Bright Side of Life
Things are a bit chaotic in the world these days and it’s not just Covid-19. We’re at the end of a long term economic and social cycle and the imbalances from this cycle need to be rectified before a sense of normalcy will return to our lives. The history books are full of such time periods. Our ancestors found a way to thrive in such times and we will too.
The title for this piece is based on the song “Always Look on the Bright Side of Life” by Eric Idle of the Monty Python comedy troupe and is featured at the end of the movie “Monty Python’s The Life of Brian.” After another day of reading the news and how our country is losing its collective mind, this song just popped into my head and I’m glad it did. Things may be getting a bit out of control but change brings opportunity.
The markets came roaring back in the second quarter with the S&P500 now down a mere 4% for the year on a price basis. With this move, we can safely close the book on the argument of whether the government/Federal Reserve is intervening/controlling the markets. Governments want stability above all else and today, the only way to stabilize our economy is to keep the markets elevated.
There will be consequences to these actions but even consequences bring opportunity as long as you prepare ahead of time. I won’t dwell on those consequences in this piece because only the near term opportunities are important for client wealth generation. Besides, to quote the song, “when you’re chewing on life’s gristle, don’t grumble give a whistle and this’ll help things turn out for the best.” If the Fed is going to keep the markets elevated, it gives us more time to add to the value of client portfolios before it’s time to make some changes.
Over the past quarter, the stocks that have performed the best are the ones that did the worst in the first quarter with the exception of large cap tech such as Amazon and Microsoft. If we separate the two types of stocks, the large cap techs are something of an aberration much like the “Nifty Fifty” from the early 1970’s. On a cash flow growth basis, there is no way to value them in a way that makes any sense to own but on the basis of money flows where success begets success, they continue to perform well. Unfortunately, that form of investing is outside our disciplines and to attempt to follow it at this late stage invites destruction of client capital.
The companies that snapped back after a lousy first quarter are largely companies that benefit or get hurt by the economic cycle. We continue to expect the US economy to remain weak throughout the rest of the year, apart from the benefits of government spending such that cyclical companies make little sense for our clients.
Instead, we believe the winners going forward will be companies that are best positioned to grow earnings in this increasingly complex economic environment. With so many people still unemployed, it’s going to be difficult for manufacturing and other industrial companies to thrive and maintain profitability. This is why we continue to favor industries with pricing power and steady demand for their products.
We reduced our positions in electric utilities for this very reason in our lower risk accounts. In the month of June, 30% of the US population failed to make a housing payment. This is a combination of renters and homeowners with mortgages and it shows just how difficult this downturn has been on the average household. This begs the question of whether these folks are paying their utility bills during our national crisis.
We owned a large number of electric utilities for clients because they paid handsome dividends but will they continue to pay those dividends when so many people are skipping their utility payments? It’s possible that they can borrow the money to maintain their dividends, hoping to collect late payments in the future but that’s a bet I’d rather not make with values at current levels. They were excellent stocks for us but it was time to say good-bye to most of them.
Now, you might be wondering how stocks are able to stay elevated despite the worst economic climate since the 1930’s and the answer is the combination of US government fiscal stimulus and the expansion of the Federal Reserve’s balance sheet. The US government has put money in our pockets while the Federal Reserve has been injecting money into the banking system with nowhere else to go but in securities. The chart below makes it abundantly clear that the Federal Reserve is keeping stocks elevated.
As they say, you can’t fight City Hall and in the markets, you can’t fight the Fed. This doesn’t mean that stocks will continue to rise forever and it certainly doesn’t mean that we are bullish on the stock market and economy. Instead, we acknowledge the unprecedented current circumstances and will continue to look for opportunities even as “end of cycle” dynamics play out.
This is where things get very interesting. As I’ve said innumerable times before, the world runs on US dollars. It’s the currency that drives trade in the world. Historically, the world banking system accumulated vast amounts of dollars thanks to trade, particularly the years where we ran massive trade deficits such as when we were importing most of our oil.
Based on the chart above, you can see where the Federal Reserve took its balance sheet up from around $3 trillion to $7 trillion. Some would argue that this move is swamping the global economy with dollars but if you actually analyze money flows, you’ll see that fewer dollars are moving into the global economy. The reason is that world trade has collapsed thanks to the virus.
