Reversing two consecutive monthly losses in May and June, the S&P500 recorded nearly a 7% gain in July, helped by strong 2nd quarter earnings from the US large cap group. So far, about 80% of the S&P500 companies that reported earnings have beat expectations, largely consistent with what the large cap group has done in recent quarters. Strong corporate earnings have assuaged concerns that the macro economy is slowing down, although disappointing economic data released in July and so far in August have generally suggested a dimming economic picture. Let us review a few select economic items:
1. The Institute for Supply Management’s (ISM) manufacturing index fell more than forecast to 56.2 in June from 59.7 in May. It fell further to 55.5 in July. ISM’s index of non-manufacturing businesses, which covers about 90% of the economy, fell to 53.8 in June from 55.4 in May. The index expanded slightly to 54.3 in July.
2. In mid July, the Fed officials cut their forecasts for 2010 US GDP growth to 3 - 3.5%, down from the previously forecasted 3.2 - 3.7%, although Bernanke publicly downplayed the odds of the economy sliding back into a "double-dip" recession. As for 2011, Fed officials predict that US GDP will rise in a range of 3.5% to 4.2% compared with a range of 3.4% to 4.5% in the last projection. In the 2nd quarter, the US GDP rose at a 2.4% rate, below the 2.5% expected, as consumer spending rose by a moderate annualized rate of 1.6%. First-quarter growth was revised up to 3.7%, from the originally reported 2.7%. Consumer spending rose by 1.9% in the first three months of the year.
3. The official unemployment rate remained at 9.5% in July and the total jobs lost were 131,000, largely due to 143,000 temporary government census jobs that were lost. The private sector added a net of 71,000 jobs. For the last six months the private sector created an average of 37,000 jobs each month. As we all know, the US economy needs at least 125,000 permanent full time jobs added each month just to keep pace with U.S. civilian workforce population growth. The economy has lost 8.4 million jobs during the recession. To get back to pre-recession unemployment rate levels, the US economy needs a good 400,000 permanent jobs created each month over the next 2 years.
4. According to an index of 28 retailers tracked by Thomson Reuters, same-store sales rose 2.9% in July, below the 3.1% increase that analysts were expecting. This was the fourth consecutive month of softer-than-expected sales gains. In addition, the Thomson Reuters/University of Michigan final index of consumer confidence declined to 67.8 in July from 76 in June, the lowest level since November.
It is no surprise that consumers’ spending less prevents companies from expanding. Completing the loop, however, as companies have spare capacity to utilize due to less than robust demand, they have lower employee needs, resulting in sustainably high unemployment, which further hinders consumer spending. Just like the proverbial chicken and the egg puzzle, it is hard to exactly pinpoint which of these issues emerged first. It is certain, however, nobody wants to hire or spend in an environment loaded with so much business uncertainty of both the economic and political flavors: passing of the health care reform, the financial regulatory reform, the upcoming changes in tax policies, and potential torpedoes emanating from passing of new energy policies. Much has been debated over the past year about the US economy - whether it will enter a robust expansion, muddle along, or flat line, but little attention or conviction has been given to a double dip. Considering what we have been through and will encounter: the passing of the health care reform, which will add a 3.8% Medicare tax on investment income starting in 2013, not to mention the new regulation that increases health care costs and reduces quality for the typical American. In addition, the financial regulatory act is widely recognized as being unable to prevent another crisis, but is loaded with new rules that have nothing to with the crisis, such as giving two-year, zero interest $50,000 loans to underwater homeowners. It also creates new and invasive government control of financial companies’ business practices, with 67 Studies and 243 New Rules that have yet to be defined and implemented. Lastly, the expiration of the Bush tax cut at the end of the year will increase the long-term capital gains federal tax rate to at least 20% from the current 15%, increase high-income households federal income tax rate to 36% from 33% (for singles making $171,850 to $373,650 and couples making $209,250 to $373,650) and to 39.6% from 35% (for singles and couples making $373,650 and above). Dividend income will revert to being taxed at the personal tax rate, which for the highest brackets implies a 160% increase in the dividend tax rate.
