Tag Archives: income inequality

Still Dancing

The latest market wobble this week comes under the guise of the endless Trump soap opera and the first widespread use of the impeachment word. I doubt it will be the last time we hear that word! The bookies are now offering even odds of impeachment. My guess is that Trump’s biggest stumble will come over some business conflict of interest and/or a re-emergence of proof of his caveman behaviour towards woman. The prospect of a President Pence is unlikely to deeply upset (the non-crazy) republicans or the market. The issue is likely “when not if” and the impact will depend upon whether the republicans still control Congress.

Despite the week’s wobble, the S&P500 is still up over 6% this year. May is always a good month to assess market valuation and revisit the on-going debate on whether historical metrics or forward looking metrics are valid in this low interest rate/elevated profit margin world. Examples of recent posts on this topic include this post one highlighted McKinsey’s work on the changing nature of earnings and this post looked at the impact of technology on profit profiles.

The hedge fund guru Paul Tudor Jones recently stated that a chart of the market’s value relative to US GDP, sometimes called the Buffet indicator as below, should be “terrifying” to central bankers and an indicator that investors are unrealistically valuing future growth in the economy.

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Other historical indicators such as the S&P500 trailing 12 month PE or the PE10 (aka Shiller CAPE) suggest the market is 60% to 75% overvalued (this old post outlines some of the on-going arguments around CAPE).

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So, it was fascinating to see a value investor as respected as Jeremy Grantham of GMO recently issue a piece called “This time seems very very different” stating that “the single largest input to higher margins, though, is likely to be the existence of much lower real interest rates since 1997 combined with higher leverage” and that “pre-1997 real rates averaged 200 bps higher than now and leverage was 25% lower”. Graham argues that low interest rates, relative to historical levels, are here for some time to come due to structural reasons including income inequality and aging populations resulting in more aged savers and less younger spenders. Increased monopoly, political, and brand power in modern business models have, according to Graham, reduced the normal competitive pressures and created a new stickiness in profits that has sustained higher margins.

The ever-cautious John Hussman is disgusted that such a person as Jeremy Grantham would dare join the “this time it’s different” crowd. In a rebuttal piece, Hussman discounts interest rates as the reason for elevated profits (he points out that debt of U.S. corporations as a ratio to revenues is more than double its historical median) and firmly puts the reason down to declining labour compensation as a share of output prices, as illustrated by the Hussman graph below.

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Hussman argues that labour costs and profit margins are in the process of being normalised as the labour market tightens. Bloomberg had an interesting article recently on wage growth and whether the Phillips Curve is still valid. Hussman states that “valuations are now so obscenely elevated that even an outcome that fluctuates modestly about some new, higher average [profit margin] would easily take the S&P 500 35-40% lower over the completion of the current market cycle”. Hussman favoured valuation metric of the ratio of nonfinancial market capitalization to corporate gross value-added (including estimated foreign revenues), shown below, predicts a rocky road ahead.

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The bulls point to a growing economy and ongoing earnings growth, as illustrated by the S&P figures below on operating EPS projections, particularly in the technology, industrials, energy, healthcare and consumer sectors.

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Taking operating earnings as a valid valuation metric, the S&P figures show that EPS estimates for 2017 and 2018 (with a small haircut increasing in time to discount the consistent over optimism of analyst forward estimates) support the bull argument that current valuations will be justified by earnings growth over the coming quarters, as shown below.

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The IMF Global Financial Stability report from April contains some interesting stuff on risks facing the corporate sector. They highlight that financial risk taking (defined as purchases of financial assets, M&A and shareholder pay-outs) has averaged $940 billion a year over the past three years for S&P 500 firms representing more than half of free corporate cash flow, with the health care and information technology sectors being the biggest culprits. The IMF point to elevated leverage levels, as seen in the graph below, reflective of a mature credit cycle which could end badly if interest rates rise above the historical low levels of recent times.

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The report highlights that debt levels are uneven with particularly exposed sectors being energy, real estate and utilities, as can be seen below.

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The IMF looked beyond the S&P500 to a broader set of nearly 4,000 US firms to show a similar rise in leverage and capability to service debt, as illustrated below.

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Another graph I found interesting from the IMF report was the one below on the level of historical capital expenditure relative to total assets, as below. A possible explanation is the growth in technology driven business models which don’t require large plant & property investments. The IMF report does point out that tax cuts or offshore tax holidays will, based upon past examples, likely result in more financial risk taking actions rather than increased investment.

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I also found a paper referenced in the report on pensions (“Pension Fund Asset Allocation and Liability Discount Rates” by Aleksandar Andonov, Rob Bauer and Martijn Cremers) interesting as I had suspected that low interest rates have encouraged baby boomers to be over-invested in equities relative to historical fixed income allocations. The paper defines risky assets as investments in public equity, alternative assets, and high-yield bonds. The authors state that “a 10% increase in the percentage of retired members of U.S. public pension funds is associated with a 5.93% increase in their allocation to risky assets” and for all other funds “a 10% increase in the percentage of retired members is associated with a 1.67% lower allocation to risky assets”.  The graph below shows public pension higher allocation to risky assets up to 2012. It would be fascinating to see if this trend has continued to today.

