Kindle Notes & Highlights
by
Niels Jensen
Read between
June 10 - June 11, 2018
At the most fundamental level, economic growth is driven by only two factors – the total number of hours worked on an aggregate basis and the output per hour, the latter of which is effectively a measure of how productive the workforce is.
President Eisenhower had returned from the war in Europe only a few years earlier, and had noticed how quickly the German army could move around on their network of autobahns. Consequently, the interstate highway system was established. Coincidentally, airports popped up everywhere, as civil aviation became a common mode of transportation, and you could suddenly get from A to B much more quickly. A transport revolution took place.
The OECD countries that will be most negatively affected by a shrinking workforce are not European, though. Japan and South Korea will both fare even worse.
High levels of indebtedness affect productivity negatively, as capital that could otherwise be used productively is used unproductively – to service existing debt. Productivity growth therefore suffers not from one but from two counterproductive undercurrents: ageing and high indebtedness.
If GDP growth remains subdued for all those years, there are at least two important implications: government policy must change; and equity valuations must be reset (downwards).
If economic growth is comparatively low, so is corporate earnings growth, which again is likely to affect equity returns.
The key characteristic of a secular bull market is rising P/E (price/earnings ratio) multiples, whereas multiples fall in secular bear markets. Furthermore, total wealth in society tends to rise significantly in secular bull markets, whereas it stagnates or even declines in secular bear markets. Over the years, there have been many more bull (and bear) markets than secular bull (and bear) markets, and the reason is simple. A bear market is established when the equity market is down at least 20% from its previous high, whereas secular bear markets are much longer term in nature. It is not
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The love affair with the Fed has resulted in very high US CAPE multiples13 when compared to European CAPE multiples. On the days the FOMC have convened, and only on those days, if one were to replace the actual S&P 500 return with the average daily return, a very different picture would emerge (exhibit 2.5).
QE has distorted normal market mechanisms and has kept risk assets at valuation levels that cannot be justified from a fundamental point of view.
The combination of low returns and high fees has been a major turnoff for many. Consequently, equities have become the only game in town for many investors, driving ever larger pools of capital to this asset class, and that has obviously had an impact on equity valuations. One could therefore – with some right – argue that, as things stand (i.e. with interest rates as low as they are), using past valuation comparisons as your starting point is not necessarily valid when making a call on current valuations. That said, as interest rates normalise (as they will do eventually), and the appetite
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Let’s revisit BofAML’s projection that 50% of all manufacturing jobs will be lost between now and 2025. That could potentially raise unemployment levels quite dramatically and, by implication, increase the economic slack, which would almost certainly put further downward pressure on inflation.
In a debt super-cycle, as the cycle advances, economic growth is increasingly driven by a combination of growth in debt and money supply. Having said that, there are obviously limits as to how much spending can be financed by debt and money. When that point is reached, you are at the end of the debt super-cycle. John Maynard Keynes called it Push on a String, when he first described the phenomenon in 1935. Nowadays, it is often called the Liquidity Trap.
When debt rises fast – and fast in this context means faster than GDP growth – capital that could otherwise be used productively to enhance GDP growth is instead used to service existing debt, i.e. it is used unproductively.
Overall debt levels have been rising in most countries pretty much without interruption since the end of World War II and, for that reason, the debt super-cycle we are currently in is widely perceived to be about 70 years old. Debt super-cycles, which have existed for centuries, last 50+ years on average29, so it is no wonder that many investors are getting a bit worried.
There is no doubt that the extraordinarily low interest rate environment much of the world has enjoyed in recent years is a significant part of the reason behind the continued appetite for debt, but what would happen if interest rates were to normalise? Have borrowers become debt junkies just because it is so cheap to borrow these days?
Furthermore, low interest rates keep inefficient companies alive (more misallocated capital), particularly when access to capital is relatively easy, and that has indeed been the case in the US in recent years, and is increasingly the case in the UK. Many inefficient corporates are kept artificially alive by low rates. A zombie economy has been established.
My guess is a dramatic overhaul of the entire pension system in the years to come. Otherwise we are likely to see some quite spectacular blow-ups.
That has had two major effects. Firstly, there are few unfunded pension liabilities in the Danish system today and, secondly, because pension funds are no longer subject to the same restrictions in terms of what they can invest in, most Danish pension funds have since delivered much better returns to their members than peers in countries dominated by DB schemes. I think the rest of the world will eventually follow the Danish model.
