I was wondering if some of QE/ZIRP’s unintended consequences will lead to longer term, structural issues, so I decided to dive into some research on the matter.
To start, I’ve repeatedly discussed the broken transmission mechanism at the heart of QE, in that the “wealth effect” has failed to “trickle-down” (or whatever) and generate higher incomes. Summarizing a piece by the Coppola Comment in May, I wrote:
QEs have historically been deflationary (per CPIs in Japan, US & UK), which counterintuitive outcome is attributable to “unwanted redistributive effects [in that] QE benefits the asset-rich at the expense of the income-dependent.” For example:
- Banks won’t lend to small businesses due to risk & regulation, yet large companies have used the cheaper cost of capital for buybacks of their own shares (debt for equity repurchases) instead of investing in capital or people. That myopic focus on accounting profits over real growth has led to a loop of underemployment, falling productivity & weak real incomes.
- The hope was that QE would offset US & UK fiscal tightening, which disproportionately afflicts those who live on (middle/low) earned income, but QE principally supports asset prices: “[ZIRP] is supposed to encourage people to spend instead of save. But when people are saving for their old age [demographics], and they see their savings whittled away in the form of below-inflation returns, they are likely to save more, not less.”
I think that’s a poignant, sensible accusation to which many onlookers (myself included) are compelled to subscribe at a knee-jerk. Hence, it warrants further investigation…
First, allow me to frame the conversation with some background data.
In the US, real personal incomes have been slightly better than stagnant post-crisis, only +2.5% in total since 2007. The unemployment rate is down from a crisis high of 9.9% to 7.6%, but at the same time, labor force participation is down from 66.4% pre-crisis to 63.4%, which means part of the reduction in headline unemployment has come from attrition.
Demographics (the aging baby boom) have contributed to that, yet we also know that the jobs added since the crisis have gone to older generations at the expense of younger. Thus, the aging baby boom isn’t reshaping the labor force in the way you’d expect; they’re working longer, elbowing youths out of opportunities instead of creating openings by retiring. (And by all means, they should take what’s theirs, whatever they need or want, and whatever they’re capable of doing, because that’s capitalism.)
In 2009, economists were worried about the baby boom’s asset base/net worth having been halved; now the worry is that demographic’s insufficient income amid ZIRP. Think of retirees trying to annuitize their assets with near zero interest rates on savings/deposits… they can’t–at least not in principal protected securities like money markets, CDs, Treasuries, munis, or even high grade corporates. So, they have to wade out on the yield curve or up the risk spectrum, which are shell games.
Against this backdrop, how will corporations grow earnings over the long term? As of 1q13, S&P 500 ($SPX) revenue per share receded, failing to surpass 2008’s nominal high. (Real revenue is considerably below its prior high.) Actual SPX EPS are at an alltime high though. EPS have arrived at this precipice with a full 60% of growth attributable to buybacks vs only 40% to organic growth. Further, net margins are at historically high levels, two-thirds of which ascent is due to reductions in below-operating cost line items like interest expense and taxes.
In aggregate, earnings quality is low due to the mathematical limit of such accounting gains, with margins historically wide, cost of capital historically low, corporate profits historically high, and wages’ share of the economy historically meager. That’s one reason why I’m going to focus on EBIT (essentially “operating income”) in a few moments–to strip-out paper gains and accounting effects. The other reason is the misrepresentation of corporate leverage. Because interest rates are low and asset values high due to ZIRP/QE, most leverage metrics—which often employ shareholder equity (assets less liabilities) in the denominator of a ratio—misrepresent the long term sustainability of debtloads.
By the generally accepted practice of Discounted Cash Flow (DCF) modeling for valuation, monetary intervention’s lowered discount rates increase the value of preexisting, cash flowing assets. That’s fantastic for those who already own the assets, but CFOs’ models for prospective projects predict returns that’re too thin to encourage new investment–something uniquely characteristic of a ZIRP regime. We’ve seen empirical evidence to affirm this intuition in the Danish central bank’s (Nationalbanken) 2012 experiment with negative nominal rates, which failed to stimulate any lending or investment in Denmark.
Low discount rates also lower cost of capital like newly issued debt, aiding valuation metrics like interest coverage ratios, etc. That’s great as far as SPX is concerned, since the lion’s share of long term, corporate credit has been refinanced at these low, fixed rates. (I should mention that the knife cuts both ways, however, since the present value of unfunded pension liabilities also increase, but a well-run pension plan should attempt to immunize risks like this.)