Lord only knows how the laws of unintended consequences will play out as all of these ill-defined programs/changes get implemented. Added to these uncertainties, is the Federal government’s growing mountain of debt as well as a massive stimulus program with little to show but 12 months of modest economic growth. Combined, these factors have both the business and consumer sectors in a down trodden and pessimistic mood. It is baffling to us that for all the collective wisdom and education of such leading commentators, it is not clear to them that though the US economy is less sick than 2 years ago, it will not substantially improve any time soon. Back in June 2009, though economic statistics started to improve, we coined the term BOHICA AA to describe the likely path for our economy. This acronym represents – Bend Over Here It Comes Again, And Again. One year later, the economy is indeed sputtering, entering what is likely to be the “And Again” phase of an economic cycle that will not be kind to businesses or investors. Here is a summary of all the extraordinary actions the administration has taken - the historic economic stimulus, extraordinary union protection, government sector expansion, unprecedented wealth redistribution programs, raising taxes, and a particular eagerness to regulate business. We believe they will have the following impact on the US Economy:
1. Labor and capital costs increase, reducing production and thus explaining the anemic economic recovery and a likely “new norm” – a structurally slow-growing US economy.
2. By putting the stimulus under the government’s direction via unprecedented deficit spending, private access to capital will eventually be crowded out for years as a result of exploding national debt.
3. Businesses look with a worried eye towards Washington wondering if their success will be vilified or the rules changed retroactively, reducing the attractiveness of investing capital and thus maintaining unemployment at stubbornly high levels.
Taken together, it is hard for us to believe the consensus still calls for operating EPS of $82 for the S&P500 for 2010, representing approximately 30% growth from 2009, and $96 for 2011, a new record and a further 17% increase in profits. Given that operating margins are back to near cyclical peaks, it seems unrealistic to believe with the economy on the brink of a new recession, that corporate America will achieve record profits in 2011. If we were the audience of a game show, we would be yelling – LOWER, LOWER. While Sell-Side analysts won’t do so yet, we are rather confident estimates will get reduced, but only after companies guide down and share prices reflect the weakening economic fundamentals. We feel buyers depending on these earning levels to support their decisions will be disappointed.
Despite being wary of an anemic economic prospect, we are optimists and would like to end our economics discussion with a positive policy suggestion, rather than just whining about the current reality. If the US government’s actions have not helped the economy very much, what will? Recently, more and more attention has been given to Richard Koo’s concept of a Balance Sheet Recession and how under these conditions, the Fed is likely to be impotent in fighting off an economic slowdown, and how government has to cover any slack in private sector spending. The reason is that regardless of how low interest rates go, and they are basically zero now, demand for debt capital does not exist, as businesses are engaged in deleveraging so they can repair their impaired balance sheet. Before this balance sheet recession ends, it doesn’t matter how much cash the Fed shoves into bank vaults. We paraphrase Koo’s analogy of a shop owner that sells 100 apples a day, who seeks to increase his sales by suddenly stocking 1,000 apples. The act of having 10x more apples will not spur additional demand. So it goes with demand for debt at the moment, as long as corporate America and consumers focus their efforts on reducing debt, then regardless of the amount of cash the Fed shoves into the system, it will not change that equation in the near term.
If indeed Richard Koo is correct in diagnosing the “Balance Sheet recession,” the prescription he provides is worth debating. Koo preaches that the only way to ride through this environment is to have the government pursue stimulus programs regardless of the deficit implications, to shore up slack in private sector demand, so GDP is maintained at an even keel and businesses are given a chance to get their house in order and resume profit-maximizing behavior which emphasizes growth versus debt reduction. Given the inept and incompetent nature of government spending, the price of Koo’s prescription seems very steep. It is not surprising that the Japanese economy, which has been plagued with zero to negative growth despite a decade of deficit spending by the government, is not exactly the envy of the world today. What we propose as an alternative, is to introduce a massive tax holiday combined with other incentives to invest, which will be more prudent and economically effective to promote sustainable wealth creating growth.
Keep in mind, consumer spending accounts for 70% of the US GDP, with business investments and government spending contributing approximately 15% and 20% (-5% from trade deficit). The expansion of government in the economy is rarely a good thing, as the interaction between government and consumer spending is generally either ineffective, or results in severe resource misallocations – hello can anyone say Fannie and Freddie? Alternatively, we have all heard stories and may know someone who has received unemployment benefits for 2 full years that gladly rejected a part time or low paying job offer? Government programs distort market clearing processes and prolong asset misallocations. It is the interaction between businesses and consumers, through mutual, voluntary exchange, that results in good karma for the economy in the long run. We also believe the US is different from Japan in the sense that corporate America is ready to exit its balance sheet recession, and has the resources to expand under the right business climate, namely confidence in Washington. According to Standard & Poors, non-financial companies in the S&P 500 are sitting on a record $837 billion in cash, and their cash and short term investments as a percentage of debt, have risen to 36.6% at the end of 10Q1, up from 27.1% two years ago.
