I’ve updated my Keeping Score page for January’s movement in the S&P 500.
Ever since the Leavers overwhelmed the Remain faction in the UK’s Brexit vote, observers have been wondering how the UK is going to effect its break with the EU …and how complete the breach with continental Europe will be.
The two main approaches were dubbed soft, meaning that negotiations would be held at a leisurely pace, the break would come eventually–but not soon–and that the UK would retain as many of the privileges of EU membership will shedding as many obligations as possible.
Article 50 of the Lisbon Treaty lays out the process for a country to withdraw from the EU. It provides that a state that wishes to leave sets the process in motion by invoking Article 50. That starts a two-year clock running, at the end of which the separation occurs. Since two years is a relatively short period in diplomatic time, especially to arrange complex future trade agreements, conventional wisdom has been that a country like the UK would begin negotiations first and only trigger Article 50 when the negotiating finish line was in sight. Taking this path would be the more economically sensible. It would also be a clear sign that soft is the ultimate goal.
The alternative would be “hard,” meaning basically getting out of Dodge as fast as possible. Why do so when collateral economic damage would result? …because other political considerations, like halting immigration from the rest of the EU, have a higher priority.
Over the past week or so, Prime Minister Theresa May has been signalling that Brexit will not be put on the back burner, and that, in consequence, the UK government is opting for the “hard” road. She will invoke Article 50 by next March, at the latest. And she has packed her negotiating committee with the most anti-EU people she can find.
This decision has a number of consequences:
–Scotland, where two-thirds of voters cast their ballots to Remain in the EU, is reviving its own referendum to withdraw from the UK and enter the EU as a sovereign country itself
–putting itself under time pressure by effectively starting a two-and-a-half-year clock running, the UK has revealed its sense of urgency. That may have lost it negotiating leverage
–half of the UK’s exports go to the rest of the EU. Time constraints may see it leaving the EU in early 2019 without trading agreements with countries where its major customers reside–meaning export sales may fall off a cliff
–similarly, it becomes less likely that bankers based in London can retain their current unfettered access to clients in other EU countries. This suggests that banks may begin to shift operations to the Continent
–sterling will continue to slide. For portfolio investors like you and me, this has perhaps the most important near-term implications. There’s no need now, nor in the near future, to change from favoring London-traded stocks whose assets and earnings are outside the UK. Better still if the firms’ borrowings and SG&A expenses are in sterling.
Over the weekend, the New York Times published an article that contains copies of parts of Donald and Marla Trump’s 1995 income tax filings. The pages, mailed to a Times reporter in September and verified as genuine by the accountant who prepared them, contain two items of note:
–during that year, the Trumps had income of about $9 million. That was more than offset by a loss of $15.8 million generated from “rental real estate, royalties, partnerships, S corporations, trusts…”–which I take as being tax loopholes designed for the real estate industry. If we assume that this is par for the course, it would mean that the Trumps typically pay no federal or state income tax.
–the Trumps also show that as of that year they had accumulated other losses totaling a stunning $909 million. This figure is presumably the cumulative result of Donald Trump’s efforts as an investor. Two points:
—tax losses have a current economic value, which deteriorates as time passes. In this case, the value in 1995 of the Trump’s loss was about $350 million, and was shrinking in economic worth by, let’s say, $30 million per year. Logically, the best course of action would have been for the Trumps to use the loss by selling, the sooner the better, something they owned and had a profit on. The fact that they did not suggests they didn’t have any investment gains at that time–or that they used what gains they had to whittle the loss figure down to $909 million.
—Donald Trump was born into a wealthy real estate family. He entered the family business with the advice and support of his successful father. Falling interest rates + the development of New York City as a world financial center made the 1980s a golden age for real estate investing in the region the Trump family had expertise. Yet the Trump 1995 tax returns suggest that on a net basis Donald not only made no profit during a time when real estate was like a license to print money; instead, he lost nearly a billion dollars.
In a recent Forbes article, John Griffin, a finance professor at the University of Texas/Austin examines Donald Trump’s investing career using publicly available data, both independent estimates and figures self-reported by Trump. Prof. Griffin concludes that Mr. Trump has made only about half the profits of a typical real estate investor (about 40%, taking the self-reported figures), while taking on a higher than average level of risk. Mr. Griffin concludes, ” Donald Trump is obviously a skillful presenter and a talented entertainer, but in terms of his investment skills, he is a clear underperformer.” To my mind, the mammoth loss shown in the 1995 Trump tax return suggests that a less favorable assessment may be warranted.
As I mentioned yesterday, one BIG problem with the traditional business cycle model (the one taught in business schools) is that although it explains what happens abroad, it no longer fits with behavior in the US economy–which is, after all, the biggest in the world (for believers in purchasing power parity, the second-biggest …after China).
The model says that lower interest rates energize business capital spending, which produces new hiring, which leads to higher consumer activity as new employees spend their paychecks.
the US experience
In the US, however, consumer spending recovers first. Typically, soon after the Fed begins to lower interest rates, US consumers have been back in the malls, spending up a storm. Rather than industry lifting the consumer, the consumer pulls industry out of its slump.
Economists theorize that what’s at work in the US is the “wealth effect.” Two aspects:
–maybe lower rates are like Pavlov’s dinner bell ringing and consumers begin to salivate in advance of recovery (my personal take on this is idea that the office/plant grapevine signals that the worst is over, that layoffs have stopped and new hiring will soon begin)
–lower rates = house prices start to rise, as do bonds and stocks. So consumers feel wealthier as rates fall, because their accumulated assets (their wealth) are worth more.
