A Commentary of Jurika, Mills & Keifer LLC
Second Quarter: April 2012
Investing with the Gods…
In Greek and other mythology, the Gods, bored atop their perch on Mount Olympus or in Valhalla, come down to Earth to mix it up with the mortal world. Their intentions are often good to begin with – to protect a favorite child or hero, favor one civilization over another, dole out heavenly justice at ground level, and of course to father illegitimate children (Gods with benefits?). But in the process, they often end up altering the natural order of things, producing unintended consequences, and setting in motion a sequence of events that often ends with tragic consequences for all.
Although it may be too flattering to characterize the heads of the world’s major central banks and finance ministers as gods, they are actually playing a similar role with respect to their involvement in the global economy. Their divine intervention has helped to provide important stability in the face of an epic debt bubble and major deflationary forces. (BernankeCare, anyone?) But in so doing, they have also altered the nature and behavior of investors and investments, changing the course of mighty rivers, and turning some of the very underpinnings of investing upside down.
Armed with a heavenly printing press and a willingness to buy troubled assets at irrational prices, these gods have blurred the relationship between heaven and earth, public and private sector, and risk and return. The result is a bizarre world of myth and moral hazard: where the developed world is literally trying to borrow its way out of debt by printing money and buying its own bonds, like Ouroboros, the serpent in Greek mythology that tries to consume its own tail.
It is a world where risk-taking and irresponsibility are rewarded and savings and prudence are punished; where traditionally riskless assets such as Treasury bonds are likely to be riskier than traditionally risky assets such as stocks (with risk defined as the probability of permanent loss of purchasing power); where once uncorrelated assets have become correlated; where monetary and fiscal stimulus have become addictive drugs; where good news can be bad for markets and bad news can be good; where major paper currencies of the world are being systematically debased; and where the rules and regulations of commerce are in flux and uncertainty reigns.
If this sounds topsy-turvy, it is. It is also unlikely to be sustainable over the long-term. But for now, it is where we are and it requires a new framework for looking at investing and investments, focused less on traditional ideas of risk and return, and more on whether or not assets are “productive,” and have the ability to maintain or increase in value, even in the face of inflation, or “unproductive,” and likely to lose value over time. For more on this, read on…
No news is good news.
The first quarter was marked by strong returns in global equity markets, some good news, especially at home, and the absence of really bad news, especially abroad.
Sure, Europe is still a colossal mess. But, the European Central Bank has finally shown its willingness to become the lender of last resort, there is more progress towards the idea of fiscal union, and things have generally calmed down for the time being. China is slowing down, as expected, but growth in the emerging markets remains strong. In the U.S., despite the Republican primary carnival, which mercifully appears to be ending, our elected officials generally kept a low profile and did no harm, and not much else. In the Middle East, a tense calm remains.
Against this backdrop, global equity markets found more reasons for hope than fear and rose accordingly. The U.S. stock market was up 12.6% for the first quarter, led by financial and technology stocks, posting the strongest return since 1998. Emerging markets also staged a strong rebound, up over 13% for the quarter, and European stocks brought up the rear, up 10.8%.
Innocent until proven guilty.
Our view is that the U.S. economic recovery, which for the moment continues to gather steam, deserves the presumption of innocence until proven otherwise. It is still fragile and susceptible to shocks from at home and abroad, but consumer and business confidence are improving and the majority of indicators we look at are improving. Moreover, we think the United States has significant potential for further progress and may benefit more than suffer from problems elsewhere.
Chart I above right shows the U.S. Purchasing Managers Index (PMI) for Manufacturing and Services. They are both still solidly above 50, indicating ongoing economic expansion. We see a different story if we compare the PMIs in the U.S. relative to the Euro zone and China (Charts II and III), both of which are below 50 indicating economic slowing.
Employment in the U.S. is also on the mend as shown in Chart IV below. Although the most recent jobs report was a little anemic, we are currently adding jobs at an average pace of around 200,000 new jobs a month. And we have regained over 3 million of the 8 million jobs that were lost during the downturn. It is not nearly as strong as everyone would like, but it is moving in the right direction.
Also of note, businesses are reaching diminishing returns in productivity per employee. This suggests that companies are working their existing labor force about as much as they can and will need to start hiring if they are going to keep growing.
Housing, after five long years in the valley of the shadow of death, is also showing signs of improvement, both in existing and new home sales (Chart V). Credit, although cheap, is still hard to come by for those that need it, but conditions are improving and individuals and investors are starting to recognize that at current prices, housing values are compelling and are more likely to rise than fall from here. It makes more sense to be an owner than a renter, especially if you can borrow at cheap rates and pay the bank back with fixed payments of money that are likely to be worth less and less with each passing year.