It is only the US consumers that will be engaged in a balance sheet recession for a long time, and it is crucial that government policies incentivize corporate America to maximize growth potential, and create jobs, so consumers can continue to deleverage without seeing their consumption seriously impaired. A government policy that raises taxes on companies and individuals will only prolong the recession, hindering the government’s own wish to revive the economy, as businesses and individuals will have fewer funds at their disposal to get their fiscal house in order and seek investment or consumption growth. Ironically, Obama’s chief economic advisor, Christina Romer, essentially agreed with us. She documented in prior research that a dollar of government spending results in less than a dollar of wealth in the economy, while a dollar of tax cuts produces three dollars of wealth in the economy. Somehow she seemed to forget that research when she defended the stimulus program.
Let us conclude our discussion of the US economy and further support our view that aggregate corporate earnings are overstated with the following thoughts from Gary Becker :
I continue to believe that the biggest factor in the sluggish employment recovery of the US is that many of the actual new and proposed anti-business legislation, as well as the large fiscal deficits, made businessmen and investors cautious about taking on new workers. These proposals and laws include the health care bill, the pro-union bias and anti-business rhetoric of Congress and the president, suggested increased taxes on higher earners, changes in anti-trust laws to be less pro-consumer, and the endlessly complicated and largely misplaced financial “reform” law.
Now let’s shift gears. We have a quiz for you: Which country hosts the best performing stock market of the past 110 years, and arguably has the world’s most beautiful city?
If you guessed China with the Hong Kong Exchange, and Hong Kong with its glorious Victoria Peak views and magnificent Skyline – you guessed wrong.
If you guessed Singapore with its amazing Marina – you guessed wrong.
If you guessed The United States, with San Francisco’s rugged coast line, swaying Golden Gate Bridge, and rolling hills – you guessed wrong.
The winner is none other than “The Land Down Under”. Recently, Australia was recognized as the best performing , lowest risk stock market of the past 110 years. Further, for those of you that have never visited Sydney, you are truly missing out on a magical city. For Yanks, the easiest way to describe Sydney is to combine the natural beauty of San Francisco, the weather (sans smog) from Los Angeles, and cleanliness of Chicago – truly an amazing combination. Few sights in the world can match the view from the shore framed by the magical Opera House on one side and the iconic Harbor Bridge on the other. Recently I (Rafe) visited Australia as part of a global tour introducing AFG’s Global Research to investment houses in London, Singapore, Hong Kong, Sydney, and Melbourne. While each city has its own special charm, Sydney truly stands out. If you have a chance to visit, you will not be disappointed.
From a finance perspective, Australia provides an interesting case study to the global financial crisis (GFC) experience. Aside from a few speed bumps, it has moved through this period relatively unscathed. Further, Australians have an interesting election choice as two very different philosophies will be on the ballot in a couple of weeks. We will share a few thoughts on each of these issues from a policy and investment perspective.
As we discussed earlier in the letter, the GFC put American companies and consumers in a very defensive position, focusing on deleveraging versus profit and consumption maximization. The Australian experience has been very different. Whereas unemployment in the US soared from 4.6% in 2007 to above 10% and now stands at 9.5%, Australia’s unemployment rate is at 5.3%, down from 5.8% a year ago or its recent peak, and above 4.2% in September 2007, its 33 year low. Where the US Fed dreams to bring rates below zero, the Reserve Bank of Australia has been raising rates since October 2009. (This indicates how strong the Australian economy has been over the past year.) Much like the United States and Great Britain, Australia saw its government swing to the Labor (US equivalents are the Democrats) party after a 10 year run under John Howard and the Liberal Party (US equivalents are the Republicans). The Labor party reacted to the Global Financial Crisis in much the same manner as the US – enacting a massive stimulus program. Among developed countries, Australia’s stimulus was the 3rd highest as a percentage of GDP. With the subsequent performance of the Australian economy, Labor insists it is the right and proper economic steward of the country, claiming the Liberal party will likely lead the country back towards economic crisis with miss-directed economic policies. That is certainly the easiest way in which to interpret the flow of events from the start of the GFC, and one Labor hopes will resonate with the electorate.
However, rarely are things as easy as they seem in matters of economics. Niall Ferguson recently prepared a very succinct and insightful analysis of why the Australian experience differed from the rest of the world in the aftermath of the GFC. Summarizing his main points:
1. Luck that Australia did not suffer materially from a sub-prime loan based housing bubble.
2. Proper financial management under the Howard Government – effectively leaving the national debt level at zero from which the Labor Government was able to run deficits at will.