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They further conclude that “this increased risk-taking enables more mature U.S. public funds to use higher discount rates, as a 10% increase in their percentage of retired members is associated with a 75 basis point increase in their discount rate” and that “our regulatory incentives hypothesis argues that the GASB guidelines give U.S. public funds an incentive to increase their allocation to risky assets with higher expected returns in order to justify a higher discount rate and report a lower value of liabilities”. The graph below illustrates the stark difference between the US and Europe.

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So, in conclusion, unless Mr Trump does something really stupid (currently around 50:50 in my opinion) like start a war, current valuations can be justified within a +/- 10% range by bulls assuming the possibility of fiscal stimulus and/or tax cuts is still on the table. However, there are cracks in the system and as interest rates start to increase over the medium term, I suspect vulnerabilities will be exposed in the current bull argument. I am happy to take some profits here and have reduced by equity exposure to around 35% of my portfolio to see how things go over the summer (sell in May and go away if you like). The ability of Trump to deliver tax cuts and/or fiscal stimulus has to be question given his erratic behaviour.

Anecdotally my impression is that aging investors are more exposed to equities than historically or than prudent risk management would dictate, even in this interest rate environment, and this is a contributing factor behind current sunny valuations. Any serious or sudden wobble in equity markets may be magnified by a stampede of such investors trying to protect their savings and the mammoth gains of the 8 year old bull market. For the moment through, to misquote Chuck Price, as long as the music is playing investors are still dancing.

Productivity Therapy

The IMF has sponsored another paper from staffers on the global productivity slowdown, with the catchy title “Gone with the Headwinds”. The paper reiterates many of the arguments concerning advanced economies referenced in this post, such as total factor productivity (TFP) hysteresis due to the boom-bust financial cycle and resulting capital misallocation, “an adverse feedback loop of weak aggregate demand, investment, and capital-embodied technological change”, elevated economic and policy uncertainty.

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Also cited are structural headwinds including a waning information and communication technology (ICT) boom, an aging workforce, slower human capital accumulation, and slowing global trade integration (including the maturing of China’s integration into world trade). An exhibit on the ICT trends from the report is reproduced below.

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The report highlights short term remedies such as boosting private sector demand, efficient spending on infrastructure, strengthening balance sheets, and reducing economic policy uncertainty. Longer term remedies cited include policies to boost technological progress, policies to mitigate the effects of aging, policies to encourage migration, advancing an open global trade system, exploiting policy synergies, structural reforms, raising the quantity and quality of human capital.

Now, how many of these remedies are likely to be pursued in the current populist political environment? Although Trump has shown signs recently of doing the opposite to what he fought the election on, overall it does look like we are merrily going down a policy dead-end for the next few years in important advanced economies. Hopefully the policy dead-end will be principally confined to the US and they wouldn’t take too long in figuring out the silliness of the current journey and the need to get back to trying to deal with the big issues intelligently. Then again….

Risky World

The latest World Economic Forum report on global risks is out today and, as usual, it reflects current concerns rather than offering any predictions for 2017. To be fair to WEF, the top risk for 2012 to 2014 inclusive in their survey was income disparity which is commonly viewed as one of the factors behind the rise in populism.

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The report states the obvious about the impact on global risks following 2016, specifically that “societal polarization, income inequality and the inward orientation of countries are spilling over into real-world politics” and that “decision-making is increasingly influenced by emotions” due to the increase in nationalism. Where this year’s report is spot on, in my view, is in relation to the top 5 global trends that will determine global developments over the next 10 years, as below.

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The report also states that “although anti-establishment politics tends to blame globalization for deteriorating domestic job prospects, evidence suggests that managing technological change is a more important challenge for labour markets” and that “we are in a highly disruptive phase of technological development, at a time of rising challenges to social cohesion and policy-makers’ legitimacy”.

Among the many risks highlighted in the report is a reduction in geopolitical co-operation which is likely to be detrimental to global growth, action on global indebtedness, and climate change.  It’s particularly depressing to think that even if the commitments under the Paris agreement were delivered, which now looks doomed after the election of Trump, the United Nations Environment Programme (UNEP) estimates the world will still warm by 3.0°C to 3.2°C, still far above the 2°C limit where scary and irreversible stuff happens.

Another worrying risk is the possibility of a new arms race in an era of rapid advancements in a technology which also has a retrograde feel, especially “while risks intersect and technologies develop quickly, too often our institutions for governing international security remain reactive and slow-moving”.

All pretty cheery stuff! And on it goes.

As I write this, I’m watching reports on Mr Trump’s press conference today, and although there is no doubt that our world is riskier as we enter 2017, it will be entertaining to see this guy as the leader of the free world. Hopefully good entertaining, not depressing entertaining!