Despite its challenges, risks from abroad, and self-inflicted wounds from Washington, the U.S. economy is surprisingly resilient and innovative. It is still a good place to do business and we have entered a remarkable new era of value creation, much of it enabled by technology.
Consider for example that the first iPad was introduced just two years ago, and the first iPhone only five years ago. In 2011, the two products accounted for over $70 billion in sales, eclipsing in short order the total revenues of companies like Coca Cola, Johnson & Johnson and McDonalds, some of which have been around for over a century.
Think about how quickly companies like Google, Twitter or Facebook have sprung out of relative obscurity to become major entrenched franchises.In a flatter, more digital world, companies can scale more quickly, accomplishing in months with relatively few employees what it once took years and thousands of employees to do.
Outside of the technology world, we also are seeing more reports of renewed industrial growth. It may be too strong to call it a new industrial renaissance, but global companies are finding advantages to increasing their capital investment in the United States relative to other places. These advantages include access to skilled labor, rule of law, transportation logistics, relatively low energy costs and a competitive currency. Caterpillar Tractor, for example, recently relocated an excavator factory from Japan to Georgia, creating 1,400 new jobs in the U.S.
In the near term, high oil and gasoline prices are creating a headwind to the recovery, but we think that the economy can withstand the drag, unless prices rise significantly higher from here in a relatively short period of time. Much of the recent rise in oil prices is the result of uncertainty surrounding Israel and Iran, rather than an inherent imbalance of supply and demand. There is plenty of oil.
If we look far down the road, with its enormous natural gas reserves, the U.S. has the potential to not only be energy self-sufficient, but a net exporter of energy. This has been talked about for years, but we think that the stars are aligning to make it a reality in the coming decades. A nation that can power its own growth has enormous strategic advantages over one that can’t.
Meanwhile back in Washington…
The political scene has largely been centered around the Republican primaries. But, as we move towards the Fall, the markets will start to pay increasing attention to the upcoming election, as well as three key events that are scheduled to happen around year-end, often referred to as the “fiscal cliff.”
The first is the expiration of the Bush-era tax cuts. Unless they are extended by Congress and the President, they will expire on December 31st, causing tax rates on income, capital gains, and dividends to return to pre-2001 levels. The standard deduction on the estate tax will also fall from $5 million this year, to $1 million next year.
The second is the automatic “sequestration” that will kick-in in 2013, the result of the congressional “Supercommittee’s” failure to reach a meaningful debt reduction by the required deadline last fall. The sequestration will result in $1.2 trillion in budget cuts over a 10 year period.
The third is another scheduled vote to raise the budget ceiling, either late in 2012 or early in 2013. We can’t wait.
Our greatest hope is that Republicans and Democrats will come together to address tax policy, budget cuts and debt ceiling discussions with a constructive, bipartisan spirit. With approval ratings in the single digits, somewhat below Italian cruise-ship captains and Greek tax collectors, they presumably have more to gain and less to lose by doing so.
Our greatest fear is that, like tragic figures from Greek mythology, they cannot escape their destiny to make a mess of an opportunity.
But as bad as it all may seem, we think that the fear of higher taxes will be far worse than the reality. The entrepreneurial spirit will not be squelched. Private enterprise will continue to prosper. The repeal of the Bush era tax cuts may put a temporary damper on things but should not spell the death knell of the recovery. Tax revenues are near an historical low percentage of GDP and after all, the economy experienced one of its greatest periods of growth in the 1990’s under the prior tax code.
The sequestration seems like a big deal but it’s actually a drop the bucket. $1.2 trillion over 10 years amounts to a very small percentage of a $3.7 trillion annual budget.
And finally, last time Congress couldn’t agree on the debt ceiling, it caused near-term consternation in the markets, and an unprecedented ratings downgrade. This was followed by a large rally in Treasury bonds. More than anything, Congress tarnished its own reputation. We don’t believe they want a repeat performance. But even if they mess up again, we don’t expect that it will represent a meaningful risk to the recovery.
As for Europe, its challenges remain centered around growth, debt and policy. After a few relatively quiet months, and some meaningful progress, including a Greek debt restructuring, we would not be surprised to see more trouble ahead, most likely starting with Spain.
The L.T.R.O. (Long Term Refinancing Operation) facility introduced by the European Central Bank last December, calmed the markets and provided a mechanism for over-leveraged European banks to heal their balance sheets over time. It does not however, solve any of the underlying fiscal and structural imbalances that exist within and between individual countries.
