interest rates, inflation and economic growth

A reader asked me to write about this.  I think it’s an interesting topic, since traditional relationships appear to be be breaking down.

interest rates

Let’s just focus on government debt, since other debt markets tend to key off what happens here.

 

At the end of the term of a loan, lenders expect the safe return of their principal plus compensation for having made it.  In the case of all but gigantic mutual fund/ETF lenders, participants in government bonds also enjoy a highly liquid secondary market where they can sell their holdings.

The compensation a lender receives is normally broken out into:  protection against inflation + a possible real return.

In the case of T-bills, that is, loans to the government lasting one year or less, the total return in normal times would be: protection against inflation + an annual real return of, say, 0.5%.  In a world where inflation was at the Fed target of 2%, that would mean one-year T-bills would be sold at par and yield 2.5%.

In the case of a 10-year T-bond, the annual return would be inflation + a real return of around 3% per year, the latter as compensation for the lender tying up his money for ten years.  In a normal world, that would be 2% + 3% = a 5% annual interest rate for a bond sold at par.

Compare those figures with today’s one-year T-bill yield of 0.6% and 1.62% for the ten-year and we can see we’re not in anything near normal times.  We haven’t been for almost a decade.

How did this happen?

Fed policy

The highest-level economic objective of the government in Washington is to achieve maximum sustainable long-term economic growth for the country. Policymakers think that growth rate is about 2.0% real per annum.  Assuming inflation at 2.0%, this would imply nominal growth at 4.0% yearly.

expanding too fast

In theory, if the economy is running at a nominal rate much faster than 4% for an extended period, companies will reach a point where they’re ramping up operations even when there are no more unemployed workers.  So they’ll staff up by poaching workers from each other by offering higher wages.  But since there are no net new workers, all that will happen is that wages–and selling prices–will go up a lot.  They’re be no greater amount of output, only an acceleration in inflation.  This last happened in the US in the late 1970s.

Before things get to this state, the Federal government will act–either by lowering spending, raising taxes or raising interest rates–to slow the economy back down to the 2% real growth level.  Typically, the economy ends up contracting mildly while this is going on.

Given long-standing dysfunction in Congress, the first two of these remedies are long since off the table.  This leaves money policy–raising interest rates–as the only weapon in the government arsenal.

growing too slowly/external shock

If the economy slows too much or if it suffers a sharp out-of-the-blue economic shock, the possible government remedies are: lower taxes, increase spending, reduce interest rates.  Washington has elected to do neither of the first two in response to the financial collapse in 2008-09, leaving monetary policy to do all the work of helping the country recover.

Fed policy in cases like this is to reduce the cost of debt to below the rate of inflation.  That hurts lenders (the wealthy, pension funds, retirees) severely, since they are no longer able to earn a real return or even preserve the purchasing power of their money through buyng government securities.

On the other hand, this is like Christmas come early for borrowers.  In theory, they now have many more viable projects they can launch.  They’ll not only be making money on the merits of their new products/services; inflation will also be eroding the real value of the loans they will eventually have to pay back.

 

More on Monday.

 

 

more casino gambling folly in New Jersey

Tax revenue from casino gambling in Atlantic City has been an important source of income for the state of New Jersey since its inception in the 1970s.  The Atlantic City gambling market peaked, however, in 2006 and has been cut in half since then.  The financial crisis accounts for maybe a fifth of the contraction.  The rest is due to the introduction or expansion of casino gambling in nearby states, notably Pennsylvania.

New Jersey’s response to this development has been a bit bizarre.

Its first idea was to increase casino space in Atlantic City by funding an upscale casino project which had been trying unsuccessfully to get private financing for years.  How that would address overcapacity in the market was never explained.  But luckily this plan never got off the ground.

Then there was internet gambling, introduced in late 2013, which the state predicted would soon be a billion-dollar industry.  2016 revenue from this source, year to date through August, is about $32 million.

The state has also attempted to institute sports gambling in the casinos, unsuccessfully so far.  The main stumbling block, as I understand it, is that doing so is expressly forbidden by federal statute.  Before that legislation was passed, state were polled to see if they wanted to be exempted–and New Jersey said no.

The latest idea, being pitched in advertising as a cure for unemployment, is again to open more casinos–only this time in northern New Jersey, within striking distance of New York City.

As a general rule, I think that–with the exception of resort locations like the Las Vegas Strip– consumers in general, and casino gamblers in particular, normally tend to patronize the closest venue to where they live.  If so, these proposed new casinos may draw some New Yorkers away from NYC-area casinos and keep some New Jerseyans from crossing the Hudson River.  But they will certainly make a huge dent in the gambling traffic that now goes from northern NJ to Atlantic City.

 

The new casinos need voter approval before the projects can go ahead.  Hence the commercials now airing to promote their advantages.  It’s not clear, however, that their opening will be a plus for the state.  The question is not whether they’ll do damage to Atlantic City–they certainly will, I think.  It’s how many more AC casinos will be forced to close their doors, and whether as a result their south Jersey/Pennsylvania patrons will opt to gamble in PA instead.

