We continue to view the investment environment as being completely dysfunctional. When central bankers worldwide are deliberately trying to suppress the natural "risk rating" processes of markets, one is in dangerous waters. However, such epochs do take their time in winding down to their inevitable outcomes. In the meantime, monetary dysfunctionalities (what we in the past have called "Bungles in the Jungle") do offer interim opportunities.
One of these "bungles" we think will give rise to a new emerging cult of equities -- a twilight cult -- namely higher-yielding stocks of larger companies, preferably multinational corporations in certain key sectors. But it is not the "cult" of old, nor another "nifty fifty" but one rather born of current day market distortions and dysfunctionalities.
This is perverse will say the traditionalists and market history buffs. Isn't the "equity cult" dead? Doesn't history show that deflationary busts and earnings declines follow inflationary booms? (Yes indeed, we are mostly dyed-in-the-wool Austrian theorists, too). Aren't equity markets bound to suffer during such periods? And, besides, isn't everybody recommending equities these days, given the miserly interest rate levels? To that, we say both "yes, and no." It is markets that are perverse, not us. Let us explain.
To start, as an investment class, very few are inclined to view equities favourably these days. In fact, a recent survey of Wall Street strategists (people that give investment advice, but don't actually manage money ... somewhat akin to friars that provide marriage counselling) shows their equity preference to now be at the lowest level in many decades. All the while, household have been net sellers of equity mutual funds for almost three years whether stock markets may be rising or falling. However, there is more to this phenomenon that may meet the eye. While the "big money" households were huge sellers of U.S. equities back in 2006 and 2007 ($1.4 trillion worth in those two years alone) the masses were still piling into equity mutual funds. The opposite trend is likely is beginning to play out now.
Next, let's deal with the voices of history. Yes, indeed, all periods of malinvestment and inflation end up in a bust ... eventually.
However, while the outcome of the current and ongoing Global Financial Crisis will ultimately be the same as all other deflationary, debt deleveraging periods (and very likely, even worse, we think), the topology is different in some crucial respects. Just as floods all have the same basic destructive effects, the course and channels they follow are dependent on the landscape. Similarly, the landscape that we see today is indeed very different. How so?
For the sake of brevity, we will focus on the key differences from prior "similar" eras in today's global economic landscape ... what we call Situational Realities (SRs).
- Demographic. The first-ever demographic deceleration phenomena of any period of peace time ever in world history is playing out. As such, income crisis stand to be become very acute ...much more so than already observed. This is a different era.
- Globalization Overload. Yes, the globalization of the late 19th and early 20th century may still be seen as the Gilded Age. But this late period of globalization of the post-Bretton Woods era (since 1970) carries with it a particularly nasty bite upon its denouement. This time, globalization impacted a greater percentage of the world population ... certainly so many multiples that of the High Income Countries ... ending with the most rapacious economic transformation of what was the world's most populous country -- China. (Will the world ever again see a country of 1.2 billion people go from a home ownership rate of 0% to 60% in less than 3 decades?) What will be the encore to this?
- Corporation Concentration. MNCs (what UNCTAD calls transnational companies) not only today account for some 30% of world GDP (estimates vary here), up from only 2% or so in the early 1950s, they are also more concentrated in each of their respective industries. As such, they have much more pricing power globally ... not just domestically. For example, there is a reason why heretofore highly cyclical commodities such as iron ore are no longer so cyclical. Why? The major iron ore miners are exactly that ... major. And as such, they have now become more price makers than takers. The same applies to other industries. To wit, declining interest rates and price increases have been key drivers of corporate earnings increases in recent years.
- OECD Defaults: The very foundation of the global monetary system of the post-WWII financial is kaput. It depended upon the existence of a so-called "risk-free" asset. None exist anymore following the default of Greece, an OECD country. More OECD countries are heading toward the same outcome. Spain and France (yes also France) are presently on course for the maws of the classical Dept Trap. Sovereign bonds aren't what they used to be ... indeed, some now refer to them as the "return-free" risk. At the very least, the balance sheet of IBM will have better disclosure than that of a disintegrating country's balance sheet.
In conclusion, the corporate sector (apparently, also including the financial sector but for different reasons) is much more powerful than at any other time in the history of modern financial markets. They're more globally diversified than ever before; are agents to an ever greater portion of world GDP; and therefore are likely to be more resilient for longer, despite slow economic growth and periodic demand shocks.
But will corporations do their part?
Here, several "behavioural truisms" (BTs) -- these being among the few indicative beacons that we have during the uncharted financial waters of the times -- point to an answer.
- Corporate executives will continue to manage their companies the best that they can, though likely not in a way that will reduce their bonuses.
- Corporate executives will not lose sight of the fact that a higher stock price will lead to a bigger pay-off on executive share options. (This applies to money managers, too.)
- Failing that corporate earnings are no longer rising, or that markets are not willing to pay higher price-earnings multiples, corporate boards will soon enough realize that corporate interest rate levels are at all time lows. Not only that, they are at an all time-low relative to the return on capital. (Think of the possibilities of just such a cornucopia!)
- Skilled CFOs (Chief Financial Officers) the new wunderkinds of the executive suite since at least the early 1990s, will note that with plentiful cheap money on tap, higher earnings can easily be manufactured through corporate takeovers. Not only that, markets these days are more willing to pay for yield than they are earnings. That means a 100% dividend payout at any point in time will yield a higher stock price than any lesser payout.
- Wall Street excels at manufacturing supply. Where there is demand, supply will appear. Right now, there is insatiable demand for yield. What will be manufactured next?
- Finally, corporations are sitting on record-high cash balances, particularly so when including the cash held in overseas subsidiaries. (At the same time, corporate indebtedness is also high.) Declining interest rates and rising confidence (when this occurs we do not know) will be sure to again unleash corporate opportunism.
The above tendencies, everything else being equal, favour equities over bonds these days. Of course, whether such a preference will produce higher investment returns, will depend on the economic environment and whether a double-dip of the Great Recession will spread further. Should this occur, equities will certainly have a tougher time. Corporate bond yields could actually rise in such an environment.
However, considering the combination of BTs and SRs we have briefly reviewed, it still suggests that equities will outperform bonds (certainly over the longer-term), and that rising dividend payouts, corporate share buybacks and mergers and takeovers will play an influential role.
If corporations do their part, what about the investor? One thing is sure: a massive income compression is occurring. Some of this compression will not strike household spending until much later ... that being when pension plans no longer can pay out benefits. In the meantime, "zero intolerance" is driving investment behaviour. There is little doubt that markets have been reflecting the primordial urges to reach for higher yield. Even now, equity markets may be grinding higher (though remaining volatile) for no other reason than dividends yields can be twice as high as a 10-year treasury yield. That said, one of the strangest of sensations for any "boomer" (or "bull market baby") money manager is that raising equity weightings in a balanced portfolio actually raises yield ... particularly so after-tax yield. It is a nice feeling.
While Bill Gross may pronounce the equity cult dead, he is only stating the obvious. It has already happened. This is not a prediction. Looking ahead, however, we think we see the makings of a new "twilight" equity cult. It surely would be one of the strangest ever. It is simply the situational reality (SR) of a broken financial system and a dysfunctional monetary era. We can agree that it cannot last. But, in these times of skinny returns, it can also not be missed. (We will provide more supporting reasons to these views in future issues of ETFlash)