The problem here is that we’ve had zero rates for eight years without seeing the traditional recession-ending spending surge
where’s the capital spending?
Whether capital spending is the locomotive or the caboose, it’s still arguably an integral part of the economic recovery train. Why haven’t we seen a capital spending surge in the US? Is the lack of capital spending an indication of continuing weakness in the US economy, as the traditional business cycle theory would suggest?
I think four factors are involved here, the sum of which suggests reality has sped far ahead of theory:
–the internet. Typically, there’d be a surge in construction of shopping malls as recovery gains speed. But as online commerce has developed, we’re finding that we already have maybe 20% too much bricks-and-mortar retail space
–globalization. Continuing industrialization in emerging economies like China during the last decade has decisively shifted lots of low-end US-based manufacturing abroad. In addition, I’m also willing to entertain the thought that crazy spending in China has produced an enduring glut of manufacturing capacity there, although I have no hard evidence
–software. For many (most?) US companies, the largest target for new investment spending is not bigger, newer plants but faster, more efficient software. The National Accounts, the government system of tallying economic progress, have no effective way of recording this expenditure for analysis. The traditional business cycle picture is similarly stuck in the world of fifty (or a hundred) years ago
–skilled vs. manual labor. This is a thorny issue, and one I have strong opinions about. Here, I think it’s enough to say that the traditional model doesn’t distinguish between a twenty-year old with a grade school education and a strong back vs. a college dropout like Mark Zuckerberg. A generation ago, the distinction wasn’t important. today, it’s crucial.
The easiest place to start is at the low point of the cycle–and to talk about every place in the world except the US.
the target for government policy
A typical rule governing policy action would be for a country to act so as to maintain the highest sustainable (that is, non-inflation-inducing) rate of economic growth.
At its low point, activity in an economy is advancing at considerably less than that. The economy may even be contracting. The cause may be prior action by the government to slow the economy from a previous overheated state (policy actions are blunt tools: most often they overshoot their objective) or the economy may have been hit by an out-of-the-blue event, like an oil shock or a financial crisis.
In either case, companies are laying off workers, reducing inventories, closing now-unprofitable operations …all of which is causing the slowdown to feed on itself.
The traditional remedy to break the downward spiral is to lower interest rates–we might also describe this as lowering the cost of money by making a much larger quantity available to borrow.
What does this do?
In theory, and often also in practice, companies have a list of new capital projects they are ready to implement but which are unprofitable at the high interest rates/weak growth that accompany/trigger a slowdown. By lowering rates, the monetary authority makes at least some of those projects into moneymakers. So companies commit to new capital projects. They hire planners and construction firms; they buy machinery; they hire workers to staff new plants.
As these formerly unemployed workers get paychecks, they begin to consume more–they buy clothes, and then houses and new cars. They begin to eat restaurant meals and go on vacations again. As consumer-oriented service industries see their businesses picking up, they begin to hire again, too–adding to the new wave of consumer spending. At the same time, the supply chain begins to expand inventories to be able to satisfy rising demand. Similarly, manufacturers hire more workers and begin to expand their own productive capacity.
In this way, self-feeding slowdown turns into self-feeding expansion.
At some point, the economy reaches full employment. Companies want to continue to expand because they now see many profitable investment projects. But there are no more unemployed workers. So firms begin to offer higher wages to bid workers away from other firms. They begin to raise prices to cover their higher costs. This activity doesn’t create more output, however. It only creates inflation.
Either in anticipation of, or in reaction to, budding inflation the monetary authority begins to raise interest rates to cool down the now feverish expansion. It keeps rates high until it begins to see signs of slowdown–inventory reductions, new project cancellations, layoffs.
The economy eventually reaches a low point …and the cycle begins again.
–in the model just described, industry recovers first, followed by consumers. This happens in most of the world. In the US, however, as soon as interest rates begin to decline, the consumer typically begins to spend again. Business follows with a lag.
–conventional wisdom is that money policy actions need 12 – 18 months to take full effect. In the current situation, short-term interest rates have been effectively at zero for eight years (!!) without seeing a sharp surge in economic growth in either the US or the EU.
–economists have been concerned for years that there’s been no oomph in capital spending in the developed world, despite low rates. The traditional model explains he concern–business capital spending is thought to be a key element in any recovery.
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.
The Bureau of Labor Statistics of the Labor Department released its latest JOLTS report on Wednesday.
The main results:
–nationwide job openings are now at 5.9 million, the highest figure in the 16 year history of the report. This is substantially above the 4.5 million level of 2006-07.
–the rate of new hires has been flat for about two years at just over 5 million monthly. While this is 5% – 10% below the rate of 2006-07, the very high number of job openings would have been consistent with an unemployment rate of 3% ten years ago. This seems to me to be a point in favor of the idea that the main impediment to filling jobs is finding workers with needed skills.
–3 million workers are voluntarily leaving their jobs monthly. This is a sign they’re confident of finding employment again without much difficulty. That’s back to the pre-recession levels of 2006, and almost double the recession lows.
All of this argues that the US is at or near full employment. On the other hand, however, there’s little sign of the upward pressure on wages that this situation would have produced in the past.
Whatever the reason for slow-rising wages, it seems to me there’s no reason in the employment figures for the Fed to maintain anything near the current emergency-room-low level of short-term interest rates.