US Recovery Awaits Corporate Investment Rebound…

26th October 2013

‘First, if the bubble were to deflate on its own, would the effect on the economy be exceedingly large? Second, is it unlikely that the Fed could mitigate the consequences? Third, is monetary policy the best tool to use to deflate a house-price bubble? My answers to these questions in the shortest possible form are, “no, no and no.”  Incoming Fed Chair Janet Yellen speaking in 2005

Dovish comments like that from Ms. Yellen as well as the soft September payrolls report are driving investors to assume Fed tapering has been postponed toward Q2 next year, if not the indefinite future. The key issue remains very low levels of investment in the US economy, which correlate well with job creation – if private investment remains moribund, escape velocity for the labour market and wider economy will prove elusive. As covered in previous notes, overall investment as a share of GDP is trending down over time for demographic reasons as the economy matures and also as it becomes more IT driven; sustained deflation trends in computer software and hardware give companies more bang for their investment buck, while faster inventory turn via ecommerce has reduced the need for warehousing etc. (think Amazon versus WalMart sales per square foot). Nonetheless, we are several percentage points short of trend investment levels and a key issue for 2014 is whether corporate boards from the US to Japan decide that they have sufficient visibility to justify capacity replacement and/or expansion. Markets face a pivotal moment in coming months; either the unprecedented stimulus since 2009 has failed to ignite a self-sustaining recovery, despite the energy windfall, in which case the Fed is pushing on a monetary string and earnings momentum   will roll over in a manner painfully familiar to GEM investors.   Alternatively, we finally get the last cylinder of growth firing and corporate investment pushes US growth toward 3% (and the fiscal drag will ease considerably next year), in which case the Fed will have to expedite its balance sheet normalization. I’d still bet on the latter outcome, but  either way as the S&P grinds toward 1800, it would be wise to finally begin paring US exposure. Record net cash levels for the S&P  500 certainly support an investment rebound thesis, with the caveat that  the tech companies who are the clear winners in the new ‘asset lite’  economy are generating the bulk of that cash, and hoarding it overseas out  of reach of the IRS.

It was odd that the Nobel Prize in Economics was split three ways this year and focused on market theory; most market observers are oblivious to a bubble inflating around them, but none  more so than academic economists with their beloved general equilibrium models. Among the winners, the one you might trust with your money based on  his track record is Prof. Shiller (of US house index fame) who suggests that prices are currently “high” in the US equity market at current levels of his estimated cyclically adjusted PER. This implies that objective measures of the risk premium (expected returns) are lower than average that is, expected  risk premia must inevitably rise. 1990’s, when of course Alan Greenspan  echoed Janet Yellen’s housing comments in relation to the tech boom   although he has since partially recanted). The real  contrast between Shiller and his co-winner Prof. Eugene Fama, originator  of the Efficient Market Hypothesis, is that he remains agnostic about what  risk premium is sustainable. In other words, he doesn’t accept that  there is a ‘fair value’, and so has no room for the prediction that prices  will fall. In the current circumstance, he might say that investors are  highly tolerant of risk i.e. they are willing to accept low expected  returns for taking on US equity risk.

The S&P 500 price/revenue ratio of 1.6 is now 2x its pre-1990s historical norm; the 1987 peak occurred at a price/revenue ratio of less than 1x, but of course margins are considerably higher now. A key support remains LT interest rates at historically low levels and share buybacks as companies use record net cash flow relative to GDP to shrink their equity base. Back in the 4th September weekly, which looked in detail at the CAPE and other long term valuation methodologies, I noted that: ‘Some investors take a macro view of corporate profits using the Kalecki equation (Profits = Investment – Household Savings – Government Savings – Foreign Savings + Dividends) and thus argue that the large US deficit has been the big source of (excess) corporate profits. With the deficit now declining and both earnings growth and sales growth on the S&P decelerating, there will be a  double whammy of less fiscal stimulus on demand and a shrinking source of profits that needs to offset that impact, preferably by corporate investment. Overall, after the outperformance seen YTD, US equities no longer look compelling, although a push to my original 1800 S&P year-end target is still feasible on inflows from bond/GEM fund refugees.Those inflows as much as the rally in 10-yr Treasury yields are a key support near-term; data from EPFR Global shows that $69.7bn was withdrawn from money market funds in the week ending 16th October while equity funds captured net inflows of $17.2bn as the debt ceiling crisis was resolved.