 

the investigation of Exxon’s (XOM) oil and gas reserves

The Wall Street Journal has recently reported that the New York attorney general and the SEC are investigating whether the accounting XOM gives of its oil and gas reserves in its annual 10k filing is accurate.

There appear to be two points to the probes:

–the SEC wants to know if/how XOM has factored the cost of increasing environmental regulations into its evaluations

–the NY attorney general observes that other publicly traded oil and gas companies have written off $200+ billion from the balance sheet carrying value of their exploration and development assets.  XOM has done none.  He wants to know how that’s possible.

oil and gas balance sheets

These are very murky waters, for a number of reasons:

–there probably isn’t any “right” way to account for future environmental regulations.  It’s possible the SEC just wants to send a message to the industry to do something

–balance sheet writedowns aren’t required when assets become less profitable, which they obviously have as oil prices have plunged, but only when they become unprofitable.  For oil and gas fields that may have decades of future life, this requires some judgment about what future selling prices and costs will likely be

–the unprofitability test isn’t done well by well or even field by field.  It can be done for pools of assets that are as big as a given country.  For a mature company like XOM this will mean a pool can contain not only fields put into production two years ago but also ones from the 1960s, when crude went for $1 a barrel.  It’s possible that XOM has simply not been as aggressive (read: reckless) as its peers in chasing discoveries that are only viable with oil selling for over $100 a barrel.

supplementary present value disclosure

There is also another–more significant, in my view– set of calculations of the present value of oil and gas reserves that each company is required to include in its 10k.  This is a standardized measure with fixed assumptions.  The most important are that selling prices are assumed to be constant at those of the time of the report, and the discount factor to be used is a whopping 10%.

On this measure, XOM has already written down the present value of its oil and gas holdings by a gigantic amount.  From December 2012 on, the figures are as follows:

2012          $225 billion

2013          $220 billion

2014          $208 billion

2015          $71 billion.

Based on the 2015 figure it’s hard to make an argument that XOM is somehow covering up the loss in value it has experienced with the fall in oil prices.

 

globalization and the stock market

For most of the thirty years I’ve been a professional investor, there has been a very dependable, high-beta link between world economic growth and world trade.   When economies were expanding, trade would expand at a much higher rate;  when economies were slowing, or contracting, developments in world trade were much more negative.

 

What was equally important for an investor was that although the economic data were clear from the outset, for many years equity investors in the US and Europe were slow to figure out what was going on.  As a result, from the 1970s through the 1990s there was plenty of outperformance to be had simply by overweighting multinationals and global transport companies during economic expansions and underweighting them during slowdowns.  Of course, one also had to give at least some consideration to currencies–that is, to make sure that a company had its revenues generally in harder currencies and its costs in weaker ones.  Still the main idea was to exploit the high sensitivity of trade to world growth.

 

Today’s equity markets have caught on.  It’s now part of most equity portfolio managers’ tool kits to favor multinationals and transports in upturns and shy away during downturns.

 

What I find interesting–and important–is that the economics seem to have changed over the last half-decade.  Over the past few years, global trade has grown no faster than the world in general.  It’s not 100% clear why this is so, but a reasonable guess is that the era of global production reshuffling between developed and developing nations to take advantage of lower labor costs, newer, more efficient plant and stronger management is over.

If this is right, and if I’m correct that stock markets haven’t really caught on to the new reality yet, then multinationals will be disappointing vs. expectations and the (more difficult) place to look for outperformance is with domestic firms within a given national arena.

There are also political implications (although I usually find political speculation irrelevant for making stock market gains).  Maybe the anti-trade stance of both Hillary and Trump is a case of fighting the last war.  The new economics would also suggest that the Trump campaign is much more deeply rooted in notions of white supremacy we thought had been left behind in the 1960s than we would like to believe.

 

 

online ordering/delivery and supermarkets/drugstores

In Manhattan, where I spend a considerable amount of time, a reasonable rule of thumb is that household goods and food both cost about twice what they would in nearby suburbs.  Part of this premium, I’m sure, has to do with high rents and the logistics of getting inventory into the city.  But I also think that if we could see into the management control books of the firms involved, we’d see that these urban locations are extraordinarily profitable.

Online is changing this situation in two ways.  Anyone who is able to wait a day or two–and who has a way of accepting delivery safely–has been shifting away from bricks and mortar.  Just as important, fringe areas in the city, which have few (if any) drugstores/supermarkets, become more attractive as neighborhoods because traditional infrastructure is no longer as crucial as it once was.

 

On the other end of the population density spectrum, the Wall Street Journal recently reported that in rural areas online ordering is also supplanting supermarkets–at least for non-perishables–in much the same way that Wal-Mart disrupted mom-and-pop retailers a generation ago.  The Journal cites a Kantar Retail study that shows 30%+ of rural shoppers are now members of Amazon Prime and almost three-quarters are online shoppers of some sort.

