Saturday, May 17, 2014

Reframing an Old Picture

The macro narrative of the US stock market is weird. It has been on a tear higher since early 2009, recovering the losses seen during the 2008 crash, and continuing on to make new all-time highs. Meanwhile, the real economy is having a much harder time keeping up with the higher valuations. Mainly due to unemployment and to a certain extent underemployment, which is filtering through to low-to-no wage growth, the same for trends in consumer spending, and the same for GDP, and the same for inflation expectations, the list goes on.

How soon is still very fuzzy, but whenever interest rates start rising, the discounting approach to equity valuation would suggest a correction in stock prices, or at the very least a slowing of the rate that the securities appreciate. Especially when further increases in dividend payouts don’t seem very likely from this point. Companies have already paid out massive amounts of cash from earnings back to shareholders in the form of dividends and share buybacks, which have done nothing but support the run-up we’re seeing in stocks.

Low interest rates have been a good input for a valuation model that uses them as the denominator, perfectly suited for an economy emerging from a recession. But as the denominator in the model gets bigger, the output should get smaller. Stock prices going down flies in the face of intuition, so I suggest we simply just pick another way to prove that stocks should definitely be worth more over time. A method that better suits a rising interest rate environment.

The logic would be, if interest rates are rising the real economy should be growing [at least consumer prices should]. If the economy is growing coming out of a recession or a protracted period of slow growth, behavioral economics can kick into overdrive and propel equity prices higher as investors rationalize higher and higher multiples of earns in their forecasting and valuation models. That’s all good and well, but the real economy doesn’t have the convenience of swapping out one valuation method for another to outline the same growth narrative.

Thursday, May 1, 2014

Labor and Capital in a Globalized World

I remember sitting through economics courses listening to lectures on labor mobility and capital mobility, and their flows in relation to countries competing globally. Fast-forward ‘X’ number of years [I’m not going to date myself.], and I’m looking at the same concepts, but this time with a more realistic perspective.

For a country like the US, that a generation ago was leading the world economy with manufacturing at its base labor was an especially important factor of production. Capital in the form of investable funds has always been relatively available and at relatively low costs in the US, but particularly so in the post-depression decades. Labor on the other hand was not available in similar abundance. The economic models would suggest that an economy with abundant capital and scarce labor should specialize in services versus manufacturing as services are less labor intensive.

In the time frame that the US was making strides in manufacturing, the rest of the developed world was recovering from World War II. With the US being one of the few participants that did not suffer domestic destruction from warfare, there was no recovery time between switching from war-supply manufacturing to consumer goods manufacturing as the capacity already existed. And with industrial capacity decimated across the developed world and Asia, there was artificial demand for US made goods.  The external demand would have spurred investments in manufacturing technology in the US to keep growing capacity, but also making the sector relatively more capital intensive.

By the start of the US-Korean War, manufacturing would have been on the rebound across the developing world. Again, as the economic models would suggest, countries where capital is relatively scarcer than labor should specialize in more labor intensive production, like manufacturing. So while manufacturing and export centers materialized organically across the globe, it took US government wartime spending to artificially propel the manufacturing base forward at home. This would however, be the last war to have this benefit.

Since the protectionist days of the great depression, the major trade participants of the world, and progressively more minor ones have been moving towards connectivity and away from isolation. In an ever globalizing world, capital and to a lesser extent labor would have begun moving across borders with more and more ease, which meant global imbalances became more apparent. As the global market for capital and labor sought to reach a state of equilibrium, the US economy began a fundamental shift towards services and away from manufacturing as the increasing cost of labor would have destroyed competitiveness.

By the time the Vietnam War was in full swing, the US economy was at the height of the transition from a manufacturing based economy to a service based economy. At that point, manufacturing had almost been completely eroded away by the high relative cost of labor, while the technological infrastructure to make a service based economy more viable was still in its early stages of development under the guidance of the military.

Unlike previous war-time spending campaigns by the US government, which had subsidized and stimulated the manufacturing base, spending on the Vietnam War did not ‘trickle down’ to the man on the street. He had not had a job in manufacturing in years and his skills were outdated for the technological applications. The service sectors that were emerging at the time required a re-tooling of the American workforce and so also increased in capital intensity. Though it would have been much easier at the time [and frankly still is today] to increase the capital stock in the US by allowing more foreign investments than to increase the labor stock by allowing in more foreign labor.

The period following the Vietnam War was plagued with high unemployment and high inflation, which ushered in the era of stagflation. Tracking the US Balance of Payments of accounts we can see that the US became a net importer of manufactured goods in the middle of the 1970s, but did not become a net exporter of services until the middle of the 1980s. Almost a decade of no clear base for economic growth and fiscal drag from financing war, and the threat of limited supplies of oil due in part to geopolitics, US economy was in dis-equilibrium. 


Balance of Payments on Services
(Billions of $US)


 Balance of Payments on Merchandise 
               (Billions of $US)

The level of economic hardship that was experienced by so many during that period was indicative of what happens when an economy is too heavily weighted in one sector over the many, and how artificial supports [whether intended or unintended] tend not to work over time.

During the same time period that the economy was re-inventing itself, Congress was hard at work putting together new ways to make things better now, but worse later. In 1977 Congress passed the Community Re-investment Act (CRA) and, in my opinion, this put a series of events in motion that inevitably lead to the housing market bubble of the early 2000s and the ensuing global recession. That piece of legislation, along with others de-regulating the largest banks and financial institutions, created the space for a secondary market for mortgages to develop. Along with that came the idea of securitizing mortgages and reselling them to investors, from there the rest is history.