What results from that dynamic is higher shareholder equity values, with higher present value of assets less lower present values of liabilities. This effect upon corporate and household balance sheets is part of why QE/ZIRP cannot be declared a success until unwound, at which point real growth must be realized in order to maintain net worths. Analysts’ equity valuation models usually utilize datapoints like ROE, which today would extrapolate off a high 2012 base. Given valuation models’ sensitivity to initial conditions, today’s valuation outputs are likely depreciated by their misrepresentative inputs (i.e. garbage-in/garbage-out), with 2012 data not only above-trend, but also ephemeral after [60% of] growth in the bottom line arose from the aforementioned financial chicanery.
There is a shark to jump now, with Street consensus still expecting 10.5% y/y EPS growth in Q4, for example, attributable to only 0.6% revenue gains–leaving the onus on margins. Margins simply will not, can not, increase. Forget mathematics or common sense; rising rates alone will pose as a headwind. At best, rising rates will end the virtuous cycle of positive accounting effects, with today’s stimulative benefits having pulled-forward accounting profits from the future; at worst, rising rates will fully unwind these profits.
So, the Street’s consensus model for forward earnings (FY1/2) really relies on a multiplicative leap in organic growth to displace accounting profits. Meanwhile, the hidden costs of opportunities forgone are accruing. These heretofore intangible economic losses are associated with a misallocation of financial resources. Chief of my concerns are capital expenditures, the absence of which [at least] illustrates both misallocation and opportunities forgone.
Broadly, corporations have tapped credit markets not for operating or investing purposes, but for financial reasons—specifically share buybacks and dividends. CapEx has been left wanting. If you look at broad SPX CapEx/Sales,¹ the run rate since 2011 has actually been slightly above its long term average. However, a forensic analysis gives a different opinion. The energy sector has been booming, and its gross CapEx is up from an average of $30B/quarter to $47B as of 1q13. Removing the energy sector, SPX CapEx/Sales “ex-energy” only just now reached up to its long term average on a trailing 12-month basis, as shown in the chart to the left. I see considerable slack therein, since the green, ex-energy histogram displays a substantial, cumulative void from 2009-12, which is even incorporating the crisis’ collapse of sales (in the denominator). Such massive underinvestment should have been displaced with a rush of pent-up demand thereafter.
On a more macro basis, growth in private nonresidential fixed investment–a GDP component–during the post-recession recovery (+20.6% since 2009) is the second weakest on record, compared to 7 other economic expansions since 1961.
Why should companies invest in this environment anyway? Again, DCF and opportunity cost modeling say they shouldn’t. Real interest rates are negative, which makes the expected return (i.e. IRR/required rate/breakeven) on projects a lot skinnier than in a normal rate regime. That erodes a company’s risk/reward profile for investing. Because of negative real rates, corporations can’t sit in cash either. Given the low cost of capital, a company is encouraged to opt for the bird in hand by diverting debt away from investment and into shareholder friendly programs like buybacks and dividends. The downside, however, is that those benefits are ephemeral–short term and non-recurring.
So, with CapEx having been largely displaced by buybacks and dividends, how have corporations been actively pursuing future revenue growth? They’re just not. The absence of sufficient CapEx and fixed investment is troubling, because these are literally expenditures creating future benefits (e.g. investments).
I’ve already established that the household sector certainly doesn’t have the income growth to increase future consumption. Now, I’ve determined that the future for corporate America don’t look that good either. In fact, the cracks are already showing: not only has SPX operating income flat over the past year, but it’s also failed to exceed 2007’s nominal high. (Obviously, it’s even worse in real, inflation-adjusted terms.)
Now, let me tell you why all that doesn’t matter. (I painstakingly spilled-out all that glorious research in support of a bearish point of view, because I knew that what follows is really solid if I can sway me/you to the converse.)
We’re living through a renaissance today. Remember when everyone looked at a 30x multiple in SPX and justified it by citing the pervasiveness of the internet? Then the tech bubble burst, and they were all wrong. It was too soon; it took time for the real economy to embrace, enact, and realize the benefits of technological innovations. The byproduct of innovation’s efficiency gains is a fair amount of creative destruction, which is best manifest by headline unemployment still at 7.6%. We don’t need a fleet of bank tellers, discretionary traders, warehouse laborers, etc. A computer or robot does a large share of that work today.
