Trump and the Federal Reserve

dubious strategies…

I was thinking about last year’s Federal government shutdown the other day.  There are two million+ Federal workers.  They make an average salary of just above $90,000 a year, which is 50% more than the typical worker in the US.   Add in health insurance and pension benefits and their total compensation is double the national average.

On the surface, it seems odd to me that Federal workers began to run out of money almost the minute Mr. Trump laid them all off late last year.  On second thought, though, given their apparent job security and generous benefits, there’s arguably no urgent reason for them to build up savings.  Maybe they do live at what for others might be right on the edge.

That might explain the outsized negative impact laying Federal workers off en masse had on the economy, given that they represent only about 1.3% of the workforce?  If each consumes as much as two average workers, which I think is a reasonable guess, then the layoff does the same damage as 2.5% of the total American workforce becoming unemployed.

This is bigger than you might think.  A 2.5% rise in unemployment is what happens in a garden-variety recession.  No wonder the economy appeared to fall off a cliff in January.

 

Consider, too, the effect of the Trump decision to withdraw from international associations in favor of waging country-to-country trade warfare.  The resulting flurry of highly targeted tariffs and retaliatory counter-tariffs has made the US, at least for the moment, a uniquely bad place for new capital investment.  That’s even without considering the administration’s policy of restricting domestic firms’ ability to hire highly talented foreign technicians and executives–a policy that has made Toronto the fastest-growing tech city in North America.  Again, no surprise that new domestic capital additions sparked by tax cuts have fallen far below Washington estimates.  And, of course, tariff wars have lowered demand for US goods abroad and raised prices of foreign goods here.

My point is that–apart from the ultimate merits of administration goals–they are being pursued in a strikingly shoot-yourself-in-the-foot way.

…continue

Yes, Federal workers are back on the job.  I can’t imagine that they will resume their old spending habits, though, given the new employment uncertainty they are facing.  Last week the administration discussed disrupting the supply chains of American multinationals with operations in Mexico.  Yesterday, the talk was of a possible $11 billion in new tariffs on imports from the EU …and the retaliation that would surely follow.  Even if none of this materializes, their possibility alone will increase the reluctance of companies to operate inside the US.  The negative effect of all this may be much greater than the consensus thinks.

 

now the Federal Reserve

This central bank’s official role is to set monetary policy through its control of short-term interest rates.  Its unoffical role is to be a political whipping boy.  It takes the blame for (always) unpopular rises in interest rates that are needed to keep the economy from overheating, and on track to achieve maximum sustainable long-term GDP growth.

The two instances where the Fed has succumbed to Washington arm-twisting–the late 1970s and the early 2000s–have created really disastrous outcomes, the big recessions in 1981 and 2008.

Despite this, Mr. Trump has apparently decided to offset the negative economic effects of his tax and trade policies, not by stopping doing what’s causing harm, but by forcing the Federal Reserve into an ill-advised reduction in interest rates.  His first step down this road will apparently be the nomination of two loyalists without economic credentials to fill open seats on the Fed’s board.

If the two, or similar individuals, are nominated and confirmed, the likely result will be a decline in the dollar, the start of a residential real estate bubble and a further shift of corporate expansion plans away from the US.  We may also see the beginnings of the kind of upward inflationary spiral that plagued us in the late 1970s.

 

investment implications

Replying to a comment on my MMT post, I wrote:

“Ultimately, though, the results would be a loss of confidence, both home and abroad, that lenders to the government would be paid back in full. That would show itself in some combination of currency weakness, accelerating inflation and higher interest rates. Typically, bonds and bond-like investments would fare the worst; investments in hard-currency assets or physical assets like real estate/minerals, or in companies with hard-currency revenues would fare the best. I think gold, bitcoin and other cryptocurrencies would go through the roof.”

I think the same applies to Mr. Trump gaining control over the Fed.

 

 

 

 

 

 

 

 

 

 

 

my take on Kraft Heinz Co (KHC)

Late last week, KHC reported 2Q18 earnings.  The figures were disappointing.  More importantly, the company announced it is:

–cutting the $.625/quarter dividend to $.40,

–writing down the value of its intangible assets by $15.4 billion (about 28% of the total) and

–involved in an SEC inquiry into the company’s accounting practices for determining cost of goods sold.  Apparently prompted by this, KHC boosted CoG for full-year 2018 by $25 million in 4Q18.

