Posted by David Tillson 2014 Third Quarter Commentary
Two problems that we see today that may impact the future earnings power of companies are the developed world’s buildup of government debt and the issue of income and wealth inequality. Why should we be concerned about such macro issues when companies can do little to change the outcome and when their impact is probably at least several years in the future?
Third quarter performance for the market was relatively calm with the S&P 500 Index rising about 1%. Volatility was low with only a late July swoon marring the pattern of slowly rising stock prices. For much of the quarter world economies were still expected to grow modestly, interest rates remained low and the geopolitical situation, while unsettling, was not materially shaking investors’ confidence. But then October arrived, shall we say “right on schedule.” The October Effect is, in theory, the tendency of stocks to decline during the month. While it is considered to be more psychological (due to some major market crashes in the past) than an actual phenomenon, markets did experience a nearly 10% correction from their highs as of October 15th. The reason for any market correction is usually an actual event with an emotional reaction, and in this case, it probably was one or more of the following: the continuous unsettling news of the Russian/Ukraine turmoil, slowing economies in China and the Eurozone, the end of the Fed’s bond buying program, the “war” with ISIS and finally, Ebola. Of these, the slowdown in Europe is the most concerning to us because it may change the future earnings power of companies. The others will likely be seen as just noise in the continuum of history.
As long term investors in companies, we aim to stay focused on individual companies’ earnings prospects while still being acutely aware of the major social and economic changes that can impact business fundamentals. While keeping in mind that with every problem there is an opportunity, two problems that we see today that may impact the future earnings power of companies in which we invest are the developed world’s buildup of government debt and the issue of income and wealth inequality. Neither of these issues is likely to result in an immediate impact to companies, but over the longer term, we could see societal shifts that will. Why should we be concerned about such macro issues when companies can do little to change the outcome and when their impact is probably at least several years in the future? It is simply because well before they reach a crisis stage, these issues will begin to shape the environment in which companies must operate. The first issue is one of basic accounting while the second is one of perceived fairness, and as the first is addressed, it is probable that the solutions will spill into the second.
Since the Great Recession, individuals and corporations in the developed world reduced their borrowings along with their risk taking. Governments, on the other hand, increased their debt levels through deficit spending while central banks embarked on various Quantitative Easing (QE) stimulus programs trying to promote investment which would lead to economic growth. The low interest rates policies have increased risk taking, but it appears that it has not had governments’ desired effect of substantial increases in investment and employment. We remarked in last quarter’s letter that any economy is merely the trading of goods and services and that savings is simply consumption that has been deferred. If too many people defer consuming some of what they earn, the economy will slow, but those savings must reside somewhere. In the old days, the grain which was saved for the winter was in a storehouse. Today the savings are in banks (and bonds). Today’s economies are more complex than in the past, but the basic tenets are the same. Currently storehouses are packed full with people’s savings but few people are willing to risk these savings to build a new one (invest and hire employees). The world has an excess of savings and a dearth of investment since many investors are not willing to risk their savings by making an investment where they can lose it all. They are however, willing to buy financial assets, in part because they feel that they are being supported by the central banks’ and government programs.
In the past six years, the world has witnessed some seemingly rational behavior with some surprising unintended consequences. While this may be a behavioral economist’s dream, it can turn into a policy maker’s nightmare. Massive government spending and central banks’ quantitative easing programs did prevent a probable deflationary depression, but it also was expected to spur economic growth. Instead, growth in the US has been stubbornly slow and the Eurozone is teetering on the edge of its third recession since 2007. Two of the unintended consequences are that risk-averse savers are “taxed” with artificially low interest rates and the wealthy have become even richer due to these government policies. Recessions and stock market declines often induce people to exit the market at exactly the wrong time. The Fed’s Survey of Consumer Finances shows that among the bottom 90% of households by wealth, families bailed out of the stock market between 2007 and 2010, thus locking in their losses and missing the rebound in stock prices. Some of the selling was necessary, such as needing funds after losing a job, but much of it was due to fear, and many of the 90% never did get back into the market. Their assets instead have been parked in low interest rate CD’s or bonds, which has exacerbated the problem of preserving one’s purchasing power. Consider the following: the US Federal Reserve has a long term inflation target of 2.0% and the yield on a 10 year US Treasury Note is 2.26%. This means that if the Fed is successful in reaching its inflation target, an investment in the 10 year Note will just barely maintain its purchasing power – before taxes! The Germans and Japanese may be even less fortunate since their 10 year note yields are 0.83% and 0.46%, respectively, which signifies that either the “tax” on their savings is more onerous than ours or they are facing deflation.
Japan and many governments in the Eurozone have large amounts of debt already outstanding, are continuing to run budget deficits, and have massive unfunded pension/social programs. Populations are ageing, taxes are already high, and government regulations are often unfriendly to businesses. The U.S. is not yet in the same predicament as these countries, but is moving in that direction. Everyone is aware that an individual or a corporation cannot borrow too much without eventually having to pay it back, or at least be able to service the debt. Governments are different, but it is still an open question how all of this excess liquidity will be resolved. One solution is economic growth; a second is inflation – simply make the debt worth less in the future. Growth is the ideal solution but difficult to achieve as emerging market countries want to catch up to the U.S. and Europe. A 1970’s style inflation would fairly quickly make current debt less of a problem, but the dilemma with inflation is that interest rates will rise, threatening those countries’ ability to pay the interest due. As an example, the U.S. with $18 trillion in total debt outstanding would incur additional interest payments of nearly $1 trillion if interest rates rose only 5%, taking more than a quarter of our current federal budget. We can only imagine the Congressional budget discussions: massive cuts to social programs and massive tax increases - all while trying to grow the economy and employment, and get reelected. This is where too much debt and too many promises interact with income and wealth inequality.
Inequality has become a much more discussed topic recently. Part of it is political but as readers of some of our past letters may recognize, it is also a normal behavioral economics issue. People do not want everything to be equal, but they generally do want them to be fair, and they would like the same access to opportunities as anyone else. Most people would not work very hard, take risks to build something new, or try to better themselves if the results were the same. The challenge is to balance the rules, laws and social norms so that everyone feels that they have a seat at the table and a stake in the outcome. Federal Reserve Chairwoman Janet Yellen recently said that rising inequality of wealth and income in the U.S. was impeding the economic mobility at the heart of American values. She noted that this disparity has been growing for decades, in part because housing is the primary asset for the majority of households and that those at the very top are most likely to own stocks. She did not address Fed critics’ arguments that the central banks’ bond buys and zero interest rate policies have contributed to inequality, but did counter that their policies are aimed at boosting the overall economy, thus helping lower income Americans.
We share Janet Yellen’s concerns and one need only remember the 2011 Occupy Wall Street movement to understand the gravity of the issue. We believe that any solution must start with government since only they have the power to regulate behavior, set tax policies and encourage investment. The best outcome would be to recognize our problems and address them in a bipartisan way, stop kicking the can down the road, work toward raising the standard of living of the middle class and sincerely focus on growing the economy. The worst outcome will be for politicians to focus only on getting reelected by fostering even more of a “we versus they” mentality, to continue to allow debt to rise to unsustainable levels, and to focus only on how to carve up the pie rather than making it larger. Every generation faces challenges and with rare exception, societies evolve and survive. For those of us who are still around in 2050, we will probably live in a very different world than today. But we will also probably still be buying goods and services from Procter & Gamble, GE, CVS Healthcare, Exxon and JP Morgan. Our job remains finding companies in which to invest that are financially strong, are capable of growing their earnings and dividends, and that have the ability to adapt to change.