Equities are a little different. Debt super-cycles rarely end without significant damage to equities, and I would be very surprised if this one is going to be fundamentally different. There is one significant difference, though, when I compare the current cycle to past debt super-cycles.
In the equity space I favour income-generating equities, but I would disregard those companies that pay attractive dividends without generating the required cash flow internally. A surprisingly large number of companies borrow to pay attractive dividends, and they will struggle in a post-debt super-cycle environment.
Thirdly, I would add gold to my portfolio. In over 30 years in the financial industry, I have never recommended adding physical gold to anyone’s portfolio, but gold is the ultimate currency in a world of extreme uncertainty, and the end of the debt super-cycle is likely to cause a great deal of uncertainty, hence my advice.
The more wheels that come off as the world de-levers, the more likely it is for the financial industry to sustain some serious damage and, when that happens, you never know what could happen next. Consequently, I would recommend the most conservative investors to buy gold bullion and store it somewhere safe, but to all those (and I am in that camp myself) who believe that the financial industry will survive as we know it today, buying synthetic gold (e.g. an ETF on gold) is most likely good enough.
Regardless of what happens to inflation, GDP growth is likely to stay muted for a long time to come. It is therefore not entirely unthinkable that we end up with a very unpleasant combination of low GDP growth and relatively high inflation – i.e. stagflation.
To begin with, policy makers must distinguish between the private and the public sectors: In the private sector, there is only one way to re-accelerate economic growth, and that is to establish conditions for demand to shift out faster than supply and, in the public sector, it is all about increasing government spending (in an intelligent way).
Let me give you just one example. If (when) tariffs are raised on international trades56, shipping goods as cheaply as possible would become more important than ever. Low-cost shipping implies larger container ships, though, and many container ports are not deep enough to facilitate the largest containerships now in operation. This means that there will be plenty of excavation work to come in container ports around the world, and it will be up to the government in question to ensure that returns on those infrastructure projects are high enough to attract capital from institutional investors.
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As already pointed out, the very first consumer good that is positively affected by rising per capita income is food. Next comes housing – as people migrate to urban areas, housing is very much in demand. After housing comes transportation.
Meanwhile, the country’s investment programme is to a significant degree based on maintaining social stability, as millions of people continue to migrate from the rural parts of the country to urban areas in search of better times. As the urban population has swelled, the government has responded by creating jobs, often in construction, and habitually by building bridges to nowhere. This strategy has resulted in a banking industry that is over-leveraged and increasingly looking like an accident waiting to happen.
Firstly, aviation leasing in Asia. I note that this industry is not as cyclical as the underlying aviation industry is. Rising living standards throughout Asia in the years to come will put the growth rate of this industry at par with the growth we went through in mature economies back in the 1970s and 1980s, when flying became standard practice. Moreover, it is an investment strategy that generates a respectable amount of regular income. Fixed income investors should therefore treat the investment strategy as a proxy for corporate bonds. Secondly, agriculture. As per capita income rises, the
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Australia can not only produce vast amounts of meat; they can also do it very cost effectively. Australia is therefore likely to be a major beneficiary of the overall Asian drive towards more protein-rich food.
First and foremost, low productivity growth leads to low GDP growth, which again leads to low growth in corporate profitability. An obvious implication of that, combined with my findings in this chapter, is that investors should limit their beta exposure. Much more about that in chapter 12 – all I wish to say now is that taking broad market risk is not likely to be particularly rewarding in an environment of energy producing countries “confiscating” an ever larger share of the capital available.
2017). In other words, US wealth-to-GDP is now a whopping 4.9 times. To understand the deeper meaning of that number, think of wealth as capital and GDP as output. The wealth-to-GDP ratio is therefore the capital-to-output ratio, and an average ratio of 3.8 implies that it would (on average) take $3.8 of capital to produce $1 of output. Hence, the ratio is effectively a capital efficiency ratio, and the lower the ratio is, the more efficiently a country utilises the capital at its disposal.
The stable nature of wealth-to-GDP was first recognised by the Swedish economist Knut Wicksell, and he used it in much of his work in the late 19th century. In mathematical terms, the stable nature of the capital-to-output ratio was first expressed by Paul Douglas (economist) and Charles Cobb (mathematician). Their work in the 1920s turned into what is now known as the Cobb-Douglas production function. The standard version of that production function with only two input factors – capital (K) and labour (L) – states that output (Y) can be defined as follows: Y = AKαL1-α
That doesn’t at all imply that bonds and equities don’t matter. Of course they do, but falling bond and equity prices will only have a limited impact on the average American or British family, whereas falling property prices will do significant damage.