I just finished reading James Altucher’s Choose Yourself, which talks a lot about entrepreneurship in the innovation economy, where technology helps corporations function with fewer and fewer employees. Just think of the banking system, where a lion’s share of the job losses occurred: I deposit checks on my phone; poof, 20k bank tellers are laid off.
As Mr. Altucher urges: ‘Go start your own business!’ There are a lot of unemployed people out there who lost their jobs due to technological advances. Not all, but many of them can leverage free resources and build a startup business–lean and not that capital-intensive.²
My point is that waning CapEx may be structural–in a good way. Like Ed Yardeni mentioned:
“The Cloud has radically increased the productivity (bang per buck) of technology… Less IT hardware and software can do much more than in the past… [so] there isn’t much here to make the case for a capital spending boom in the US.”
The economy now runs a lot leaner, more automated. Those are productivity advancements. We can reallocate our human capital away from traditional stalwarts of the corporate economy towards other endeavors, where the real economic profits lay (as opposed to accounting profits). QE and ZIRP were never intended to stimulate the next American growth phase; they were simply bridges over troubled waters. We had a credit/housing bubble, demographic cliff, and an onslaught of creative destruction, then the Fed gifted unto us 5 years to retrain the growth of our plant, so to speak.
I’ll concisely summarize all that in an effort to bring this piece to a close.
In 2008, we met this issue of the baby boomers having passed peak spending, which should’ve intuitively dragged on consumption for a generation to come. Consumption has exceeded all expectations in the post-crisis years, but CapEx (investment) has underwhelmed, as I’ve made clear herein.
Under the weight of stagnant incomes, the consumer may take a breather in 2h2013-2014, while CapEx doesn’t budge.³ Some other GDP component will need to carry the torch if growth were to continue. The most likely candidate is export demand from Europe, hastened by a Eurocrisis recovery and strong $EURUSD. I think you can add China to that mix too. That’s the upside of our maturing economic renaissance: a global, competitive advantage wrought from productivity and efficiency gains. This isn’t some pie-in-the-sky hopium; we’re already seeing signs of increasing external demand. Again, I’ll quote Dr. Yardeni:
“There could be booming demand overseas for capital goods made in the USA. The latest US trade figures show capital good exports (excluding autos) rising rapidly to a new record high of $554.6 billion (SAAR) during June. They account for 62% of nondefense capital goods shipments.”
An American energy renaissance, technology revelation, and unprecedented monetary accommodation have conspired to usher us to this precipice, where–after years of slow growth averted a depression at the end of a lost decade–the export economy is primed to reverse 30+ years of trade deficits, take the handoff, and carry GDP growth. In much the same way, SPX revenues will fill the void to maintain growth in risk markets.
But, be forewarned, this is a narrow window, because international aggregate demand is fickle, and competitive advantages fleeting. We cannot rely on a pseudo-beggar-thy-neighbor status to provide exogenous growth indefinitely, nor can we expect corporate America to re-absorb the unemployed. This should buy us some more time to keep retraining the growth of our plant. But, for a secular expansion to occur, we must reallocate our human capital into the jobs with highest economic profits.
¹SPX CapEx data already excludes financials (“ex-financials”), since they’re not capital-intensive businesses.
²There is a systemic noise problem burgeoning, however. Mobile app startups are a good example: there needs to be a shakeout, not so much because they have no revenue model, but because they’re all competing for our time, a precious commodity of which there’s too little to go around.
³As of this past week, retailers from WalMart ($WMT) to Joseph A Bank ($JOSB) have come out with 2H profit warnings. It’d be really bad for markets if the consumer has to dip into savings/investments to finance consumption, but I am hoping that a pickup in bank lending can steadily finance a path forward via the relevering or stabilizing the private sector. That growth is critical to maintain the private sector’s net worth too. The Fed has absorbed a ton of the economy’s duration risk in their $3.2T marketable securities portfolio, consisting of the highest duration paper out there. Those are also the safe assets, literally the “risk-free” bonds. The economy’s failure to grow sends capital chasing the best opportunity cost, flying to quality, Treasuries, which today come in short supply. Another recession (negative growth) would mean risk assets’ expected growth rates are negative, so with policy rates already at the zero-bound, the short-supply of T-bills may get bid high enough price-wise that nominal risk-free rates are negative (and still capital’s best opportunity cost).