of well-being.

The statistical evidences of saving are found in the increase in life insurance assets, the growth of building-and-loan associations, savings-bank deposits, and the purchase of new security issues. These have reached figures which would have seemed fantastic to the Statistician in pre-war days. It is this large growth in the supply of capital, bottomed upon our increase in industrial output, which explains the downward course of interest rates since 1920.

For the demand for capital has likewise been unprecedented. This demand comes from those who desire to use money at present but who have not sufficient resources of their own to carry out their projects. These projects usually involve the production of durable things such as railroads, public utilities, manufacturing plants, buildings, and roads. The desire for durable goods is at the foundation of the demand for capital. Whenever people desire such long-lived structures or machines and decide to have them produced, they thereby contribute to the demand for capital. If their own savings are not adequate to carry out their projects they come to the capital market and borrow funds, by the sale of securities or otherwise.

The volume of construction of durable things has been proceeding at a high rate since 1922. Automobiles and buildings — residential and otherwise — constitute the most important demand. Then follow the construction of public-utility plants, the building of public roads, the expansion of factory plants and of railroads. In addition, the demand for capital has been augmented by foreign borrowing. Our loans abroad have amounted to well over a billion dollars annually for the past few years. There has certainly been no lack of demand for savings.

Yet, in the face of this large demand, interest rates have fallen, because the supply has been so large that in order to invest all our savings it has been necessary to loan them at lower and lower rates.

What, then, is the outlook for the future with respect to the supply of and the demand for capital? There is no likelihood that the savings of our people will decline. Production is large, and the habit of devoting a portion of our output to provision for the future has become firmly established with us. From our corporations, which set aside roughly one third of their profits as surplus, down to the laborer who is paying for a home or making installment payments on his automobile, the practice of saving is established. As long as production maintains its present high level, the supply of capital will be large.

When business depression comes and reduces output, savings will doubtless fall somewhat, but they will not decline as much as one would expect. People are more cautious about spending in hard times, and so continue to save even out of reduced incomes. The supply of capital in this country will continue to flow into the investment market in large volume.

On the demand side the outlook is rather for a decline than for an increase. During the war many things were left undone in order that we might supply our armies and navies with goods and services. The post-war period began with a large deficit in the supply of buildings, in railroad improvement, and in public-utility facilities. The building industry has, therefore, been at high tide for some years. At the close of the war the automobile was an instrument of transportation which appealed to all classes and which was already well beyond the experimental stage But there were less than six million machines in use, while from that time to this the number has grown to twenty-two million. Such an expansion made a widespread demand for improved highways. The immediate future gives no promise of an increased demand, either for automobiles or for building construction. The demand for increased public-utility and manufacturing plants and for railroad facilities will undoubtedly continue, but hardly at a higher rate than we have seen in the last five years. Our domestic demand for capital is therefore not likely to increase.

Nor is there a prospect of greatly increased borrowing from abroad. The European nations, especially Germany, have been bidding actively for capital in America during the last three years. That source of demand will hardly continue in large volume. France, despite popular notions to the contrary, does not need to borrow capital and will not do so. She may refund a few loans which are already outstanding, but she will not demand new capital. For France is essentially a capital-exporting nation. Unless Russia can reorganize herself politically and industrially in such manner as to command confidence in our capital market and so become a borrower, the demand from Europe for American capital is certain to decline after 1928. The less developed nations of South America and the Orient will borrow considerable amounts of capital, but upon the whole the outlook is not for any considerable increase. It is a safe prediction that the total demand for capital in the next half-decade will not increase as rapidly as does the supply of our investment funds.

With this out look for capital accumulation and for investment demand, the investor will undoubtedly be obliged to content himself with smaller returns upon his funds. There have been periods in the history of this country when good railroad and industrial Stocks sold at a price which capitalized their dividends at 4 per cent and their earnings at 6 or 7 per cent. High-grade bonds sold on a 3½ per cent basis; and good government securities yielded even less. Toward such an era our industrial process is carrying us to-day.