As you can see, the secular bull market we have been in since 2009 is dramatically above the long-term trend line but, when secular bear markets take charge, equity markets rarely just go back to the trend line. Most of them go all the way back to the bottom of the channel. In other words, there is considerable downside risk associated with holding equities – particularly US equities77 – in the current environment.
If we continue to sit on our hands and assume everything will return to normal, GDP growth will eventually turn negative. Simple as that.
Meanwhile, the elite assumes the mob is plain stupid, but it would be a monumental mistake to underestimate the mob, as King Louis XVI learned when the mob took control of his country during the French revolution. I am not anticipating a revolution like the one we had in France in the late 18th century, but less can also do great damage.
That said, there will unquestionably be a significant positive impact on the West from rising living standards in the East, and I recommend long-term investors to structure their portfolio with that theme in mind.
Let’s begin by taking a closer look at various demographic factors – immigration first. As Mrs Merkel in Germany has clearly understood, but perhaps not communicated as well as she could – and should – have, one obvious way to address the ageing problem is to allow more refugees into your country.
The combination of inflation targeting and structurally low inflation has had the effect of plenty of capital being misallocated every year – capital that could, and should, have been used productively, has instead been used unproductively. The best example of that is probably the vast amounts of capital that is finding its way into property at present.
Few would disagree that a better infrastructure enhances the productive potential of the economy, but there are two caveats86. Firstly, the political decision-making process often leads to bad decisions, which results in more infrastructure not always leading to a productivity-enhancing infrastructure. Secondly, and partly as a result of the first issue, there is little robust evidence of a systematic link between the level of infrastructure spending and economic growth. It is therefore next to impossible to document any correlation between the two, which just goes to show that too much public
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China, because of the sheer number of people, cannot allow robots to replace hundreds of millions of workers.
The best line of defence against Chinese competition is therefore likely to be more automation.
Moreover, the only way Trump can be certain the economy will continue to grow at all in the years to come is by letting in more immigrants, and the same could be said about most other developed countries. The US workforce will decline significantly over the next 20 years, if you include only those born in the US with US parents (exhibit 11.1). This would obviously be a rather dramatic U-turn on his declared policy on immigration, but low or no immigration would most likely be massively damaging to economic growth.
Likewise, migration could also have hit an inflection point. One of the less admirable aspects of human behaviour these days is the growing sense of nationalism. There is absolute nothing wrong about being proud of your origin – and I am certainly proud of being Danish – but I have a big problem when I can smell 1930s-style nationalism on the march again, and I can. If the massive influx of Eastern Europeans into Western Europe has hit an inflection point – and early signs would suggest it may have – there are several implications. GDP growth will slow even further (if possible), but workers’
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Neo-nationalism is driven by the stagnating (or even declining) spending power of the majority of the workforce. As a foreigner in the UK (as I am), I suddenly feel I have to justify my presence when speaking to strangers. (“Where do you come from? Why are you here?”) Never before have I encountered that attitude.
Could the era of neo-nationalism be the catalyst that sets the mean reverting train in motion? I think so.
I distinguish between four types of risk – beta, alpha, credit and gamma risk, all of which will be reviewed in the following. Before I do so, though, let me make one thing perfectly clear. What I am about to say is not at all the holy grail. There are many ways one can choose to approach portfolio construction.
Beta risk is market risk – plain and simple. I distinguish between equity beta, credit beta, etc., and it goes without saying that for beta risk to be quantifiable, the underlying asset(s) must be listed. Returns from taking beta risk are primarily a function of how you choose to allocate your capital across different asset classes and countries, but the cost factor is also significant – particularly in a low return environment. As most active investors underperform passive investors once costs are taken into consideration, the most cost efficient way of getting exposure to beta risk is
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Anyway, back to my two reasons. Firstly, there is far more capital chasing mis-pricings today, making margins harder to come by and secondly, technology has changed dramatically. Algo-based trading now accounts for a large percentage of total volume on all major exchanges, and inefficiencies are harvested in nanoseconds rather than days or weeks, as we saw back in the golden years. However, alpha will not entirely disappear, as long as markets don’t go up and down in straight lines.
With those formalities sorted out, let’s jump straight in at the deep end. I would keep my exposure to beta risk – whether credit beta or equity beta – quite low, at least until the world returns to some sort of normality (whatever that means), and that could take many years. Alpha returns are notoriously difficult to come by, so alpha risk is also low on my list of priorities. Credit risk and gamma risk are my top picks with the latter being my undisputed favourite at the moment.