We expect the overall Euro zone to move into a recession, but with a marked difference between northern European countries like Germany, where things are better, and Southern countries like Spain, Portugal and Italy, where they are not. We are particularly concerned that the forced austerity programs being imposed on the most troubled nations such as Spain and Italy have the potential to do more harm than good, slowing growth at a time when growth is needed, and making it ever more difficult for them to escape their debt burdens. Rising levels of unemployment also breed social unrest and make the politics of managing unpopular fiscal reforms more difficult.
For the time being, the leaders of the major countries including Germany, France and Italy, as well as the ECB, now seem to realize that their fates are tied together. In an ever more competitive World, their best way forward is to move towards some form of full fiscal union, with the ability to issue common debt on behalf of member countries. This wouldn’t make the existing debt burdens go away, but it would buy time to address the longer-term imbalances while focusing again on growth.
The key question for investors on this side of the Atlantic is what impact will Europe have on growth in the United States. Our base case is that as long as European policy discussions and actions keep moving generally in the right direction, a moderate recession in Europe will dampen but not derail the recovery here.
In fact, the U.S. may continue to benefit from problems in Europe as global companies allocate more of their capital spending budgets to the U.S. where things are less bad and more predictable. As we commented above, despite all of our problems, this is still not a bad place to do business. And problems in Europe should also keep up demand for Treasury bonds, allowing us to continue to fund our massive deficits for peanuts. This can’t last forever, but for now, it beats the alternative.
Conversations about “emerging” economies often center around China and whether it is going to have a “hard” or “soft” “landing,” a euphemism for an economic slowdown.
True, China is the 800 pound Panda in the room. As the World’s second largest economy by GDP, what happens in China does matter. But it is naïve to lump all developing and emerging countries together in the same basket.
From a market perspective, for the present, emerging markets investments are all highly correlated to one another, and hinge on China.
China’s economy is slowing, but it is still growing, likely at a 6% to 8% annual rate. This hardly seems like a hard landing to us. Part of this slowdown has been engineered by the government in an effort to tame inflationary forces and improve the quality of growth. Another part of the slowdown is the natural hangover after a binge of capital investment in infrastructure and real estate development in recent years.
This is what we think is important to keep in mind about China in specific, and emerging and developing markets in general:
First, China is in a transition from an export-driven economy to one that is driven more by internal consumption and a large and rising middle class.
Second, despite episodes of capital misallocation, such as in residential real estate, China’s economy is strong and diversified. It can withstand corrections in sectors without tanking the entire economy, and over time, the economy will grow into its oversized infrastructure. Its bigger long-term challenges relate to managing growth, securing access to natural resources and power, pollution, and providing healthcare to an aging population.
Third, the Chinese government has a war chest of reserves and policy tools at their disposal to offset periods of economic weakness if needed. They tend to think strategically, with a long-term perspective and can make decisions quickly.
Fourth, developing and emerging nations are in much better shape financially than developed nations and are expected to generate the majority of GDP growth in the coming years. It is therefore important to have meaningful exposure in portfolios to them, understanding that they may be more volatile in the near term, but are also much more likely to grow and prosper over the long-term.
Finally, we think they are attractively valued relative to slower-growing developed economies.
Events from left field
The major event from left field that everyone is worried about is an Israeli attack on Iran’s nuclear facilities. We think the fear likely overstates the current reality but do believe that a cloud of uncertainty will persist for a long time until the matter is finally resolved either through peaceful means or military action.
Investing with the Gods
So against this backdrop how do you invest? Governments and Central banks are playing an unprecedented role in the financial markets and banking systems around the world, developed economies are mired in debt while developing economies have become our creditors, many companies are in better shape than most countries. Many of the traditional beliefs of investing have been turned upside down.
Our first conclusion is don’t bet against the gods, or at least, try to stay out of their way. It makes sense that central banks around the world will ultimately do all they can to maintain stable financial markets and avoid a deflationary spiral. It may not work, but they will try.
It also makes sense that Treasuries will print money to devalue currencies and outstanding debts, to incur new debts, and to make exports more competitive. Not everyone can do this at the same time, of course, though they may try.
As always, we think it makes sense to maintain an appropriate balance between appreciation-oriented and defensive-oriented strategies. Although things are generally headed in the right direction, there are plenty of things that can and will go wrong.
Productive and unproductive assets.