Money isn’t leaving the US for distant shores like it normally does. Not only are we largely self-sufficient in oil production, demand for imported products has declined thanks to the economic downturn that started in February. This means that the global banking system isn’t taking in new dollars.
Yes, we exported vast amounts of US dollars in the past through trade but it appears that much of that money has been squandered by investing in China and the emerging markets. Those economies are NOT generating dollar revenues with their past investments because Americans are not consuming at the same pace as in years past.
With China no longer able to grow itself through uncontrolled investment, the global economy is left to run on the US consumer and since there is no way to jumpstart the US consumer back into consumption mode, there is no organic way to move US dollars into the global economy. This is made worse by talk of moving parts of the global supply chain back to the US, which would mean even fewer dollars travelling abroad.
If the US actually succeeds in bringing jobs back to America, it will mean an end to the global economy because it is our trade deficit that feeds the rest of the world. Knowing this, it’s easier to understand why companies like GE moved so many operations abroad with the blessing of the US government. The US Treasury wants to maintain the dollar as global reserve currency and thus, they faced a choice of allowing domestic producers to thrive and possibly lose the dollar as sole reserve currency or favoring international producers and expand the number of dollars in circulation. They chose the latter and it’s one of the biggest reasons why we have an opioid epidemic throughout the Rust Belt – people had their livelihoods shattered by outsourcing production.
Without a reason to invest in US operations, US companies have been buying back stock for the past thirty years. And now, the Millennial Generation is angry because they don’t see a future for themselves because it takes investment to create jobs. These are young people in the early stages of their working lives, many of whom are still paying off student loans. The Fed’s manipulation of the stock market has no effect on them and thus, does little to ease their economic burdens in this downturn.
As a society, we’re at a crossroads. Do we take the path of maintaining the global economy at the expense of our own people? Or do we return to a balanced economy where we largely consume what we produce? It’s too early to tell which way the majority will break.
The evidence suggests that choosing the international path and continuing to import our manufactured needs is only a temporary solution at best. Without well-paying jobs for our Millennial Generation, they won’t be able to enjoy the same standard of living as their parents – a standard of living that was built by competitive advantages versus the rest of the world. Those competitive advantages have been ceded to the rest of the world thanks to global outsourcing.
The more US companies move operations outside the US, the less control they have over maintaining intellectual property and thus, long term profitability. This is because our trade partners “champion” their domestic companies and do whatever they can to steal US competitive advantages. US companies enjoy short term benefits but those early benefits are competed away by international companies using US intellectual property. Let’s take General Electric as an example.
GE was one of the first companies to move operations out of the US to enjoy the benefits of lower costs from locales such as China. But to get into China, GE had to share most of its intellectual property with Chinese competitors, with the result being temporary low prices but ultimately, a loss of market power in their primary markets. Let’s take a look at how this has worked for GE’s investors over the long term?
Over the past 25 years, GE’s stock price has lost 80% of its value. Keep in mind that GE was the pioneer when it came to shifting production outside the US. In the end, what did they get for the effort? How did American workers across the country fare when their jobs were outsourced for short term gain?
The great bull market that started in the middle of the 1980’s was first built on the benefits of technology which then became the benefits of outsourcing operations abroad and finally, since 2014, has been driven by stock buybacks. Since September, stock market performance has been driven by liquidity injections by the Federal Reserve. US corporate earnings stopped growing in 2012 although earnings per share continued to rise thanks to massive stock buybacks, which spread those earnings over fewer shares of stock.
It’s pretty clear that something has to change if we’re to start growing again in the future. It takes capital investment for an economy to grow and our corporate champions have been loath to spend capital for domestic growth. This is the essence of our national economic difficulties and it will require a choice by us.
The GeoVest Approach
For the moment, we are in limbo as to the direction of our economy which is why I favor companies that will continue to generate positive cash flow regardless of what direction we choose as a nation. The Federal Reserve is likely to continue supporting the equity markets so we want to grab as much extra value as we can for clients before a choice is made. From everyone at GeoVest, we wish you and your families’ health and good fortune through these difficult times. Thank you and it’s our continued privilege to serve you.
Philip M. Byrne, CFA
Chief Investment Officer