Volume 58, Number 8 | February 25, 2011
Real GDP growth was revised down to just 2.8% annual rate for the fourth quarter of 2010, and nominal GDP – best thought of as cash register receipts – grew at a very modest 3.2% pace, as inflation rose at only a 0.4% annual rate in the final quarter of 2010. After the revisions, real GDP growth for the four quarters of 2010 was just 2.7% — split almost exactly evenly between the first half and second half of the year. Moreover, both final sales to domestic purchasers and private sector GDP were roughly equal in the first and second halves of the year. This means that neither trade, nor inventories, nor government spending showed much volatility over the year. Indeed, about the only discernable difference in growth from the first half to the second was stronger growth in personal consumption – concentrated in automobile sales – and weaker investment growth in both equipment and construction. We read this as the positive effects of QE2 lifting the stock market and spurring luxury sales – especially autos. With the 100% expensing rules now in place for 2011, autos are strong out the gate in January and February (as are class 8 truck sales) but we wonder if this will have legs. The weakening investment in the second half reflected a sharp slowdown in domestic profits growth from a torrid 34% annualized growth rate in early 2010, to just a 4% growth rate in the second half – and an estimated decline in the fourth quarter. Despite the strength in manufacturing, we still see first quarter real GDP growth in the low 3% range and the GDP deflator no higher than 1% — leaving still meager 4-4.5% nominal GDP growth. That is not the kind of income growth that leads businesses to add lots of employees or make big investments – as was reflected in the second half of 2010.
We admit that we currently have an out of consensus view. We are much less certain about the sustainability of the current expansion beyond 2011 than the consensus. The following provides some insight into how we view the current economy from a historical perspective and why we think it is critical to at least examine the possibility of a slump in 2012 – which could have profound economic consequences as we would enter the downturn with a 9% unemployment rate and a 9% of GDP budget deficit. I hope we are wrong, but prudence suggests that investors prepare themselves for a more volatile and uncertain future – as the events of the past month show — with both greater potential risks and returns for active participants and near zero returns for passive observers.
What Kind of Cycle Are We In?
The dynamic of a cycle are largely determined by the nature of capital spending that drives the expansion. In the post war period up until 1980, the US economic cycle was largely dominated by inventory cycles, with wild short swings in production of durable goods. The cycles averaged about four years in length, and were noticeable for the excess of inventory building at the top of the cycle and offsetting draw downs at the bottom. As production could be quickly ramped up or down to meet projected needs, the period of investment in inventories was relatively short, and so was the uumph to the expansion. By contrast, after 1980, economic cycles were more heavily driven by longer term capital investment. In the 1980s, the Reagan defense buildup provided a steady diet of higher capital spending that sustained the expansion for almost a decade. In the 1990s, after a slow start, it was the tech boom that provided ever stronger investment toward the end of the decade. And, over the past cycle, it was investment and ultimately vast overinvestment in housing and real estate that sustained the cycle. Note that the exceptions to the short cycles in the early post war period were a volatile but sustained uptrend in the 1960s, when the government was funding the space race, and the late 1970s when virtually every piece of industrial equipment in the world had to be replaced because of the oil shock.
We are concerned that we have returned to shorter inventory led cycles, like in the 1950s- 1970s. First, there does not appear to be a capital spending impetus for this cycle now or in the near future. Housing is a wreck compared to traditional levels of investment, accounting for only 2.2% of GDP compared to the 5.3% averaged during the six year period from 2002-2007. However, every other form of investment is also underperforming historical standards: equipment spending is down -0.6% of GDP, nonresidential investment -0.3%, government investment down -0.3% and consumer spending on durables down -1.1% of GDP. For the past seven quarters, total investment in the US economy has failed to exceed depreciation, meaning we are running down our capital stock – a natural reaction to earlier overbuilding, especially in housing, and a necessary step at the individual level in rebuilding financial savings. Unfortunately, the reality remains that if everyone saves and no one risks an investment, the economy won’t expand and interest rates stay near zero to discourage saving and spark investment.
A curious by product is that the lack of investment causes bottle necks which dramatically drive up the price of some goods – currently food and energy. In the short run, rising prices compared to zero rates will lead to hoarding exacerbating the rise in those particular prices. However, this is neither inflation nor sustainable. The consumer has no more income with which to pay the higher prices because financial investment – unlike real capital investment – creates no jobs. Ultimately, they will have to spend less on items with rising prices or cut back elsewhere reducing overall production. Hoarding is effectively a short cycle phenomenon like inventory building. Real sustained growth comes when an investor commits to building additional capital stock which will increase production of the scarce goods down the road, and employs someone to make the machine. Now incomes rise and higher price are justified, sparking even more investment until eventually new supply curbs the expansion. The longer the commitment to investment — like the space race, or an arms build up, or a tech boom that destroys capital as it grows, or multi-year real estate projects — the longer the cycle. There appears to be little appetite for long term investment in the US – or the rest of the developed world – today.
This marks a profound change from the environment that prevailed from Reagan to Lehman. After the Volker squeeze, the path to profits became clearer and clearer as interest rates and inflation fell steadily, and lower tax rates and regulation freed up markets. Essentially the investing environment went from a narrow winding mountain pass without guardrails to a flat Nevada six lane with no speed limits on which the biggest risk takers got there fastest with a few notable wrecks. Driving a mountain pass even with guardrails requires the driver pay more attention regardless of speed.
