Posted on July 10, 2014 by David Laidlaw
One of the most notable characteristics of the economic recovery from the financial crisis that developed in 2007 and 2008 is the extremely slow pace of economic growth. The recession officially ended in the second quarter of 2009. However, since then, the US economy has only grown by 10%. The latest revision to economic growth by the Bureau of Labor Statistics reported that the United States economy shrunk at a rate of 2.9% during the first quarter of the year. While some of this shrinkage was due to inclement winter weather, a healthy economy would not have contracted at this rate.
The first chart plots cumulative economic growth between the end of each recession noted and the subsequent 4.75 years. The second chart records the cumulative change in the S&P 500 since the beginning of the economic expansion. The periods are Early 80s: 10/1/1982-6/30/1987; Early 90s: 4/1/1991-12/31/1995; Post Tech Bubble:10/1/2001-6/30/2006; Post Financial Crisis: 7/1/2009-3/31/2014.
The slow rebound in economic growth is not limited to the United States. Europe’s banking crisis was deeper than our own and the Euro-area’s policies much less effective in clearing the bad debt from its international banks. Therefore, growth there has stalled to an even greater extent. Japan continues to stagnate after three decades of contraction. Finally, while still growing, the rate of expansion in China is slowing further as the country’s transition from an export led economy to one led by internal consumption has proven difficult.
Corporations have been very adept at increasing their levels of profitability even though economic growth has stalled. The first strategy was to fire employees and require the remaining labor force to work harder or face a similar fate as their colleagues. This strategy caused profits to jump since labor is the largest expense for almost any business.
The most recent maneuverings by corporate managers to increase profitability without growing revenues involves taxdriven Mergers and Acquisitions. The United States taxes multinational companies’ profits at a 35% rate, which is the second highest rate in the world after Japan which charges 40%. A number of US-based companies are now strategically acquiring or merging with foreign businesses in lower tax nations so that their combined businesses can then be taxed at the lower foreign rate. This practice is known as a “tax inversion” and is happening with greater frequency.
A recent example includes Medtronic’s proposed acquisition ofCovidien. Both companies are in the medical device segment and may benefit from jointly marketing their products to large purchasers, such as hospitals. However there appear to be limited operational synergies between the two companies. Medtronic designs and sells high-end devices such as cardiac defibrillators, stents and spinal cages. Covidien makes a broader array of products including surgical sutures and staplers. However, Covidien is based in Dublin, Ireland and pays a corporate tax rate of 12%. Therefore, Medtronic is happy to pay a 29% premium for Covidien so that it can then domicile in Ireland and reduce its tax rate substantially.
There are many other examples of these “tax inversions” including the current pursuit of United Kingdom based Shire by Abbvie, a US based spin off of Abbott Labs. Even though Pfizer’s attempted acquisition of Astra Zeneca fell through, tax strategies were one of the driving rationales since Pfizer would have been able to change its tax domicile to the United Kingdom (corporate tax rate of 21%).
Corporate managements are very clever and pursuing tax strategies such as inversions increases the cash flows to which shareholders are entitled. However, there are limits to the amount of profits that can be generated if underlying revenues are stagnant or growing very slowly.
The stock market has continued to rise significantly even though dynamic growth has been very limited. The second quarter represents the 6th quarter in a row during which the market has increased in value. For the first half of this year, the S&P 500 has advanced another 7.1%. This advance comes after annual increases of 16.0% and 32.4% in 2012 and 2013 respectively.
Relative to bonds, which are still providing historically low yields, stocks are attractive. However, stock market valuations are getting extended, especially in light of slow economic growth. As depicted in the chart on the first page, the market has increased by almost 100% compared to the economy which has only grown 10% since the end of the recession in the second quarter of 2009. This stock market rebound only trails the asset price increases experienced in the early 1980s, while the economic rebound is the slowest on record in the last 35 years.
We are not predicting an imminent sell off, but at some point in the future, corporate managements will run out of strategies to increase profits meaningfully. Without economic growth, the stock market will not be able to sustain its unending gains.