Fourth Quarter 2013
Perhaps you have heard the Walgreens’ advertising that includes the tagline, “at the corner of happy and healthy”. In the current investment world context, it strikes us that the prevailing views about U.S.-traded stocks and the underlying economy remain much closer to the corner of unhappy and unhealthy.
New all-time stock market “highs” have elicited little happiness among many. Instead, the stock price advance has brought widespread talk of a market bubble.
Meanwhile, many regard the backdrop as dangerously lacking in health. Some argue that the lone catalyst behind the economic expansion and the stock market advance has been the Federal Reserve’s bond-buying activities. With the Fed recently signaling its intention to taper their bond buying, is the proverbial “other shoe” about to drop in both economic and investing terms?
Has the stock market really detached from economic reality?
While we understand the unhappy and unhealthy fears, we think they are significantly exaggerated. We do believe an important corner — or more appropriately, a big intersection — is at hand, however.
This intersection represents the confluence of a number of important trends. The intersection came into clearer focus during 2013 and remains likely to shape the investment environment for some time yet, in our estimation. Best of all, the intersection may well prove more healthy and deliver more investment happiness than many currently believe.
The intersecting trends include:
A discussion of each of these trends follows.
We have explored the innovation trend previously, but it is significant enough to warrant more comment.
Consider the words and perspective of outgoing Fed Chairman Bernanke. While the markets and the popular financial media were obsessed with Fed bond-buying prospects last May, Bernanke offered observations about the most important factors shaping the economy in a speech1 :
Finally, pessimists may be paying too little attention to the strength of the underlying economic and social forces that generate innovation in the modern world. Invention was once the province of the isolated scientist or tinkerer. The transmission of new ideas and the adaptation of the best new insights to commercial uses were slow and erratic. But all of that is changing radically.
Innovation is the central issue in economic prosperity.
- Michael Porter, Harvard Business School
In short, both humanity’s capacity to innovate and the incentives to innovate are greater today than at any other time in history.
Moving from Bernanke’s general comments to the more specific; among the more recent transformational innovations is horizontal drilling which is unleashing an energy revolution that is a “game changer” in the U.S. (See Chart 1)
Chart 1: The revolution is for real
3-D printing, cloud computing, the “internet of things”, and the related “industrial internet” of smart machines, computational manufacturing, and simulation software are combining to produce what some believe is another phase of the Industrial Revolution. Only time will tell if current innovations live up to such a lofty characterization, of course. But the application of these and other innovations to both production processes and supply chain management, coupled with the energy revolution, are forging a domestic manufacturing renaissance.
They also continue to provide fertile ground for investment opportunity. Businesses that provide new innovation “tools” that enable other businesses to be more productive and efficient have large addressable markets. (See Table 1: The power of merely a 1% efficiency gain across a few economic sectors.)
Last quarter we noted the development of structural problems within the major emerging market economies of China, India, Russia, and Brazil. Inflation, bad debt, real estate and capacity excesses, and policy actions designed to deal with these problems are sapping economic growth in these countries.
At first blush one may wonder how a slowdown in the growth of emerging market economies could possibly be a healthy development. The favorable implications rest with the potential transmission of lower commodity price inflation to the developed world, the U.S. in particular.
Over the past decade and a half, as China has made massive investments in the physical side of its economy, its demand for commodities has rendered it the world’s price-setter for commodities of all types. The research firm, Cornerstone Macro, estimates that China — representing 11% of the world economy — has accounted for at least 40% of world demand for many commodities in recent years.
The commodity “super-cycle” that many companies, countries, and investors have come to expect from the recent past is no longer so super, as China’s economy transitions to slower growth. Moreover, their slowdown appears due to more than just cyclical factors.
China is moving to realign its economy from the unsustainable, top-down, force-fed physical investment phase that characterized the past 10-15 years, to a more consumption-based economy. In addition, its demographic situation, which had been a significant tailwind behind its growth, is soon destined to become a headwind as its long-standing “one child” policy begins to materially impact its workforce.
As these trends continue to unfold, China’s demand for commodities will likely remain much weaker than has been the case. What had been shortages now have the potential to be gluts.
“Will Ghost Cities Haunt China?” — Global Times
“In China, Empty Office Spaces Fill The Sky” — CSMonitor.com
“Tour China’s Enormous ‘Ghost Mall’ That Sits Virtually Empty Years After It Was Built” — Business Insider
Source : Cornerstone Macro
The implications for the U.S. are multidimensional. Coupled with the domestic energy revolution, lower commodity price inflation translates into more U.S. consumer purchasing power and lower U.S. inflation. In addition, the rapid increases and volatile behavior of commodity prices in recent years wreaked havoc on profit margins and inhibited planning for many businesses.
Even stability in commodity prices is favorable for the economy. We recall a meeting with a business owner in the mid-2000s when he had to pause numerous times during our visit to adjust the price of his business product due to volatile prices of key raw material inputs. With more predictable input costs, the ability and willingness of businesses to plan improves and business investment horizons lengthen.
These changes have important implications for investors. As the emerging market and commodity-based trends that had driven so many investments in the recent decade continue to dissipate, completely different investment “winners” are emerging. We suspect 2013 provided insight into identifying these “new” investment winners. (See Chart 2)
Chart 2: In with the “new”, but many overinvested in the “old”?