3. A healthy export market for Australian goods – namely resource based exports. Net AUS exports rose from 2.4% of GDP in q1 ’09 to 5.4% of GDP in q1 of ’10. In particular AUS had increased its ties with China, which was perfectly timed to China’s ongoing demand boom for all things resource oriented.
Ultimately, the fact that interest rates increased since the GFC bottom points to an overheating economy, which begs the question of whether such a strong stimulus really made sense. Understanding why Australia has weathered this crisis so well is important for investors and policy makers around the world. From a policy perspective, it is important to decide whether the above factors drove the Australian economy forward, or was it due to a government spending based stimulus, though programs like that have failed to work in virtually every other Western economy. If indeed Australia’s unique economic circumstances lead the way forward, one has to question whether such a massive stimulus was prudent and warrants continued stewardship of the economy, as higher interest rates resulting from an over-heated economy will lead to reduced economic activity in the future. Certainly it is difficult to link a massive government stimulus to such strong exports, and in fact when one considers the effectiveness with which the stimulus was administered, the case for the stimulus driving the economy becomes fairly weak.
Australians have the ultimate stake in understanding this debate, as they will have elections in a couple weeks, and set the country’s tone and direction for years to come. Far be it for a Yank to understand the political nuances driving a foreign country, though it seems two key issues have emerged which represent a larger set of philosophical differences between the parties. The first is to pass a wind-fall profit tax on the iron ore and coal resource firms. Labor supports the new tax law under which Iron ore and coal will be subject to a new, profits-based Mineral Resource Rent Tax (MRRT) at a rate of 30% on profits in excess of a 12% ROI. The Liberal Party opposes it. While such talk is currently limited to these types of resource companies, only a true naïf believes it would be limited to one group of companies as the tax becomes the country’s reality. It is easy to imagine left leaning politicians clamor that “super profits” from all firms should be controlled and subject to government regulation. Regardless of the revenue raising assumptions behind such a tax, actual receipts will almost certainly fall short of projections as companies will pursue policies to minimize their net income, and thus minimize the tax revenues from such a plan, diverting resources from wealth creating activities. Further, one has to wonder about the genesis of the 12% figure. Why not 10%? Also will the government make investors whole in years when the companies generate “super losses”.
Another issue that has gained prominence during the past month is the construction of a National Broadband Network that the Labor party is pushing, which promises to effectively provide fiber optic cable to all Australian residents in 8 years. The estimated cost of this program is $43 Billion AUD ($39 Billion USD). The Liberal party has proposed a much more modest $6 billion AUD plan to emphasize wireless technologies. Hayek discusses how centralized planning based economies tend to fail because they do not benefit from the amazing price revelation process inherent to voluntary market transactions. So it is with Labor’s decision. If 100 MPS is the right speed for households, why have they not voluntarily demanded such services from existing providers? Is it not the case that everyone would prefer a Mercedes over a Ford, if given one for free? So it is with demand for goods, more is preferred to less when things are free, but only by considering price can wealth creating decisions evolve. Once the government has spent those funds, what happens to consumers and businesses as new and better wireless technologies continue to emerge (which they will as phone based computer capabilities explode as Apple, Google, and RIMM compete for market share with better and more powerful devices)? Might an individual prefer to have slower overall internet connections, but greater portability?
But most importantly, one has to ask if the government should have the right and responsibility to pursue such projects – if the government will provide services so efficiently, why not open food markets and dry clean shops? Rarely does the government provide services more efficiently or effectively than the private sector. The current price for this program, before inevitable over-runs, (When was the last time a government provided an accurate cost projection for a road repair, not to mention such a big and complex project as this?) is already similar to Labor’s stimulus program, which may serve to put further pressure on the RBA to increase interest rates to avoid inflation. From a National Surplus to national debt, the trend is certainly a bit disturbing.
Through AFG’s research across hundreds of thousands of company/year observations, we know that markets react to regulation, taxes, and inflation. Labor’s agenda will make Australia less investor friendly on the first two counts and through stepped up government spending programs that possibly lead to higher inflation in what appears to be an overheating economy. Therefore, it is with great interest that we follow the upcoming election, as a Labor victory will likely result in lower Economic Margins for all firms, and subsequently lower valuations and multiples for traded firms, and reduced overall growth. For US investors, this will ultimately translate into lower Australian strategic allocations for funds invested internationally. For information on how you can incorporate global insights into your investment decision process, please contact your service consultant.
We conclude our July 2010 monthly market review with returns for the US markets for July (from Jun 30 to Jul 30, 2010):
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AFG's Portfolio Performance
AFG's Market Perspective - Long Term
AFG's Market Perspective - 2 Year
Russell 1000 - What's Working
Russell 2000 - What's Working