US Steps Back From Fiscal Brink…

16th October 2013

“We can’t allow 30 or 40 people to hijack the Republican Party.” Republican Congressman Peter King, speaking this week

The Tea Party zealots have been belatedly reined in by the Republican establishment (forced into compromise by collapsing poll numbers and furious corporate donors); for a party that wraps itself shamelessly in the flag, threatening to allow military pay checks to bounce at the end of the month was always political suicide. While the bipartisan committee tasked by December to agree a long-term budget deal will have its work cut out, investors can now refocus on pretty decent near-term fundamentals, despite a backdrop of longer-term structural risks from ever rising US income inequality to slowing EM trend growth. Having seen net speculative positioning move short on the debt ceiling brinkmanship, the USD index now looks very cheap, back to its five year average despite the improving current account trend, 2% plus growth and Fed tapering by Q1, and could well rally over 20% to test the 100 level in 2014.With energy imports having accounted for over 50% of the current account deficit over the past decade, the shale output boom (allied to on-going efficiency gains from hybrid cars, LED lights etc.) will be a structural dollar tailwind through end-decade, particularly as the fiscal deficit is on track to fall sub 2% of GDP in FY 2015.

The polarization of politics in Washington is fuelled by unprecedented income inequality and the fraying of the ‘American Dream’, to which neither party has a coherent response.  While the steadily rising profit/falling labour share of GDP is a pattern evident globally, it is proving particularly traumatic for the US.  Real median household incomes have fallen in each of the last five years (a similar pattern is evident in many other developed economies like the UK) and have barely grown over the last couple of decades. The sustained QE program has contributed to increasing economic inequality by enforced negative real interest rates on holders of cash, while boosting prices of riskier financial assets, more commonly held by the top decile of earners.

The market capitalization of the Wilshire 5000 is up $11.4trn, or 166%, to a record $18.5trn since March 9, 2009 while the median existing single-family home price is up over 37% through August since it bottomed during January 2012 and is now just 8% below its record (nominal) high during July 2006. With earnings growing at just 2% y/y, one source of relief for discretionary spending power may come from US gasoline prices as the EPA adjusts federal ethanol mandates (the 2005 Clean Air Act), which have artificially boosted prices by forcing refiners to buy ethanol credits as gasoline demand has fallen to decade lows due to lower average mileage and a more efficient car fleet.  A gasoline price falling back toward $3 a gallon would be a very useful windfall in coming months, after the hit to consumer confidence from the idiocy in Washington.

Political Populism Means Thailand Continues to Underachieve…

9th October 2013

Thailand is probably the most disappointing emerging economy in Asia and possibly across GEM, in terms of economic and political progress over the past decade. While unemployment is practically non-existent, productivity has stagnated. Graduates from local universities are generally only fit for (and satisfied with) low skill call centre/retail work, while factories face a labour shortage as farm workers enjoying the subsidy bonanza stay in the rice paddies. Infrastructure investment has been a paltry 1.5% of GDP and trend GDP growth has stalled at around 4% over the past decade, while private sector credit to GDP has risen to 150%, after a consumer lending boom. Overall, the country’s competitiveness has been slipping versus regional peers; in the World Economic Forum’s latest competitiveness rankings, Thailand ranks 74st globally in health and primary education provision and 85th in the quality of its institutions, 50 places lower than Malaysia and significantly weaker even than Indonesia. The seven year build out of infrastructure to integrate the wider sub-region around Thailand as a logistics and finance hub will be critical to boosting the medium-term growth trend toward 5%.

The long-term challenges facing Thailand include a fast ageing population, out-dated infrastructure/ industrial plant and a weak education system at all levels. To boost trend growth to mid-single digits, Thailand will have to bring significantly more workers into the formal economy, boost productivity enhancing investment and reduce glaring income inequalities that have undermined political cohesion. For investors, a sustained period of political stability is important in tackling these structural issues, although the current subsidy program to boost rural incomes, while reducing extreme income inequality, is having unintended consequences.

Indeed, the central bank governor warned recently that the populist subsidies “add to micro-level risks by making households addicted to ‘easy’ money, while also adding to macro-level risks by stretching fiscal resources without enhancing competitiveness in any meaningful way.” Corn famers for instance have been protesting to force the government to extend the current subsidy program due to end in December for another four months. The country has seen a range of other special interest groups from rubber to corn farmers demand hand-outs of their own. The subsidies are adding to rising public spending, led by the 700bn baht, or $22bn to support rice farmers since the 2011 election. Thailand’s rice subsidies, which bought up rice from farmers at double the market price, also have knocked the country from its position as the world’s largest exporter of the grain as huge domestic inventories build, as cheaper rice from India and Vietnam took market share.

Thailand’s finance ministry recently cut its growth forecast for this year to 3.7% from 4.5%, which still looks a bit high – growth should rebound to 4.5% next year if the delayed infrastructure program begins to be implemented. Exports account for around 60% of GDP but Thailand is trapped in low end assembly operations, without the education system or infrastructure to move up the value chain. At the same time, the government’s goal of raising living standards and consumer spending in rural areas appears to be having unintended consequences. Some farmers are using the promise of guaranteed future incomes as a basis for borrowing more money. High prices guaranteed by the government are encouraging over-investment in farming.