The stock declined by 27% on this news.

 

What’s going on?

broadly speaking…

KHC is controlled by famed investor Warren Buffett’s Berkshire Hathaway and by 3G, a group of investment bankers behind the consolidation success of beer maker Anheuser-Busch Inbev.

As I see it, Buffett’s principal investing idea continues to be that markets systematically undervalue “intangible assets,” accounted for as expenses, not assets–namely, successful firms’ brand-building through advertising/marketing and superior products/services.  This explains his preference for packaged goods companies and his odd tech choices like IBM and, only after all these many years of success, Apple.  All have well-known brand names cemented into public consciousness by decades of marketing expenditure.

3G believes, I think, that in most WWII-era companies a quarter to a third of employees do no useful work.  Therefore, acquiring them and trimming the outrageous levels of fat will pay large dividends.  Remaining workers, arguably, will figure out that performing well trumps office politics as a way of climbing the corporate ladder, so operations will continue to chug along after the initial cull.

These beliefs account for the partners’ interest in KHC.

 

My take here is that the investing world has long since incorporated Mr. Buffett’s once groundbreaking thinking into its operating procedures, so that appreciating the power of intangibles no longer gives much of an investing edge.  (Actually, KHC suggests reliance on the fact of intangibles may make one too complacent.)  As to G3, it’s hard for me to figure how companies fare after the dead wood is eliminated.

the quarter

The most startling, and worrying, thing to me about the quarter is the writedown of intangibles.  My (admittedly quick) look at the KHC balance sheet shows that total liabilities and tangible assets–working capital and plant/equipment–pretty much net each other out.  This means that shareholders equity (book value) pretty much consists solely in the intangibles that drive customers to buy KHC’s ketchup and processed cheese foods.  That number is now 28% lower than the last time the company looked at these factors.  Did all that decline happen in 2018?  Is this the last writedown, or are more in the offing?

The fall in the stock price seems to me to correspond closely to the writedown.  I’d expect the same to hold the in the future.  And it’s why I think the risk of further writedowns is a shareholder’s biggest worry.

 

–A dividend reduction is always a red flag, especially so in a case like this where the payout has been rising.  It suggests strongly that something has come out of the blue for the board of directors.  However, KHC appears to be indicating that cash cows are being divested and that loss of associated cash flow is behind the dividend cut.  I don’t know the company well enough to decide how cogent this explanation is, but it’s enough to put the dividend cut into second place on my list.

–an SEC inquiry is never a good sign.  In this case, though, it seems that only small amounts of money are at issue.  But, if nothing else, it points to weaknesses in management controls, supposedly 3G’s forte.

 

Final thoughts:

–Experience tells me the whole story isn’t out yet.  I’d want to know whether KHC is taking these actions on its own, or are the company’s lenders, its auditors or the SEC playing an important role?

–This case argues that the intangible economic “moats” that value investors often talk about have less protective value in the Internet/Millennial era than in earlier, slower-changing times.

 

 

 

 

the threat in Trump’s deficit spending

In an opinion piece in the Financial Times a few days ago, Gillian Tett points to and expands on a comment in a Wall Street advisory committee letter to the Treasury Secretary.  Although it may not have implications for financial markets today or tomorrow, it’s still worth keeping in mind, I think.

The comment concerns the changes in the income tax code the administration pushed through Congress in late 2017.  Touted as “reform,” the tax bill is such only because it brings down the top domestic corporate tax rate from 35%, the highest in the world, to about average at 21%.  This reduces the incentive for US-based multinationals (think: drug company “inversions”) to recognize profits abroad.  But special interest tax breaks remained untouched, and tax reductions for the ultra-wealthy were tossed in for good measure.  Because of this, the legislation results in a substantial reduction in tax money coming in to Uncle Sam.

Ms. Tett underlines the worry that there are no obvious buyers for the trillions of dollars in Treasury bonds that the government will have to issue over the coming years to cover the deficit the tax bill has created.

