During the second quarter, the stock market continued to rebound from last year’s fourth quarter swoon. This reflected the recognition that neither the trade war nor Federal Reserve (Fed) monetary policy was about to torpedo the long, slow recovery from the 2008 housing debacle. U.S. domestic economic growth remains steady and non-inflationary. The pace of economic activity moves up and down quarter-to-quarter, but remains positive. This raises two questions: 1) What happened to the business cycle? and 2) Where is inflation?
On the one hand, this recovery cycle is unique in that it was preceded by a massive housing boom and ensuing bust. Recall that the housing boom was fueled by a ludicrous lowering of credit standards and an irresponsible leveraging of the banking system. When the boom turned to bust, the banking system was severely crippled and was forced to deleverage, resulting in a long period of sub-trend housing activity, tighter lending standards, and weak growth in bank loans. As a result, the velocity of money – a key driver of inflation – declined.
On top of this idiosyncratic aspect of the recovery, there were powerful structural shifts within the economy, which have also kept a lid on the speed of the expansion and on inflation, and thereby enhanced the durability of the recovery. It is here that we want to focus today. We are now ten years into an expansion and yet we see no real signs of an imminent recession. There have been periods of slowing growth, but no recession. Slowdown maybe, recession no.
What happened to the business cycle? Historically, the business cycle could be thought of as a giant inventory cycle, which could be quickened or slowed by monetary and fiscal policy shifts.
Historically, the Fed would lower interest rates during a recession to stimulate housing and auto demand. And Congress might do some deficit spending to create additional demand. These actions would get the economy moving. Usually the recovery would be sharper than our recent experience and bottlenecks would appear. Buyers would begin double ordering goods they needed to make their products. Wholesale prices would move up – as would retail prices – and inflation would start to accelerate. Higher prices would cause manufacturers of intermediate goods to expand capacity. Producers of finished goods would see their orders filled and suddenly they would be saddled with more inventory than they wanted – remember they had double ordered. So, they stopped ordering. As a result, manufacturers of intermediate goods would see orders plummet and they would respond by shutting down production lines and laying off workers.
Meanwhile, the Fed would have become concerned about inflation and would have started to raise interest rates to choke off homebuilding and autos. As housing and auto demand collapsed, more workers would be laid off and “voila” we would be in recession. And then the whole process would start over. A few years of boom, a year or two of bust, and back to boom, etc.
This boom/bust cycle seems not to work anymore. According to the Wall Street Journal (6/18/19), construction and manufacturing jobs accounted for about 25% of total U.S. employment in 1980. Now they comprise only 13%. This means that the boom/bust cycle that we described above does not have nearly the same impact as it used to.
Add to this the very significant impact that technology – the digitization of the economy – has on inflation. As we have argued before, technology is massively deflationary, both in terms of technological products and services themselves, and in terms of the productivity enhancements of general business processes. As technology becomes an ever-bigger part of the economy, its deflationary power grows.
As the economy shifts from physical goods to software and data, the concept of inventory cycle to some extent becomes obsolete. Do we worry that Google will run out of search capacity? No. Do we worry that Facebook will run out of social networking capacity? No. Yes, they must build data centers to accommodate increased demand, but for the most part data or software-driven goods and services are a story of increasing scale and decreasing marginal costs. The benefit to the consumer is clear: the more you use, the cheaper it becomes. The benefit to the overall economy is less clear as bits don’t drive job creation in the same way as wood, concrete, hammers and nails.
Thus today, as the economy expands, bottlenecks and shortages don’t appear, prices don’t go up. Hence the recovery lasts longer, and the Fed is not compelled to raise interest rates in order to control inflation by engineering a slowdown or recession. End of the business cycle? Ten years into a recovery, the U.S. now has the lowest unemployment rate in 50 years and wages are starting to accelerate, all of which is great for the consumer (roughly two-thirds of the economy). But thanks to the deflationary impact of technology, general inflation is still tame. The expansion is therefore poised to continue.
