Exploring Four Myths
In talking with investors, I find four concepts prevail among the consensus that I believe may be wrong. In the interest of full disclosure, it is fair to say that at various points in time I have subscribed to each of these ideas. They are:
1. American Exceptionalism is a thing of the past.
2. The price of oil is likely to stay low for a long time.
3. Europe’s economy is in a slow growth deflationary trap.
4. Abenomics is not working, and Japan is in danger of falling back into a recession.
I decided to explore each of these to see whether the ideas are sound, or more in the realm of myths that have somehow gained credibility among investors, without significant factual support.
1. Economic Exceptionalism
There are many observers who believe that, from an economic viewpoint, the United States is no longer the exceptional country it was at the end of World War II. There are some good reasons for this belief. In 1947 America accounted for half of the world’s GDP; that percentage has declined to 24% now, but the global GDP is much larger. Europe and Asia, which were devastated after the war, have fully recovered. China has risen to become the second largest economy in the world from being virtually pre-industrial in the 1940s. There is a widespread belief that the mobility of Americans has declined: children born to those in the bottom two quintiles of income are likely to remain there, and the same is true for the top two quintiles. Even though America boasts many of the best universities in the world, our public school system has produced disappointing results. The United States spends more per pupil than only three other countries (Norway, Switzerland and Luxembourg), according to an OECD study of 34 systems, yet it is in the middle of the pack in reading and in the bottom half in science and mathematics. There are many other measures that would support the view that America is no longer the “exceptional” country it once was, but I thought I would explore whether there were some offsetting positives that might result in a different conclusion.
Looking at the performance of the U.S. equity market, you would certainly think that American companies have a competitive advantage. Since the spring of 2009, the U.S. market has risen over 200%, compared to 108% for the Eurozone, 118% for Japan and 111% for the emerging markets, according to a Goldman Sachs study. The dollar has outperformed every major currency except the Swiss franc. The Goldman study points out that U.S. GDP is 12.9% above its 2009 trough versus 3.8% for the Eurozone and 8.9% for Japan. Our GDP is 8.1% above its pre-crisis peak, while Europe and Japan are still below theirs. Although emerging markets were growing much faster than the U.S., this differential peaked at 6.5% in 2007 and has been shrinking ever since, and is now projected to be only 1.2% in 2015. Since 2007, per capita GDP has risen 14% for the U.S. and 185% for China, but the dollar gap with the Eurozone, Japan and the BRICs has actually increased. Both residential construction and exports in the U.S. have outperformed those sectors in Europe and Japan, according to the Goldman study. American economic improvement has been achieved in spite of a reduction in government spending as a percentage of GDP. Unemployment has declined significantly. Energy has been an important stimulus. Proven oil and gas reserves have increased 55% and 35% respectively, with the U.S. accounting for 80% of the total world increase in energy production. Significantly, the International Energy Agency projects that the U.S. will be the largest oil producer by 2020.
The U.S. accounts for 52% of the value of the world’s publicly traded equities. Since the recession, earnings per share growth has been better in the U.S. than in other countries, with higher return on equity and less leverage. In terms of productivity, the Goldman study quotes Professor Dale Jorgenson of Harvard, who found that since 2007 U.S. productivity has improved 1.2% annually as a result of innovation, compared with .3% in the Eurozone and .5% in Japan. The United States even has some competitive advantages in terms of manufacturing. Unit labor costs are less than in most industrial countries and substantially below those of the United Kingdom and Europe. Only India, China, Thailand and the Philippines have an advantage here. On electricity costs, only Norway has an edge, while Europe and Japan have significantly higher power costs. The U.S. has benefited from other factors. Immigration is an important positive, and monetary and fiscal policy were effective in dealing with the 2008-9 recession. While the United States has many social and government policy problems that are likely to be with us for some time, there is little question that the performance of the economy since the Great Recession has been impressive compared to other industrialized countries.
As we have all learned over time, sometimes painfully, an exceptional economy, just as an exceptional stock, does not always mean exceptional investment performance. Markets and stocks become overvalued, and many think the strong performance of the U.S. market over the past several years means that the indexes will have lackluster performance or even suffer a decline. The bull market has lasted 72 months; the average since 1950 has been 57 months. Investor sentiment is very optimistic, which is usually a danger sign. Interest rates are likely to trend higher, usually a market negative. Finally, earnings are important drivers of stock performance, and overall S&P 500 and company earnings estimates are being marked down. Many companies are guiding analysts to lower their estimates even further. In spite of this, I believe 2015 will be a favorable year for U.S. equities, primarily because market valuation, in my view, is not excessive.
Taking a look at past periods when the price of oil has had sharp declines shows a consistent pattern of rapid, not slow, recoveries. Thanks to the work of Evercore ISI, it is clear that over the last thirty years every major drop in the price of Brent has resulted in V-shaped bottoms, including the recession-related selloffs of 2002 and 2009. The bottom takes several months to form. The prevailing view now is that the price of oil will remain low for a prolonged period because of slow world-wide economic growth and increased production. Since the price of oil peaked, the rig count has declined from 1900 to 1300 units. A low rig count usually means that future production will fall off as existing wells mature. The first low in the oil price is usually followed by a test of the price when storage facilities are filled, as they are now, and production continues. The oil has to be sold somewhere. If that pattern is followed, we should see the lowest point soon. A reason for the possible more rapid recovery in the oil price is the continuing increase in demand from the emerging markets, primarily China, India and the Middle East, as well as some modest growth in the developed economies. Only slight economic improvement is expected from the United States, Europe and Japan.
