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ContraryInvestor

ContraryInvestor

Contrary Investor is written, edited and published by a very small group of "real world" institutional buy-side portfolio managers and analysts with, at minimum, 20…

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Looking For Love In All The Wrong Places?

Looking For Love In All The Wrong Places?...We are all very much aware of the change in market tone and sentiment over the last four to five months. Strategists and investors fretting over rapidly deteriorating macro leading economic indicators (remember the ECRI reaching levels always consistent with recession?) and contemplating the possibility of a double dip in late summer of last year has given way to these same folks now trying to one up each other in putting forth ever higher domestic GDP growth estimates for the new year. Goldman (Jan Hatzius) has been a poster child example of this about face, but they have plenty of company. The transition is not hard to understand. With the heavy POMO started in late August of last year, followed up by the reality of QE2, and now the tax cut extension legislation that should add about $350 billion of "new" fiscal stimulus in 2011, we better have an improved outlook. And we will, so count on it.

Certainly THE issue as we move into 2011 is the potential for organic economic growth, or otherwise. Personally, we just can't put a big "multiple" on marginal stimulus (read borrowed or printed money) additions to macro near term economic expansion. But this issue will not become relevant until 2011 is well underway, and more realistically it will be an issue for the second half and latter part of the year. For now, the rhythm of extraordinary monetary and fiscal stimulus will drive financial market outcomes and to a lesser extent real economic outcomes. As always, neither good nor bad. But this set of circumstances does tell us thinking in "time frames" during 2011 will be important.

Although we will not drag you through a bunch of explanatory detail, as we see it one of the really big keys for economic and we believe ultimately financial market performance in the new year and beyond will be first, whether and how corporations spend their currently amassed "savings". It's more than well known that through both operations and borrowing in a generationally low interest rate environment, corporations are sitting on top of a boatload of cash at the moment. We're already seeing the M&A deals primarily in tech and health care sectors taking place, as we should expect. Secondly, again if QE2 is to be effective, corporations must spend their cash domestically, and not let that cash "leak" into foreign direct investment and/or capital markets. Preferably, corporations would spend their cash domestically on productive investment. To be honest, that would be long term bullish. And crazily enough, it would be in stark contrast to what we believe are the misguided policies of the Fed and US government over the last three years.

As a preface, our comments in this discussion are very much longer term in nature. Little to probably nothing of what we have to say will impact financial market outcomes this week, or next. Or the week after that. Nonetheless, we believe these comments are important in trying to differentiate band aids from real economic healing and forward progress. Sorry to do this to you, but we need to start with just a touch of academic economics. Our apology if this puts you out cold. No worries though, you'll naturally be reawakened when your chin hits the keyboard. Do you remember this one from our Econ 101 class? Probably no.

Academic Economics truisms:
GDP = C + I + G + (X-M) AND S = I
English Translation:
GDP = Consumption + Investment + Government Spending + (Exports - Imports)
AND
Savings = Investment

In brief, US GDP is determined by the combination of domestic consumption, investment (we mean corporate investment in productive assets - think capital spending on plant and equipment), government spending and the difference between exports and imports. Secondly, and very importantly, savings in any economy should ultimately be near equal to investment. Okay, over the last few years of the Great Recession, everyone and their brother knows increased government spending has been a key necessary to offset actual or anticipated weakness in domestic consumption and investment. And borrowing and spending we have had. From the fourth quarter of 2007 through the third quarter of 2010 (the latest available Fed Flow Of Funds data), incremental US Federal debt has increased by just shy of $4 trillion. As the chart below tells us, this number is equal to all Federal borrowing from 1978 through the third quarter of 2007. And no, the initial year 1978 is not a typo. Lastly, none of what you see below includes SSI, Medicare, Fannie, Freddie, etc.