As our opening unhappy and unhealthy remarks suggest, in the long shadow of the 2008 Financial Panic, fear, uncertainty, and doubt about the economy and stocks remains deep-seated. To the extent that the fragile psyche keeps expectations muted, reality has a “low bar” to clear to create favorable surprises.
Markets are forward looking; as a result general expectations are important. Therefore, when things are “better than expected” or “worse than expected”, catalysts for market movements often exist.
The year 2013 (and most years since 2008 for that matter) displayed the “better than expected” catalyst. Remember last year’s worries and warnings about the dreaded “fiscal cliff” triggering another recession, Fed tapering, the debt ceiling default and government shutdown? The economy in 2013 demonstrated more resilience in the face of these troubles than many expected.
We expect more of the same from the economy in 2014. Yes sticky problems persist, but the economy will remain in the growth mode, unemployment will grind lower, and the corporate earnings up-cycle will continue.
When will it become time to worry about the economy? This answer lies in business cycle dynamics.
As an economic expansion ages, over investment, excess inventories, credit creation, debt loads, and inflation accumulate. This condition makes an expansion brittle. The expansion typically ends when the Fed jumps on the brakes and moves to combat inflationary pressures by significantly raising the short-term interest rates under its control. An inverted yield curve (longer-term interest rates below short-term rates) almost always precedes recessions.
At 50+ months of age and counting, the current economic expansion already exceeds the 33-month average age of U.S. expansions. Yet do not fret. With few (if any) excesses, a yield curve that is far from inverted, and where so many still fear a repeat of 2008 financial panic conditions, this expansion is still young at heart.
Despite the bubble talk, in our estimation the stock market advance has more room to run. Although stock prices may be making new highs, corporate earnings have been making new all-time highs for more than 3 years now. Stock prices may finally simply be catching up to their underlying “fundamentals”.
Furthermore, the valuation the market is placing on the earnings does not appear near a bubble danger zone. A recent Market Commentary, “Now is the Market Overvalued?”, addressed this issue in more detail. The answer to the overvalued question, is in our estimation — no. (See Chart 3)
Chart 3: Valuation Looks Fair
What about the Fed and money printing fears? As discussed in another recent Perspective, “Telling the Time”, we believe the Fed’s actions have simply filled a “hole” in the financial system. This “hole” resulted from private sector de-leveraging and extreme risk aversion in the wake of the ’08 panic. (See Chart 4) Credit creation certainly does not look worrisome in this context.
Chart 4: Change in Consumer Debt Outstanding + Change in Federal Reserve Balance Sheet
The Fed has stepped in to fill a hole created as the private sector retreated and retrenched
(vertical axis = % change, horizontal axis = year)
With the economic expansion now well underway and extreme risk aversion dissipating, it is appropriate for the Fed to wind down their hole-filling activities.
Similar to last year’s fiscal cliff worries, the economy should prove sufficiently resilient to withstand the cessation of the Fed’s bond-buying program.
The economy should also prove resilient in the face of interest rates and bond yields “normalizing” at higher levels. Our work continues to suggest 4% – 4½% 10-year Treasury bond yields would represent a “normal” relationship with the underlying modest inflation, moderate growth economy.
From the current 3% level on the 10 year, the normalization adjustment process may well continue to create heartburn for many bond investors. Accordingly, our bond investments remain “defensively” positioned.
However, normalized yields will remain “low” by historical standards (Chart 5). As such, the envisioned rise in yields should not derail either the economic expansion or the corporate earnings up-cycle, or be the end of the advance for U.S. traded stocks. However, we are aware the yield normalization process may well create periodic bouts of angst for the stock market.
Chart 5: U.S. 10-year yields have rarely been so low since 1800
Just as stable commodity prices aid economic activity by allowing businesses to expand their investment time horizons beyond the immediate, a stable exchange value of a currency helps as well. A U.S. economy marked by low inflation, widespread innovation, a favorable energy situation and a Fed ending its hole filing activities, should help create a backdrop of relative dollar stability.
We believe the fiscal policy has reinforced the pervasive fear, uncertainty, and doubt that have marked the period since 2008. We hear it from business leaders all the time — “we just want to know what the rules are and the costs associated with them. Whether we like the rules and costs or not isn’t the issue from a business perspective. We will adapt, but we need to know what specifically we need to adapt to.”
Sweeping, complex legislation involving significant segments of the economy with critical details still being worked out “on the fly”, exemptions from new rules granted for some but not others, the rapid expansion of future liabilities of the government, tax hikes, and open animosity among the major parties of government, heightened fears of the IRS and NSA, have all contributed to the prevailing uncertainty during this period.
The good news is that D.C. gridlock suggests few new major intrusions into the economy by the government are likely for a while. This relative stability should allow businesses to increase their focus on creating and delivering products and services designed to win customers within the competitive marketplace. This will be a healthy change.
Finally, the financial markets will continue to be driven by volatility, impatience, fear, greed, and conventional wisdom that is often off the mark. Still, we believe rewarding returns await investments positioned to benefit at the big trend intersection.
As always, we remain focused on understanding the current trends in fundamentals because it gives us the best probability for success. And if you’re an active social media user, please consider sharing this topic with your acquaintances.
1 Bernanke, Ben, “Economic Prospects for the Long Run”, at Baird College at Simon’s Rock, Great Barrington Massachusetts, 18 May 2013.