But we also think it makes sense that investors think more in terms of investing in productive versus unproductive assets rather than more conventional terms of stocks (risky) and bonds (safe).
We expect that the nominal value of “fixed” price and income investments that are traditionally thought of as “safe,” such as bonds and annuities will become increasingly illusory and subject to monetary debasement. They can still serve an important role as a defensive bulwark and source of liquidity in a portfolio, but should not be thought of as a source of long-term value creation or maintenance. In fact, as we will demonstrate, they will almost certainly lose value over time.
Instead, investors need to focus more on productive assets that can survive the ravages of inflation, such as stocks, natural resources and real estate. They may experience greater near term price volatility, but over the longer-term, they have the greatest ability to generate growing streams of cash flow, and maintain and increase in intrinsic value.
Consider the following: since the United States abandoned the Bretton Woods agreement in 1971 that, among other things provided for the direct convertibility of the dollar into gold, the dollar has lost a whopping 82% of its purchasing power as measured in 1971 dollars (Chart VI). Over time, cash is trash!
A Tale of Two Investments:
If we think of investing $1,000 in a 10 year U.S. Treasury bond today, with a 2% yield, the presumption is that it is a safe investment, and that in 10 years, along with your annual coupon payment of $20, you will receive your $1,000 back, safe and sound.
Conversely, suppose we think of investing the same $1,000 in a typical hypothetical stock with a similar 2% dividend yield. The presumption is that this is a much riskier investment, although over time, the stock price and dividend payments should appreciate.
Chart VII shows the projected nominal value of each of the two investments, including interest and dividend payments over a 10 year period. With stock investments there are more assumptions that have to be made. (We assume a fairly conservative 6% sales and earnings growth rate, a constant dividend payout ratio and a steady P/E multiple of 12.5.)
In this example, in nominal terms, in ten years your Treasury bond is still worth $1,000, and your coupon payments are still worth $20.00. Meanwhile your stock and dividend payments have appreciated by about 80%.
But we don’t live in a nominal world. What if there is inflation? How much will that $1,000 bond be worth in 10 years, and how much will the fixed payments of $20 a year be worth in today’s dollars? What will be the impact on your stock investment?
Chart VIII shows the answer. If we assume just a 3% annual rate of inflation, over 10 years, your $1,000 “safe” Treasury Bond investment would lose over 26% of its purchasing power.
Conversely, your stock investment and dividend payments would still have appreciated by 34% in real terms (i.e. increased purchasing power).
Over time, productive investments like stocks have the power to grow, to pass through inflation, to increase their dividend payments and increase the intrinsic value of their enterprise. Bonds do not.
For someone who is dependent on maintaining and increasing the purchasing power of their investment portfolio to fund retirement or other objectives, what has been the case over history is even more likely to be the case in the coming years: stocks have the highest probability of achieving the investor’s objective and bonds have the highest probability of failing to achieve it. What is perceived of as “safe” has the greatest risk of losing value. What is perceived of as risky, is actually most probably safe.
One of the most common knocks we hear about stocks is that over the last decade, they have gone nowhere. First of all, this is no longer true. Over the 10 years ending March 31st, stocks are up about 4% per year. But it was true a year or two ago, if one measured from the peak of the “dot com” bubble in 2000 to the aftermath of the credit bubble. But those are extreme starting and ending points and are unlikely typical of most investors’ portfolios.
But if we take a longer period of time, going back 14 years to 1998, one could make the point that the market is only today, back where it was then, although the ride in between was admittedly quite a doozy.
As we see in Chart IX below however, the focus on price alone misses the more important point that over the past 14 years, although the price of the S&P 500 index is today where it was 14 years ago, the underlying earnings of the companies in the market have grown by almost 150%, from $40 share to $100. You are getting a lot more earnings for your money today than you were then, and arguably, companies are in much better shape today than before.
And so for now, we are maintaining a full weighting to U.S. and emerging market stocks. In the U.S. we especially like technology and technology-related stocks.
We continue to minimize exposure to Europe, economically sensitive commodities, and longer maturity government bonds. There are some bargains to be found in European equities, and some of the fund managers we use are pursuing these, but by and large, we think the conditions for growth are better here. Meanwhile, slowing in the developing world should continue to put a drag on commodity prices, other than perhaps oil.
Finally, while the gods are at play, we continue to like gold. We are also maintaining hedges in portfolios should their actions, as with their mythical peers, produce unintended consequences.
As always, we welcome your comments, questions and referrals, and the chance to speak with you should you wish to discuss your own investment portfolio.
Jurika, Mills & Keifer, LLC