Federal Debt Outstanding

Into late 2008 and early 2009, US consumption and corporate capital spending blew through the guardrail of life and plummeted off of the nearest cliff. Only increased government spending could have offset this contraction. So as we look forward and contemplate the possibilities for organic economic growth, consumption and investment come directly into the cross hairs of the forward character of US GDP. We also know households are far from having completed balance sheet deleveraging so necessary to ultimately set the stage for another credit cycle (which has defined the US economy since the early 1980's) acceleration. In fact, it has really been the Federal government itself that has picked up the baton and been the key US credit cycle extension provocateur over the last three years. So that leaves macro investment as an absolutely key watch point ahead for a number of reasons. Again, we need to watch what corporate America does with their cash. Will they spend it and if so, where? Key. Key. Key to the forward reality of the US economy specifically.

Lastly, as stated in the wonderful economic theories and textbooks of life, in any economy it is savings that should equal investment in terms of balancing the books, so to speak. After tax disposable (spending on necessities inclusive of debt service) income can either be used for consumption or is saved, there are no other choices. And ultimately it is this pool of savings that becomes available for productive investment (whether borrowed for this purpose or invested as equity) in the macro sense for any economy. Has your chin hit the keyboard yet? If so, don't feel bad. Our chins hit it twice while we wrote this. And we have formal economics degrees! Imagine how much snooze time we had in school.

Right to the key point that actually happens to be a question and will hopefully become clear as we look at a few longer term data points. Why has the Fed and Administration focused their monetary and fiscal policies virtually exclusively on consumption when it is productive investment that is the key to longer term sustainable economic health and ultimately growth? We mentioned earlier that a KEY watch point for 2011 is corporate spending on productive plant and equipment. We know this sounds sarcastic, but we are dead serious as hopefully this data will reveal. Are the Fed and Administration carrying out a failed longer term policy of focusing virtually exclusively on trying to stimulate consumption? Unless they change their ways, and fast, it will only be the corporate sector that can truly save the day for the longer term sustainable health of the US economy. We told you it would sound melodramatic. Keep an open mind and let's walk through a bit of history.

You may remember that some time ago we did an entire discussion on the history of US credit market debt and GDP. We looked at both GDP and systemic leverage in decade long time frames. We used a rolling ten year moving average of nominal US GDP growth. And so we recreate this data in the bottom clip of the chart below. The top clip is self explanatory. You may also remember, and we will not drag you through it again, that US credit market debt relative to GDP began a three decade acceleration in the early 1980's leading up to the recent peak of a generational credit cycle.

Personal Consumption and US GDP Growth

Hopefully without laborious rambling, we believe the message of the combo chart above is as clear as a bell. As consumption became an ever larger piece of US GDP over time, the ten year rolling average of US GDP growth went into longer term rate of change decline. Again, if we presented the chart of US credit market debt to GDP, it very much directionally parallels consumption relative to GDP you see above. So, in very quick summation, from 1980 to present, US systemic leverage commenced an almost uninterrupted upward march, as did consumption as a percentage of total GDP. Is it fair to say that debt financed consumption at least in good part truly characterized and drove the US economy of the last three decades? You bet it is. And we believe this is exactly why the Fed and Administration very much desire to get right back on the horse that brung us, so to speak, by focusing their stimulus efforts virtually exclusively on the consumption side of the economic equation. And as opposed to the public being the one's to borrow to finance that current consumption, the government is doing it instead in an attempt to "keep the game going". But the point is that debt financed consumption pressured the longer term growth rate of US GDP over time as consumption adds nothing back to the longer term infrastructure and productive capacity of the economy itself. Exactly the opposite of what we have seen in places like Japan and China (and we are not saying these two are necessarily model citizens by a long shot, in fact far from it).

Now, remember that disposable income can either be consumed or saved. And it's that very savings that ends up as productive economic investment over time. So next up is a look at the US savings rate relative to the 10 year rolling average of US GDP growth over the last half century. Notice anything? Of course you do.