What we would argue is that the expansionary phase of the modern business cycle can last longer (as it has) and be far less inflationary than it was historically. But we continue to believe in the business cycle. Eventually, there is bound to be a slowdown and even a recession, perhaps due to an exogenous event, and this is the subject that attracts our biggest concern. The risk is that in a somewhat deflationary environment, such a downturn might also last longer than historic averages for the simple reason that the Fed never seriously raised interest rates so it may not be able to accomplish much by cutting them. We worry that we could be in a “pushing on a string” world, where monetary policy has lost much of its punch, leaving fiscal policy as the tool of last resort. And in a fractious political environment as exists today, that fiscal policy tool could prove much less effective than in previous downturns.
Given these concerns, we believe it is important to concentrate investments in companies able to grow in all economic environments. Such companies are either riding a durable technological trend or have very company-specific drivers of success. The latter would include companies with new products and companies experiencing a major turnaround. We want to avoid also-ran companies struggling to compete or companies subject to a great deal of cyclicality (unless, of course, we can pick them up at the bottom of the cycle). At this point in the cycle, we want to own companies with strong balance sheets and ample cash generation ability. In sum, we want to focus on companies able to compound earnings and cash flows over an extended period through both good times and bad.
Before concluding this Outlook, we want to address the other question raised in the first paragraph, namely what happened to inflation.
The current lack of inflation appears to be largely driven by three secular trends: demographics (aging population), globalization and technology. Because technology is becoming an ever-larger part of the economy, one needs to ask whether the era of low inflation could morph into outright deflation. If so, what does that mean? We have not seen any substantive commentary on this question but suspect central bankers must be thinking about it. The evidence of strong deflationary forces is simply too great to ignore. Below we cite some of the more stunning examples.
Technology
Cloud computing costs have declined by over 90% from 2008 to present.
Energy
Since 2010, the levelized cost of electricity from wind and solar has declined nearly 75%, or about 15% per year. Within a couple of years, wind and solar are on track to be the cheapest forms of energy without subsidies. Meanwhile, fracking has brought down the cost of producing oil and natural gas by about 40% in certain regions.
Health Care
Generic drug pricing has been in freefall for several years, declining some 4% per year. Generics now account for about 90% of all prescriptions in the U.S. The cost of genome sequencing has plummeted from $100,000 per genome to around $1,000.
Financial Services
Discount brokerage fees have declined an average of 4% per year since the first quarter of 2004.
Consumer Non-Durables
The intrusion of Amazon into multiple areas of retail has all but obliterated traditional retailers’ pricing power. Because consumers now have the ability to price comparison shop on their smartphones, retailers have to compete more aggressively on price than ever before.
Perhaps just as importantly, firms like Google and Facebook offer consumers free services – search and social media – which makeup an ever-larger share of the consumer’s “shopping basket.”
Whether these trends contribute to low inflation or more ominously portend a deflationary future remains to be seen. For the moment, we would bet on low inflation. Record low unemployment is causing some labor shortages and is leading to a modest uptick in wages, thus creating some cyclical upward pressure on inflation. Offsetting that is the growth in technology, the benefits from globalization and the impact of demographics. The demographic shift to an aging population also contributes to a deflationary trend. As people approach retirement age, they tend to spend less and save more, thereby causing economic growth to slow and at the very least relieving some inflationary pressure.
In future Outlooks we will examine deflationary forces in greater detail, try to understand what a deflationary world might look like and develop a cogent strategy for investing in such a world. As a starter, we would posit that if indeed the economy does slip into outright deflation, it would be important to invest in the companies causing deflation, such as technology leaders, and to avoid those harmed by it. We would also seek to invest in companies with the greatest pricing power, enabled by competitive position, brand strength, or other attributes. Please call us with any comments or concerns.
Sincerely,
John Osterweis
Past performance is no guarantee of future results. Index performance is not indicative of fund performance. To obtain fund performance call (866) 236-0050 or visit osterweis.com.
This commentary contains the current opinions of the author as of the date above, which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
Earnings growth is not a measure of the Fund’s future performance.
Cash flow measures the cash generating capability of a company by adding non-cash charges (e.g. depreciation) and interest expense to pretax income.
Free cash flow represents the cash that a company is able to generate after laying out the money required to maintain and expand the company’s asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value.
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© Osterweis Capital Management
© Osterweis Capital Management
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