What About the Long Cycle
We are a big believer in the Kondratieff Wave, or more to the point that generational cycles exist. In our view there have been three major events that have shaped economic behavior over the past 120 years – the Panic of 1894, the Great Crash of 1929, and the Fall of Lehman in 2008. All three were preceded by periods of intense wealth consolidation – the robber barons, the roaring twenties, and the as yet unnamed past decade. This almost by definition means that there was also a massive upswing in the use of debt as those that controlled the wealth lent it to others to make investments. As wealth consolidated further through the use of leverage, the ever increasing risk led to a Minsky moment – a time when new loans ceased to fund investments, but rather speculative ventures which depended on a greater fool paying a higher price to generate any return. When the bubble popped, what looked like investment was revealed to be a mal-investment (or consumption) and a massive downward adjustment in lifestyle was required to reestablish real savings for real investment.
In the aftermath of these great crises, the consolidation of wealth that had occurred reversed – but not right away. After the Panic of 1893, William McKinley became President as Republicans fended off the free silver movement of William Jennings Bryant. However, following McKinley’s assassination in 1901, Teddy Roosevelt unleashed the Progressive Era. By 1920, four new amendments had been added to the US Constitution: women got the vote, direct election of Senators, prohibition, and the income tax. These greatly shifted control of the economy toward the less fortunate at the expense of the wealthy. There is little need to address the programs that followed the election of FDR in 1932 – but it is crucial to remember that it took from October 1929 until March 1932 before the shift began and even then it was by no means immediate. The bottom line is we suspect a significant global redistribution of wealth is likely in the coming decade or two. It maybe take its primary form as a rising tide in emerging markets – however, a narrowing of budget deficits in the US is likely to reduce business profits as well. Whether the government spends less on goods and services or raises taxes, businesses end up with less income. Even if the government cuts entitlements or taxes only the poor, it still hits the entrepreneur as his customers have less money. To increase government saving – that is reduce the deficit – you have to reduce business savings, which means spread the wealth. Forewarned means forearmed, so investors need to remain active to insure it is not their wealth being spread around.
The Big Picture
The single greatest force driving economic events for many coming years will be the convergence of earning power in the emerging markets with incomes in the developed world. The fall of communism released hundreds of millions of workers from China, Russia, and even India onto the world markets. The process is continuing even now with new Middle Eastern countries coming out from under their dictator’s thumb. As these new market participants see their incomes grow, they want stuff – more and better food, housing, clothing, appliances… To make this stuff takes resources and so raw material prices have been under steady upward pressure. The purpose of the higher prices is so consumers in the developed world consume less, freeing up resources for the emerging markets. Unfortunately the process is not so smooth, because the consumer in the developed world does not want to give up their resources. When oil prices rise, rather than using less fuel by driving less, the consumer adjusts by still buying oil but cutting back elsewhere – and particularly on items that are high in developed world labor. US consumers still drive, but they eat more at home to cut out the waitress’ tip, or shop at WalMart instead of Macy’s to save on customer service. This puts the burden of the adjustment on the unlucky few who lose their jobs, but even they sustain their consumption of goods and cut back on areas like education and health care. Thus, the prices of commodities stay sticky and high and the brunt of the adjustment is in a higher unemployment rate in the developed world.
How long can this convergence go on? How soon will labor costs in the emerging markets reach some reasonable standard? In China, the average income per capita is now $4,500, roughly equal to Iran or Thailand. If they doubled, they would reach Mexico, or Brazil or Russia. Quadrupling would bring them to Taiwan or the Czech Republic. That might be a reasonable level, but it would take a ten-fold increase to reach the US or Western Europe or Japan. India is even lower on the scale at $1,150 per person. In populous Indonesia and for the 80 million newly freed Egyptians annual income is about $2,800. It will take many years before the balance is reached, so commodities remain a center of the plate investment.
Who Drives the Cycle?
Another key reason we are concerned about 2012 is that the leaders of the world economic cycle, are tightening their policies aggressively in an effort to get runaway inflation under control – which does not bode well for growth after a long and variable lag. China is now a $6 trillion economy growing at about 20% in dollar terms – 10% real growth, at least 5% inflation and 5% appreciation in the currency. That means it will contribute $1.2 trillion to world growth in 2011. Meanwhile the US is a $15 trillion economy which will grow about 4% in 2011 – 3% real and 1% inflation – generating roughly half the growth seen in China. Europe’s $16 trillion dollar economy will grow even more slowly than the US and Japan not at all. Is it any wonder that companies all over the world are focusing on the emerging markets — and just not China.
Over the past five years, all of the BRICs have all had exceptional growth, as have Indonesia and Australia. India and China provide the bodies eating one more egg apiece, while Brazil, Russia, Indonesia and Australia are more pure commodity plays. As many investors learned during the gold rush, you can make a lot of money selling the miners their picks and shovels. Indeed, the recent global bottle necks that are driving up food and energy prices suggest that the upper hand has shifted at least for the moment from the producers to the suppliers. This is just one more brake on the Chinese juggernaut that leads us to worry about 2012. We are headed to Hong Kong Saturday and will return through Beijing. We will let you know next week what we learned along the way.