What had once been protecting the margins of local rural retailers is the cost of shipping items to out-of-the-way locations.  But with the near-ubiquity of free/membership shipping (meaning the bargaining power of, say, Amazon to lower shipping costs), this barrier has been substantially reduced.

 

My guess is that the biggest winners from this rural trend are local convenience stores.  Since these are typically linked with gasoline stations, which have long benefited from lower oil prices, I think they’re no longer hidden gems.  The idea that locals will have more money to spend may mean the convenience stores will run for longer than the consensus expects.  During a correction maybe, but right now I’m not a buyer.

 

crude oil: from shortage to surplus

Until very recently, petroleum industry thinking about crude oil supplies has been dominated by what has been called “peak oil theory.”  Developed by geologist and Shell Oil researcher M. King Hubbert in the 1950s, the simplest statement of the theory is that world production of crude oil would peak shortly after the year 2000, and then begin an inevitable decline.  The reason?   …all the world’s oilfields would have been discovered and fully exploited by that time.

We now know that Dr. Hubbert’s hypothesis is incorrect.  In fact, it’s wildly–even directionally–wrong, done in by the incentive of high prices and the development of hydraulic fracturing.

 

Peak oil is of more than academic interest, since strong belief that the world is facing an inevitable decline in oil production has informed the capital spending budgets of all the major oil companies for the past generation.  For them, the present situation of abundant supply at around $50 – $60 a barrel was unthinkable.  As a result, the majors have poured billions and billions of dollars into locating very high-cost hazardous-environment oil prospects that may now be not economically viable.

What happens now?

 

My mind keeps going back to the late 1990s and the mad rush to lay fiber optic cable around the world to support the internet.  Corning and a few Asian suppliers made the highest-quality glass cable.  Global Crossing and others spent immense amounts of money as they raced to complete undersea cables to connect the US to the rest of the world.  Internet traffic was expanding at such a fantastic rate that, in these firms’ minds, the fact that a whole bunch of firms were all doing so made no difference.

In hindsight, a key assumption these companies all made was that each optic fiber in a cable would be able to handle only one transmission at a time.

Then came dense wavelength division multiplexing.   DWDM amounted to putting a prism at each end of a fiber, breaking the light into a number of different wavelengths and sending a separate communication over each wavelength.   First it was two wavelengths, then four, then 256…

Suddenly the looming fiber optic shortage was an actual fiber optic glut.

What happened beak then?    The fiber optic cable business fell apart.  So too equipment suppliers like JDS Uniphase.  The most aggressive fiber optic cable layers went into bankruptcy.

 

I’ve been thinking that it’s time to poke around in the wreckage of smaller US oil exploration firms, although I suspect we may not see oil price lows until the end of the winter heating season (assuming there is one) next February.  But I also continue to think that the DWDM analogy is a reasonable one.  It suggests that there’s still lots of trouble ahead for the biggest and best-known names in the oil industry.

 

 

index fund gains in the US

According to a survey reported in the Financial Times and done at the newspaper’s request by Morningstar, assets in US index mutual funds now comprise a third of total domestic mutual fund assets.  That’s up from 25% this time three years ago.

Nevertheless, actively managed assets under management have risen by 14%, despite the market share shift.  So the fees being collected by active managers are up.  This is doubtless due mostly to the fact that markets have been rising.  The S&P 500 is up by about a third over the three-year span, the Bloomberg Treasury index by 12%.  Watch out, though, if markets flatten or begin to decline.

 

More bad news:  the FT is reporting that 90.2% of US active equity managers underperformed their benchmark, after deducting fees, over the twelve months ending June.  Not numbers that will stem outflows.

 

Since I’m getting such an unbelievably late start today, I’ll only make two points:

–in the investment organizations I’m aware of, management control is in the hands of professional marketers, not professional investors.  I think their giving a much higher priority to selling rather than making products is a substantial part of the underperformance problem for these firms.  It’s highly unlikely, I think, that marketers will volunteer to step down and turn the reins over to makers.  So I expect underperformance issues will continue.  If I’m correct, the next bear market could prove crushing for these organizations, since the combination of falling prices and client withdrawals will doubtless mean sharp declines in profits.  Where will the money come from to beef up research and portfolio management operations then?

–some large investment management firms known for active management are reported to be finally entering the index fund market themselves.  First of all, this seems to me to show the marketing bent of their managements, giving support to my first point.

In addition, index funds have very large economy of scale effects and the oldest/largest have been in existence for decades.  Because of this, I can’t imagine that Johnny-come-lately firms will ever have profitable index offerings.  The firms may subsidize their index funds  so that the fees for you and me will be on a par with bigger rivals’, but I don’t see how the subsidies can ever be taken away.  Yes, such firms may retain assets, but their bottom lines will be worse off than if they retained them.