by David Robertson, CFA
April 2016
Of all the twaddle and rancor emanating from the campaign trail, one message comes through loud and clear: people want change. We can see that sentiment reflected in the unusual success of anti-establishment candidates, in a distrust of institutions in general, and in greater consideration of interventionist economic and monetary policies.
Simply wanting something badly enough is rarely a sufficient condition to make it materialize, however, and frequently strong desires actually impede or obstruct the way to a goal. This was a recurring theme on the old television show, Fantasy Island. On the show, guests could pursue any fantasy, but those fantasies "rarely turned out as expected." Increasingly, continued efforts by public officials, especially through monetary policies, seem like similar fantasies and ones that are also likely to produce unexpected results.
One of the loudest calls for change came during and after the financial crisis in 2008 and 2009. The market was crashing, the economy was unraveling, and as the book and recent movie, The Big Short, highlights, there were heaping portions of ignorance, complacency and malfeasance. Change was needed.
Subsequently, change, of sorts, did happen in various forms. The 2,300 page Dodd Frank act sought to reign in Wall Street and the Fed's emergency measures sought to support the market and eventually re-energize the economy. While these measures did help stave off the immediate emergency, they did virtually nothing to solve the underlying problems. It was like giving a drink to someone with a hangover headache; it eased the pain for the time being, but did nothing to alter the preconditions for the next one.
One particular manifestation of the change mandate was an effort to increase profits. In the absence of sufficient political cohesion for remedial fiscal policy, central bankers took over with monetary policy. One focus of that effort was to stave off the solvency concerns that rampaged through the financial system by allowing banks to gradually recapitalize themselves through essentially subsidized profits. While this effort targeted a real increase in profits, FASB also created the illusion of better profits by significantly weakening the standards for accounting for bad loans (see [here] for an excellent account by John Hussman).
While banks were clearly a focus of such efforts, lower rates and other ad hoc efforts helped boost profits for nearly all companies. Clearly, higher profits addressed some immediate concerns, but as the recent Economist feature article, "Too much of a good thing" [here], highlights, persistently high profits create their own set of longer term problems. Among its conclusions is that high profits conspire to perpetuate incumbency, a result that seems remarkably discordant with the greater public desire for change.
Although on one hand higher profits can denote a healthier economy, on the other, "high profits across a whole economy can be a sign of sickness. They can signal the existence of firms more adept at siphoning wealth off than creating it afresh, such as those that exploit monopolies." Further, "High profits can deepen inequality in various ways. The pool of income to be split among employees could be squeezed. Consumers might pay too much for goods. In a market the size of America's prices should be lower than in other industrialised economies. By and large, they are not."
While the exact causes of corporate incumbency are not clear, the article makes some notable observations: "Business theory holds that firms can at best enjoy only temporary periods of 'competitive advantage' during which they can rake in cash. After that new companies, inspired by these rich pickings, will pile in to compete away those fat margins, bringing prices down and increasing both employment and investment. It's the mechanism behind Adam Smith's invisible hand. In America that hand seems oddly idle."
Consolidation is most likely one factor in reducing competition. The article noted that "The Economist has divided the economy into 900-odd sectors covered by America's five yearly economic census. Two-thirds of them became more concentrated between 1997 and 2012." Increased concentration normally leads to decreased competition which retards evolution and perpetuates the status quo.
Concentration not only increases economic power, it increases political power too. Accordingly, "Business spending on lobbying doubled over the period as incumbents sought to shape regulations in ways that suited them." And power can be used to thwart potential competition: "The ability of big firms to influence and navigate an ever-expanding rule book may explain why the rate of small-company creation in America is close to its lowest mark since the 1970s." Not only has public policy largely failed to eliminate "too big to fail", then, but is has perversely created a landscape in which many firms are "too small to compete," a reality that contrasts sharply with America's entrepreneurial (and faster growing) past.
