There are a two main themes I’ve noticed in the new year so far.
- Corporate earnings are slowing, cost cutting is up
- Governmental QE programs are still ramping up, but easy money is not generating tax revenue
- The US is cutting back, but very, very slowly. Rest of world expanding.
Other media focal points include emerging market slowdowns, recessionary fears and oil prices, but I believe these can be seen as sub-themes.
Erasing Public Debt in a Stagnant Economy
Hook, Line, Sinker
Many countries are in the woes of huge fiscal deficits, debt, which is owed both domestically, but more worryingly, abroad. Part of this is due to a massive shift from private to public debt during the last financial crisis. However, this can be seen as just the last straw from years of low tax, high expenditure budgeting.
In order to cut these debts, governments have been using quantitative easing, or “easy money” policies to encourage business to take on cash and invest or produce. In Japan, the “easy money” ideal has been pushed to extremes with negative bank rates. This is all in the hopes that the revenues generated by firms using this easy cash will increase tax revenue and the government can begin paying back principal on these deficits. This requires either a massive increase in production and consumption, or increased tax rates, or possibly both for the severely indebted countries.
The Fish Are Not Biting
Unfortunately, corporate earnings in highly industrialized economies have been on a slowing growth trend for a long time. While this is making headline news today, I believe that this pattern started pre-recession to some degree. During the build-up to the 2008 financial crash, corporate earnings where expanding mostly on the wave of financial expansion. During the period, consumers feeling rich because of inflated home values were willing to spend enough to the mask structural flaws in these conglomerate based economies.
What Everyone is Talking About
Today, all these fault lines are on the forefront of investor’s thoughts instead of the back of them. So here we are. For years large institutions have been riding a wave of surplus consumer wealth, aggressive financial accounting practices, and bull markets. Now the consumer surplus and bull markets are gone, and regulators are cracking down, looking for extra tax money.
While governments are extending the hand of easy money in the right, on the left is the knockout of higher taxation. Most larger companies have few facets for organic growth, having largely ignored infrastructure for investment innovation. It will be a long time before innovative new tools and practices can be implemented into major corporations. For instance, cloud computing is a phenomenon that has been a huge boon for small and mid-sized enterprises, but few major corporations have the infrastructure or plans to utilize flexible digital storage solutions. With shareholders pounding at the door, there is no time to develop and implement such innovations now. Instead they pursue cost cutting.
Cost-cutting is not a terrible thing. It means jobs losses but also increased efficiency. Cost-cutting sets the path for future growth. However, it is late. Many corporations would have had a better time cutting costs in the early 2000s, but such policies in times of economic growth are frowned upon. Instead, newly jobless citizens will now be searching for employment and trying to develop new skills in a stagnant economy that will soon value youth, technological prowess, and cheap labor.
In terms of recession and further crisis, there is a seemingly thin edge to fall over. For example, a larger than usual decline in emerging market growth or a collapse of the EU, such unlikely but possible events have larger probabilities of triggering recession if they do occur. But more rational investors will recognize that while economies have large slowed, they are no longer shrinking. Short of an economic disaster, soon the buzzword will be stagnation, not recession.
First, there must be a re-balance. Economies will only begin growing meaningfully once technological advancements are again a norm. Unfortunately, this will mean the death of more industries. A major disruptor is 3-D printing. As it becomes commercially viable for small scales, many suppliers of menial parts will die. While this may seem like a natural evolutionary market path, the question remains whether such a shock would lead to more good than harm at the moment. Other trends like green energy are also disrupting markets. Genetic engineering and manipulation may spell doom for traditional pharmaceuticals. However, finding winners in haystacks of government funded drags is difficult, as the collapse of SunEdison shows. Furthermore, large firms are still exerting pressure against these smaller disruptors both through legislation, cost cutting and talent poaching. In terms of government policy, there are the dual edges of increasing deficits vs fostering innovation to balance. Progress will be slow, even if it is in the right direction, which is not guaranteed.
Crossroads for Emerging Markets
In terms of emerging markets, there are still opportunities, but of different sorts. Record revenues have been made by banks in fixed income from emerging markets. This implies that equity investments in emerging markets are dulling, due to slowing economies and political risk, but safer bets like bonds are still returning. However, the theme in emerging markets is mostly about when these bonds will stop returning just like equities. Interest rates are a major signal. There is a possibility of a rebounding equity environment, but this will depend on how these economies transition to services based economic cycles while managing a high debt load. Those that fail will end up like Japan or worse, Greece. Brazil seems to be in the latter path, but China and India hopefully will draw positive lessons from past mistakes and modernize smoothly.
Big Fish no Longer Rule, Buy the Fish with Guns
Companies that have long focused on technological innovation with constant revenue growth are good bets. Microsoft, Google and Amazon are established tech giants and thus valuations are high. While Apple was the crown jewel under Steve Jobs, today the company seems to be faltering on innovation, but the down prices may raise bulls. Facebook could be a dark horse. Profits are growing and product improvements have not failed as poorly as Twitter, but there is still the question of whether a single platform social company can be a lasting creator of value. These companies will not escape economic malaise, but they are already cutting-edge.
Outside tech, companies that started cutting costs pre-recession are on a faster track to recovery. GE and McDonalds stand out, though now in the stages of innovation, there are no guarantees of returns. Large blue chips in the throes of just beginning to cost cut may see a small rebound, which will then be offset once the companies begin realigning for the future. The ones that realign properly will survive to prosper. Financial firms for instance, are mostly just beginning to cut costs. The ones that survive will have to realign to a more technological and algorithm aligned business. JP Morgan is a good bet, as the smaller and nimbler Goldman Sachs. Prices of financials right now may be high short term, low long term. Servers, cloud companies and IT Security firms are a good bet, but there is a diverse field as entry costs to these markets are relatively low compared to manufacturing giants. Oracle and Salesforce are long standing leaders, but face competition today from giants like Amazon, Google, Microsoft, as well as small firms like VMware. These leaders are now middle of the pack.
Mid-sized to small cap firms may have trouble with the increased taxes and a fickle consumer demand. In previous years, many of these firms used mergers to survive, but tax laws seemed to have dampened desire to continue with this route, as the failed Allergen-Pzifer merger shows. For investments in such firms, look for outstanding management and fiscally sound operational policies.
On the other hand, small businesses seem to be thriving, as more trained, experienced but out of job people turn to their own firms or smaller firms for opportunities. Unfortunately, short of venture capital, these firms are not really investable. However, these acorns being planted is a positive sign for the economy, and prudent investors will track IPOs once the cycle begins again some years from now.