Tax revenues are only 18% of GDP, and a proposed corporate tax cut to compensate for higher mandated wage costs will be hard to offset elsewhere. By law, public debt must not exceed 60% of gross domestic product, from 44% currently, but is forecast by the IMF to rise to 52% by 2018. On a net debt basis and excluding the liabilities of majority government-owned state-enterprises current debt is around 21% of GDP. While those debt levels look modest, private debt is the key concern, and the public debt picture is clouded by Thailand’s population ageing faster than any other in Southeast Asia apart from Singapore, with the proportion of the population over 60 in Thailand will reach 20% by 2025 with minimal pension provision, as mortality and fertility decrease steadily. Only South Korea and China face a similar demographic challenge in the wider Asian region while net foreign investment has been trending downwards, helping to exacerbate an overall shortfall in investment, which has run at under 30% of GDP in recent years.

The 2011 election campaign focused on tackling income inequality, which has become a key regional theme. Income inequality in Thailand is more extreme than in other regional emerging economies such as Indonesia, Malaysia and the Philippines, with the wealthiest 20% of Thais earning over 14 times more than the poorest 20%, compared to 9-11 times elsewhere in the region and 5-8 times in Europe and the US. The Puea Thai party offered to guarantee a uniform daily minimum wage of 300 baht ($10) throughout the country, rising to 1,000 baht by 2020, universal medical care for under a dollar a visit, a $500 monthly starting salary for graduates and a debt moratorium focused on low earning civil servants and farmers although the most expensive promise was the rice subsidy.

Despite the robust real growth in manufacturing since 2000 (an average of over 6% annually) the share of the workforce employed in factories has stayed at about 14%, with another 3% employed in export related logistics. Increased automation and worker productivity supported higher output, but did not contribute to integrating more Thai workers into the higher value-added export sectors.   The weak employment performance of manufacturing has fed the core political problem of growing wealth concentration (one which China also now faces). The country’s income inequality is the result of many divisions including the oft cited urban-rural divide, but also one between Bangkok and the rest of the country. Less than 20% of the Thai population lives in Bangkok and along the Eastern coastal region but generate over 70% of the country’s GDP and consume the bulk of public resources such as education and healthcare. This deep rooted inequality will continue to be a source of recurrent political instability in the months and years ahead, particularly if economic growth continues to lose momentum…

Social Media Driving Political Change From Iran to US…

3rd October 2013

I  was in New York last week and investor focus there was on politics, from the prospect of debt ceiling brinkmanship in the US creating widespread  volatility to détente with Iran stripping oil of its geopolitical risk premium and early Italian elections unsettling the calm in Europe.  I think developments in technology and particularly social media are playing an overlooked role in undermining the traditional party political  model and will create growing volatility; Republican Congressmen and  Senators with Presidential ambitions answer to the virulently  anti-Obamacare ‘Tea Party Taliban’ in real time via Twitter, undermining  the authority of party leadership. Obama himself used technology very  effectively in his last campaign to get his core vote out among ethnic  groups like Hispanics and the young. Perhaps most intriguingly, in Tehran, where   internet access is censored and Revolutionary Guard spies eavesdrop on café conversations, the parks and squares are full of thousands of kids   using Bluetooth on their phones to circumvent controls and support the reformists.  Combined with record youth unemployment and a collapsing currency, the  impetus for a breakthrough ‘grand bargain’ on nuclear and Syria looks  promising but it would drive the Republican fringe even more apoplectic. As  ever, the impact of technology cuts both ways…

In fact, several seasoned observers I met believe that the impact of tech savvy right wing activists  means that the Republican party will split into at least two factions soon, perhaps in the aftermath of what amounts to outrageous debt ceiling extortion (strip funding from Obamacare or we let US default) which gives the extremists no way out. The current government shutdown in and of itself won’t have too much material impact. If it extends to the 21 days in 1995 and 1996, it could shave 1-1.25% off Q4 growth (although back pay to the 800,000 laid off Federal workers would then feed into Q1). Even if the debt ceiling is breached, there are mechanisms in place to avoid a default, although the US credit rating would likely be downgraded again. It will be a tense and volatile few weeks, but overall, the market reaction to the unedifying stunts in Washington is far calmer than in mid-2011 because the underlying economy has far better momentum, notably from autos and housing with small business hiring and corporate investment intentions looking positive into 2014 and state and local government payrolls growing again with tax revenues.

In fact, current growth would be well over 3% without the 1% or so fiscal drag from the sequester mandatory cuts earlier this year during the last political showdown in Washington, and the fiscal deficit looks set to fall sub 2% by FY 2015. Most bullish longer term for the USD (aside from the improving energy balance, and it is remarkable that taxis and police cars in NY are now largely hybrids) is the sharp decline in healthcare inflation having run well ahead of broader CPI for decades was just 1% y/y in July, a 50 year low, which if sustained slashes longer term entitlement budgets. This has little to do with Obamacare directly, but reflects a greater proportion of out of pocket expenses as well as the squeeze on real household incomes driving price sensitivity and hence cost controls. The risk that healthcare might absorb 20% plus of GDP or more than twice the level prevailing in other advanced economies by end decade is now receding, and this shift will also suppress US trend inflation.