Another interesting factor which may be contributing to "stickier profits" is "the growing clout of giant institutional shareholders such as Black-Rock, State Street and Capital Group. Together they own 10-20% of most American companies, including ones that compete with each other." Although the authors refrain from claiming that index funds "rig things", they do suggest that "they may well set the tone, for example by demanding that chief executives remain disciplined about pricing and restraining investment in new capacity."
The overall conclusion of the article is that "the American economy is too cosy for incumbents" and that this causes its own set of problems. Interestingly, these problems, which to a large extent stem from interventionist public policy (including monetary policy), very closely resemble the challenges such policy was originally intended to solve: to institute change for the better. Instead, the continued implementation of such policy measures now appears to have much the opposite effect: to preserve and fortify the status quo.
Historically, the answer to slow growth in free economies has been greater competition, and Joseph Schumpeter's concept of creative destruction illustrates well why this is the case. According to the concept, economic growth does not happen in large, monolithic movements, but rather as a constant process of renewal, "incessantly destroying the old one, incessantly creating a new one" [here]. It is akin to gardening in that pruning dead branches allows a plant to divert its energy to more productive growth. In short, creative destruction is the process by which an economy cycles out old ideas, institutions and companies and brings in new and better ones.
Indeed, the Economist article recommends a similar way forward: "A new commitment to competition could be the source of optimism that America is desperately searching for. After all, it is only a healthy dollop of greed and a belief in a better future that prompts people to start from scratch and try to cross the moat that has been dug around corporate America."
All of this creates a bit of a conundrum for investors; what can be done with it? For starters, as economic conditions become more difficult, it becomes progressively more important to view them clearly rather than through rose-tinted glasses. As such, it is important to appreciate that a good portion of the unusually high profits of the last six years or so have been a fantasy and that those days are numbered. This isn't to say that there hasn't been some recovery or that nothing has gotten better; that's not true. But the notion that the economy is "fixed" or that corporate profits are going to remain on a permanently higher plateau is a fiction.
One person who is especially well placed to gauge the current "temperature" of economic conditions is David Golub, CEO of Golub Capital BDC. He noted in the April 26 edition of Grant's Interest Rate Observer that, "a theme we hear over and over is that margins are under pressure." He elaborated that, "They are under pressure for two reasons. One is wage pressure. The second in currency-related - either lower profits from abroad due to currency translation or increased competition from foreign suppliers who are getting the benefit from the strong dollar."
Golub's assessment highlights an upcoming challenge: It would be one thing for companies to confront burgeoning economic headwinds well prepared, but that doesn't seem to be the case. Instead of saving up some its record high profits for a rainy day, corporate America seems to have been doing just the opposite. Over the last year for example, S&P 500 companies increased total debt by 1.3% while reducing net capital spending by 1.8%. While these aren't huge numbers, both are in the wrong direction. Further, debt is outpacing cash flow by the most on record according to an analysis by SocGen and posted on zerohedge [here]. If anything, companies seem to be cannibalizing future growth in order to keep the good times rolling just a bit longer.
This analysis can also help investors evaluate and handicap the consequences of public policy that has come to dominate markets. The growing body of evidence suggests that persistent intervention is not only not helpful, but is actually counterproductive. Not only do persistently high profits disproportionately benefit incumbents, they also hinder real recovery by reducing the rewards to entrepreneurship and impeding the process of creative destruction.
Warren Buffett once advised that, “The most important thing to do if you find yourself in a hole is to stop digging.” As growth begins to slow and most policy tools are used up, it is an imponderable question as to whether public officials will "stop digging" or not. It may not matter, however. As their efforts to boost profits increasingly undermine sustainable growth by rooting out competition, so too do their actions become increasingly disconnected with the original mandate to change things for the better. In the context of progressively louder calls for change, these positions will become increasingly untenable.
In short, investors should start paying less attention to what public officials intend to do and more to what they are likely to be able to do.