GDP Growth and Savings Rate

In fact it's probably the most important chart in the entire discussion. What are the key messages? First, again, it's in the early 1980's that we see the peak in the US savings rate. The same period where we began a three decade acceleration in US systemic leverage and a meaningful increase in consumption relative to GDP. That consumption was certainly financed with an ever accelerating amount of leverage, but also importantly it was also "financed" with a quarter century draw down in US savings. Savings that otherwise would have become productive investment. Get it? We know you do. From the late 1950's through to the early 1980's, the US savings rate reached ever higher highs, as exactly did the rolling ten year average of US GDP growth. But once the decline in the savings rate began, so did the decline in the longer term growth rate in US GDP. Directionally these two data points are twins.

Final chart, we promise. Below we're looking at the year over year change in, nominal US GDP. About as simple as it gets, no? Alongside is the year over year change in non-residential US fixed investment. A very broad proxy for productive investment/corporate capital spending. These two data points are about as highly directionally correlated as they come. And what this clearly implies is that the longer term rhythm of the US economy is integrally tied to productive investment. Not consumption, but productive investment.

US Investment in Productive Assets and US GDP

So stepping back just a bit, a key macro question becomes just why have the Fed and Administration been focusing their efforts on consumption when it's clear that productive investment is the driver of longer term US economic growth? Is it consumption that allows China to grow its economy at double digits, or productive investment? Again, we know there has been over investment in China and we have too much productive capacity globally for now, as this is really a story for another complete discussion. Additionally, it is clear that a huge amount of Chinese investment in productive assets was financed by reckless bank lending and money printing. But China never could have "arisen" economically without this important investment in long lived productive assets. Never. You know the fiscal remedies so far stateside. Cash for clunkers, home buyer tax credits, appliance purchase rebate credits, the recent one year drop in the employee side of payroll tax rates, etc. - every single initiative focuses on consumption as opposed to investment. Again, maybe we'll look like nut balls before the current cycle is over, but Fed and Administration policies are not going to put the US on a longer term firm economic footing, especially within the context of a globalized economy, unless we change focus. The US is not going to borrow and consume its way to prosperity. That only enriches the nations doing the actual production. We did the borrowing and consuming over the last thirty years and the rolling ten year US GDP growth report card is our reward.

We remain convinced that the US will experience at least some type of manufacturing renaissance in the years ahead. Why? Because we have to. It's either that or stagnate economically. Unfortunately, as opposed to supporting and encouraging this transition from reliance on consumption (in a still highly levered economy) to increasing focus on productive investment, the Fed and Administration are acting in contravention. They appear blind to the messages of history. We're scratching our heads. To be honest, we have only one answer as to why this is happening, and we sound like conspiratorial maniacs when we voice it. Consumption favors the financial sector, especially if that consumption is even partially financed. With corporations flush with cash and being able to borrow in the global capital markets at rates they never thought possible, they don't need the banks and financial sector broadly.

For now, the $350B of additional government spending (and borrowing) in 2011 along with the ongoing and unprecedented Fed QE will give the US economy a few near term economic "legs". "Legs" Street strategists/economists specifically are rejoicing and investors broadly are pricing in. But from a longer term standpoint, it's all about the ability to grow the US economy unaided by either additional debt or monetary debasement. That's the key. And that's going to mean increased savings and investment at the expense of current consumption at some point. The sooner we realize this and act accordingly, the better. So moving into 2011, it's really the US corporate sector that could potentially be an important provocateur for more sustainable US economic growth. It's all about how they spend their cash, how much they spend, and where it is spent. Key macro for 2011. But the corporate sector cannot do it alone. The government must act to encourage capital formation and productive investment. The US either continues as band-aid economy, or one refocusing away from consumption and toward investment and production so necessary in an ever more interdependent and interconnected globalized world. Which is it going to be?

We told you this would be meaningless to financial market outcomes near term. For that we watch the rhythm of Fed money printing and the financial market fingerprints of momentum. Companies that act to bolster their productive investment as well as research and development using their current balance sheet strength will be the long term winners upon which we want to ride as investment. This is a global comment. Let's hope US politicians and appointed Fed officials ultimately come to the same conclusion.

 

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