Stuff just happened…

Many, like me, are scratching their heads this weekend about the Brexit vote. Besides the usual little Englanders and other crazies who crave an idealised yesteryear, a significant proportion of sensible people registered their protest in the vote, in a result that is clearly against their and their children’s economic interest. Places in the UK with significant employers dependent upon European access, places like Sunderland, Swindon and Flintshire (with bases for Nissan, Honda and Airbus), voted to leave.  They choose to ignore the consensus advice of the experts and their political leaders, the elite if you like. That’s what makes the outcome of this vote so significant.

In an article two years ago called “The Pitchforks are Coming”, the billionaire Nick Hanauer, who made his fortune on Amazon and aQuantive, wrote the following to his fellow billionaires:

“If we don’t do something to fix the glaring inequities in this economy, the pitchforks are going to come for us. No society can sustain this kind of rising inequality. In fact, there is no example in human history where wealth accumulated like this and the pitchforks didn’t eventually come out.”

The thing is, would the populations of other major European countries also register such a protest, even where it was clearly against their interest? The graph below from Bloomberg suggests it could be a distinct possibility.

click to enlargeBrexit Contagion Bloomberg

The problem now is that the EU cannot be seen to give the UK a deal which may encourage more discord. And, of course, the UK has no idea what deal it wants. The political turmoil in the UK government means they can’t even decide when to trigger Article 50 of the Lisbon Treaty, which will likely need a vote in parliament. The economic factors upon which any deal should be decided are illustrated in the exhibit below from a 2015 Open Europe report on Brexit. These economic factors may not play as important a part in the negotiations as they should given the emotive opposition to free labour movement, aka migration, which is a key issue for all Europeans.

click to enlargeOpen Europe Sectors Impacted by Brexit

Matching these interests to the exit options available, as outlined in the exhibit below from Bloomberg, whilst satisfying the diverse opinions of the Brexiteers is the mess that we are now in. Any deal, whenever it arrives, will likely have to be voted upon again by the British public, maybe in the form of a general election.

click to enlargeAlternatives of EU for UK Bloomberg

Before that agreement can be made, we are in for an extended period of uncertainty. Radical uncertainties are a more apt term, with the emphasis on the radical.

Let’s hope that pitchforks are not part of our future.

Piddling Productivity

Walk around any office today and you will likely see staff on the internet or playing with their smartphones, the extent of which will depend upon the office etiquette. The rise of the networked society would intuitively imply increased productivity. Data analytics, the cloud, the ease with which items can be researched and purchased all imply a rise in efficiency and productivity. Or does it?

Productivity is about “working smarter” rather than “working harder” and it reflects our ability to produce more output by better combining inputs, owing to new ideas, technological innovations and business models. Productivity is critical to future growth. Has the rise of social media, knowing what your friends favourite type of guacamole is, made any difference to productivity? The statistics from recent years indicate the answer is no with the slowdown in productivity vexing economists with a multitude of recent opinion and papers on the topic. Stanley Fisher from the Fed stating in an interesting speech for earlier this month that “we simply do not know what will happen to productivity growth” and included the graph below in his presentation.

click to enlargeUS Average Productivity Growth 1952 to 2015

Martin Wolf in a piece in the FT on recent projections by the Office for Budget Responsibility (OBR) calls the prospects for productivity “the most important uncertainty affecting economic prospects of the British people”.

Some think the productivity statistics have misestimated growth and the impact of technology (e.g. the amount of free online services). A recent paper from earlier this month by Fed and IMF employees Byrne, Fernald and Reinsdorf concluded that “we find little evidence that the slowdown arises from growing mismeasurement of the gains from innovation in IT-related goods and services”.

The good news seems to be that productivity slumps are far from unprecedented according to a paper in September last year from Eichengreen, Park and Shin. The bad news is that the authors conclude the current slump is widespread and evident in advanced countries like the U.S. and UK as well as in emerging markets in Latin America, Southeast Europe and Central Asia including China.

A fascinating paper from December 2015 by staff at the Bank of England called “Secular drivers of the global real interest rate” covers a wide range of issues which are impacting growth, including productivity growth. I am still trying to digest much of the paper but it does highlight many of the economists’ arguments on productivity.

One of those is Robert Gordon, who has a new bestseller out called “The Rise and Fall of American Growth”. Gordon has long championed the view of a stagnation in technology advances due to structural headwinds such as an educational plateau, income inequality and public indebtedness.

click to enlargeAverage Annual Total Facor Productivity

Others argue that productivity comes in waves and new technology often takes time to be fully integrated into the production process (e.g. electricity took 20 years before the benefits showed in labour productivity).

Clearly this is an important issue and one which deserves the current level of debate. Time will tell whether we are in a slump and will remain there or whether we are at the dawn of a golden era of innovation led productivity growth…..