April 2016
Of all the twaddle and rancor emanating from the campaign trail, one message comes through loud and clear: people want change. We can see that sentiment reflected in the unusual success of anti-establishment candidates, in a distrust of institutions in general, and in greater consideration of interventionist economic and monetary policies.
Simply wanting something badly enough is rarely a sufficient condition to make it materialize, however, and frequently strong desires actually impede or obstruct the way to a goal. This was a recurring theme on the old television show, Fantasy Island. On the show, guests could pursue any fantasy, but those fantasies "rarely turned out as expected." Increasingly, continued efforts by public officials, especially through monetary policies, seem like similar fantasies and ones that are also likely to produce unexpected results.
One of the loudest calls for change came during and after the financial crisis in 2008 and 2009. The market was crashing, the economy was unraveling, and as the book and recent movie, The Big Short, highlights, there were heaping portions of ignorance, complacency and malfeasance. Change was needed.
Subsequently, change, of sorts, did happen in various forms. The 2,300 page Dodd Frank act sought to reign in Wall Street and the Fed's emergency measures sought to support the market and eventually re-energize the economy. While these measures did help stave off the immediate emergency, they did virtually nothing to solve the underlying problems. It was like giving a drink to someone with a hangover headache; it eased the pain for the time being, but did nothing to alter the preconditions for the next one.
One particular manifestation of the change mandate was an effort to increase profits. In the absence of sufficient political cohesion for remedial fiscal policy, central bankers took over with monetary policy. One focus of that effort was to stave off the solvency concerns that rampaged through the financial system by allowing banks to gradually recapitalize themselves through essentially subsidized profits. While this effort targeted a real increase in profits, FASB also created the illusion of better profits by significantly weakening the standards for accounting for bad loans (see [here] for an excellent account by John Hussman).
While banks were clearly a focus of such efforts, lower rates and other ad hoc efforts helped boost profits for nearly all companies. Clearly, higher profits addressed some immediate concerns, but as the recent Economist feature article, "Too much of a good thing" [here], highlights, persistently high profits create their own set of longer term problems. Among its conclusions is that high profits conspire to perpetuate incumbency, a result that seems remarkably discordant with the greater public desire for change.
Although on one hand higher profits can denote a healthier economy, on the other, "high profits across a whole economy can be a sign of sickness. They can signal the existence of firms more adept at siphoning wealth off than creating it afresh, such as those that exploit monopolies." Further, "High profits can deepen inequality in various ways. The pool of income to be split among employees could be squeezed. Consumers might pay too much for goods. In a market the size of America's prices should be lower than in other industrialised economies. By and large, they are not."
While the exact causes of corporate incumbency are not clear, the article makes some notable observations: "Business theory holds that firms can at best enjoy only temporary periods of 'competitive advantage' during which they can rake in cash. After that new companies, inspired by these rich pickings, will pile in to compete away those fat margins, bringing prices down and increasing both employment and investment. It's the mechanism behind Adam Smith's invisible hand. In America that hand seems oddly idle."
Consolidation is most likely one factor in reducing competition. The article noted that "The Economist has divided the economy into 900-odd sectors covered by America's five yearly economic census. Two-thirds of them became more concentrated between 1997 and 2012." Increased concentration normally leads to decreased competition which retards evolution and perpetuates the status quo.
Concentration not only increases economic power, it increases political power too. Accordingly, "Business spending on lobbying doubled over the period as incumbents sought to shape regulations in ways that suited them." And power can be used to thwart potential competition: "The ability of big firms to influence and navigate an ever-expanding rule book may explain why the rate of small-company creation in America is close to its lowest mark since the 1970s." Not only has public policy largely failed to eliminate "too big to fail", then, but is has perversely created a landscape in which many firms are "too small to compete," a reality that contrasts sharply with America's entrepreneurial (and faster growing) past.