 

A generation ago Japan was an avid buyer of US government debt, but its economy has been dormant for a quarter-century.  Over the past twenty years, China has taken up the baton, as it placed the fruits of its trade surplus in US Treasuries.  But Washington is aggressively seeking to reduce the trade deficit with China; the Chinese economy, too, is starting to plateau; and Beijing, whatever its reasons, has already been trimming its Treasury holdings for some time.

Who’s left to absorb the extra supply that’s on the way?   …US individuals and companies.

 

The obvious question is whether domestic buyers have a large enough appetite to soak up the increasing issue of Treasuries.  No one really knows.

Three additional observations (by me):

–the standard (and absolutely correct, in my view) analysis of deficit spending is that it isn’t free.  It is, in effect, a bill that’s passed along to be paid by future generations of Americans–diminishing the quality of life of Millennials while enhancing that of the top 0.1% of Boomers

–historically, domestic holders have been much more sensitive than foreign holders to creditworthiness-threatening developments from Washington like the Trump tax bill, and

–while foreign displeasure might be expressed mostly in currency weakness, and therefore be mostly invisible to dollar-oriented holders, domestic unhappiness would be reflected mostly in an increase in yields.  And that would immediately trigger stock market weakness.  If I’m correct, the decline in domestic financial markets what Washington folly would trigger implies that Washington would be on a much shorter leash than it is now.

 

steering through the shoals

issues for the S&P 500 in 2019:

–about half the earnings of the S&P come from outside the US.  For 2019, that’s not a good thing, since China is slowing down (more tomorrow) and the UK’s ham-fisted approach to Brexit is stalling business activity in the EU

–in the US,

—-last year’s corporate tax cut is no longer a source of year-on-year aftertax earnings growth

—-tariffs continue in place.  Tariffs redistribute,  but in the aggregate also slow, economic growth. The current ones are designed to shift economic energy toward sunset (often private) industries and away from ones with better prospects.  Some, like those on steel and aluminum, appear arbitrary, adding a layer of uncertainty to the whole process

—-the government shutdown is already pushing the US economy from a plodding advance into reverse, according to White House economists.  The central issue is a border wall, which, if news reports are correct, was originally intended only as a memory aid for a candidate who couldn’t remember his key policy positions very well

—-the lack of sensible–or even coherent–economic strategy from Washington is making corporations accelerate domestic restructuring plans and to question future investment in the country.  The administration’s hostility to admitting highly skilled foreign workers based on their religion/ethnicity is making the shift of r&d activity across the border to Canada an easy decision

In short, an embarrassing parade in Washington of own goals/self-inflicted wounds.

 

where to look for growth

The business cycle isn’t going to be much help.  In times like this, the defensive sectors–utilities and telecom, and, to a lesser extent healthcare and consumer discretionary–typically come to the fore.  But utilities + traditional telephone now amount to much less than 10% of the S&P.  More important, both areas are in the throes of fundamental alteration that is damaging to incumbents.  This leaves us with healthcare and consumer discretionary.

In both these areas, I think it’s important not to implicitly take a business cycle approach.  A key factor here is Millennials vs. Baby Boomers.

In very rough terms, a Baby Boomer earns about twice what a Millennial does.  But Millennials are entering a period of rapid growth in wages.  In contrast, as Boomers retire, their incomes are typically cut in half.  It seems to me that in all consumer areas it’s important to concentrate on firms that serve mostly Millennials, and avoid those (department stores are an easy example) that serve mostly Boomers, no matter what the level of current profits is.

My personal belief is that Americans don’t approve of making money from others’ illnesses.  That’s the simplest reason (there are others) I can give for avoiding hospitals or nursing care or other healthcare service providers.  But the premise of no business cycle help implies as well looking for smaller, more innovative, say, medical treatment development, firms    …early-stage companies with the potential for explosive growth.

In the tech area–a more business cycle-sensitive area than healthcare–I think seeking out smaller, more innovative firms is also the way to go (but I always say this).  In a so-so economy these should continue to prosper.  The big risk is that they would likely be hurt very badly if the administration continues to add to the damage to the domestic economy that it is already doing.