The argument against history repeating itself is that production from shale has changed the outlook. Shale oil was unimportant in earlier cycles, but it is a major factor now and, as the price of oil moves up, more shale oil will come into the market, limiting the rise. Whereas the lifting cost for shale oil was estimated to be $80 three years ago, technological improvements have brought this down to a $50 to $60 range now. Global (non-U.S.) oil production (OPEC and non-OPEC) has been essentially flat since 2004. At present OPEC is producing above its quota, so there must have been some reduction in output from non-OPEC countries. The swing factor has been U.S. shale production, which has risen sharply since 2010. Looking at a survey of the breakeven lifting costs for the major shale formations cited in a recent J.P. Morgan report, most are above $50 (20 out of 26), which is higher than the current market price of West Texas Intermediate oil. As a result, shale production is likely to remain modest until prices rise. A West Texas Intermediate price of $60 would be quite favorable for the shale producers, but that would represent a sharp recovery from the low in the $40s. A recovery to $70 would also go a long way to dispel deflation fears. Another factor which could keep oil prices from rising is the lifting of sanctions on Iran as a result of the nuclear weapons agreement. This could cause an increase in oil imports from that country. Also arguing against the near-term rise in oil price is the sharp rise in the long positions of speculative commodity funds. The last time this happened was when oil was $107. Nonetheless, I’m still looking for oil to rise between now and year-end.
In Europe, the Purchasing Managers Index for both manufacturing and services is currently signaling economic expansion. With the European Central Bank beginning a program of monetary easing, growth should pick up even further. At the beginning of the year it looked like problems in Greece and Russia would push Europe into a recession and the continent would experience deflation as well. I was skeptical that monetary easing by the European Central Bank would change this course. Now, three months later, the outlook has improved. The combination of lower oil prices and a decline in the euro has helped the consumer and increased exports. In Germany, the most important European economy, the Industrial Production Index now is in growth territory. Consensus estimates of real GDP increases for the continent are in excess of 1%, according to Strategas Research Partners. Unemployment is down to 11.2% and German retail sales in January were up 2.9% month to month. Consumer confidence is rising almost everywhere. Even Spain and France are looking better.
Two developments have taken place over the past month that have improved the European outlook. The first is that a ceasefire has been declared in Ukraine which looks reasonably firm. That is because Russia has, in effect, taken over the eastern territory the separatists have gained in battle. The second is that a Greek default or defection from the European Union is more clearly not going to be the catastrophe it was thought to be in 2010. That is because much of the Greek debt that was on the books of Greek and European banks has been transferred to institutions like the European Central Bank, reducing the risk that Europe’s banks would be in serious trouble if these loans were not repaid. Much of this good news has been reflected in the performance of the European equity markets, but the rise in the dollar has diminished the impact for U.S. investors.
The increase last year in the value added tax in Japan dealt consumers a powerful blow, but the drop in the price of oil was the equivalent of 2.1% of GDP, and this was, according to a study by Observatory Group, bigger than the impact of the tax increase. The decline in the yen versus the dollar has given a boost to Japanese exports. Wage growth should result in modest inflation (1%) and encourage Japanese consumers to start spending their $10 trillion cash hoard instead of parking it in bank deposits. This will take the pressure off the Bank of Japan to provide additional monetary easing. In addition, Japanese corporate profits were strong in 2014 and look even better for this year. Finally, the second increase in the value added tax planned for this year will be postponed.
The Japanese Financial Services Agency has put an improved governance plan into place, according to Observatory Group. This plan should reduce cross-shareholding and cash hoarding. At annual meetings this year, CEOs will have to demonstrate how they are complying with the new code or explain why they are not. The government has shown a willingness to be helpful in implementing regulatory reforms, the so-called Third Arrow, to encourage companies to be innovative, to spend money on capital projects and to increase wages. This should put Japan on a path toward 1.5% to 2% inflation and growth in excess of 1%, which would be positive. If the increase in inflation and growth does not happen because of natural economic forces, the Bank of Japan will increase the money supply to make it more likely. Either way the outlook for the Japanese economy and its stock market is favorable.
According to 13D Research, Japanese return on equity has risen to 8.3%, up from 5.7% two years ago. The number of bankruptcies of small and medium-sized companies is at a 24-year low. More than 80% of college graduates have unofficial job offers. Last year saw the largest wage increases in the past 15 years. Share buybacks in 2014 were at a record and they are continuing. Japanese equities have also responded to the improved economic conditions and the rise in the dollar has had less of an impact than it has had in Europe. Judging from data from fund flows, investors have not embraced Japanese equities with the same enthusiasm that they have shown toward Europe.
The positive view of Europe and Japan indicates the economies of the major developed countries are recoupling with the United States rather than decoupling, which was the view at the beginning of the year. In my talks with portfolio managers during the past month, many agreed that the Four Myths might, in fact, be “myths” and the last three of them were “actionable.” One pointed out, however, that they were “fragile” and that I should watch them closely because events could transform one or two of them from a myth to reality very quickly later in the year. I will.