Another interesting factor which may be contributing to "stickier profits" is "the growing clout of giant institutional shareholders such as Black-Rock, State Street and Capital Group. Together they own 10-20% of most American companies, including ones that compete with each other." Although the authors refrain from claiming that index funds "rig things", they do suggest that "they may well set the tone, for example by demanding that chief executives remain disciplined about pricing and restraining investment in new capacity."
The overall conclusion of the article is that "the American economy is too cosy for incumbents" and that this causes its own set of problems. Interestingly, these problems, which to a large extent stem from interventionist public policy (including monetary policy), very closely resemble the challenges such policy was originally intended to solve: to institute change for the better. Instead, the continued implementation of such policy measures now appears to have much the opposite effect: to preserve and fortify the status quo.
Historically, the answer to slow growth in free economies has been greater competition, and Joseph Schumpeter's concept of creative destruction illustrates well why this is the case. According to the concept, economic growth does not happen in large, monolithic movements, but rather as a constant process of renewal, "incessantly destroying the old one, incessantly creating a new one" [here]. It is akin to gardening in that pruning dead branches allows a plant to divert its energy to more productive growth. In short, creative destruction is the process by which an economy cycles out old ideas, institutions and companies and brings in new and better ones.
Indeed, the Economist article recommends a similar way forward: "A new commitment to competition could be the source of optimism that America is desperately searching for. After all, it is only a healthy dollop of greed and a belief in a better future that prompts people to start from scratch and try to cross the moat that has been dug around corporate America."
All of this creates a bit of a conundrum for investors; what can be done with it? For starters, as economic conditions become more difficult, it becomes progressively more important to view them clearly rather than through rose-tinted glasses. As such, it is important to appreciate that a good portion of the unusually high profits of the last six years or so have been a fantasy and that those days are numbered. This isn't to say that there hasn't been some recovery or that nothing has gotten better; that's not true. But the notion that the economy is "fixed" or that corporate profits are going to remain on a permanently higher plateau is a fiction.
One person who is especially well placed to gauge the current "temperature" of economic conditions is David Golub, CEO of Golub Capital BDC. He noted in the April 26 edition of Grant's Interest Rate Observer that, "a theme we hear over and over is that margins are under pressure." He elaborated that, "They are under pressure for two reasons. One is wage pressure. The second in currency-related - either lower profits from abroad due to currency translation or increased competition from foreign suppliers who are getting the benefit from the strong dollar."
Golub's assessment highlights an upcoming challenge: It would be one thing for companies to confront burgeoning economic headwinds well prepared, but that doesn't seem to be the case. Instead of saving up some its record high profits for a rainy day, corporate America seems to have been doing just the opposite. Over the last year for example, S&P 500 companies increased total debt by 1.3% while reducing net capital spending by 1.8%. While these aren't huge numbers, both are in the wrong direction. Further, debt is outpacing cash flow by the most on record according to an analysis by SocGen and posted on zerohedge [here]. If anything, companies seem to be cannibalizing future growth in order to keep the good times rolling just a bit longer.
This analysis can also help investors evaluate and handicap the consequences of public policy that has come to dominate markets. The growing body of evidence suggests that persistent intervention is not only not helpful, but is actually counterproductive. Not only do persistently high profits disproportionately benefit incumbents, they also hinder real recovery by reducing the rewards to entrepreneurship and impeding the process of creative destruction.
Warren Buffett once advised that, “The most important thing to do if you find yourself in a hole is to stop digging.” As growth begins to slow and most policy tools are used up, it is an imponderable question as to whether public officials will "stop digging" or not. It may not matter, however. As their efforts to boost profits increasingly undermine sustainable growth by rooting out competition, so too do their actions become increasingly disconnected with the original mandate to change things for the better. In the context of progressively louder calls for change, these positions will become increasingly untenable.
In short, investors should start paying less attention to what public officials intend to do and more to what they are likely to be able to do.
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