10 Economic and Investment Counter-Trends in the World Today

Economist Noah Smith wrote an interesting piece for Atlantic Magazine which was published at the end of last month.

Titled "The 10 Stealth Economic Trends That Rule the World Today", Smith reviewed the trends that were "accepted wisdom" just a few years ago but now have turned out completely differently.

I won't review them all - I encourage you to click on the link below to read the whole piece - but here are a couple:


7. Old Trend: Skyrocketing health care costs, skyrocketing deficits.  New Trend: Creeping health care costs, creeping deficits.

Health-care costs and the national debt are drowning the nation, right? Well, maybe. But the water isn’t rising nearly as fast as we thought it would. Health-care costs are still outpacing economic growth, but they are doing so at a slower pace, thanks perhaps to the imminent start of Obamacare, medical innovation, or the recession. Meanwhile, the percentage of health sector jobs is finally falling as a percent of the total. As for that big, bad deficit, it’s fallen by more than half since 2009, and this quarter the federal government actually intends to pay back a tiny bit of the debt. Of course, for those who think that austerity is bad for the economy, this is bad news, but Americans who are worried about the national debt can breathe a little easier.

8. Old Trend: The BRICs are conquering the world.  New Trend: China is the only BRIC in the wall.
Remember the BRICs? Those new rising super-economies that were going to eclipse the old guard of America, Europe, and Japan? Well, they hit a BRIC wall. Russia, Brazil, and India, tigers of the 2000s, have slowed to 2 or 3% growth – about the same rate as the rich countries. China is the last BRIC standing. Although it has experienced a mild slowdown, too, it is still powering ahead at a robust 7.5% rate. Instead of the rise of a new economic order, we should be talking only about the rise of China.

http://www.theatlantic.com/business/print/2013/09/the-10-stealth-economic-trends-that-rule-the-world-today/280107/

Smith's article inspired me to come up with my own list of trends that were accepted by most of the investment world just a few years ago but have turned out much differently than originally expected.

Here are my own 10 economic and investment "counter" trends:

1. Old Trend: The Federal Reserve monetary policies will lead to hyperinflation.
New Trend: Deflation, not inflation, is the Fed's worry.

In the aftermath of the credit crisis of 2008, the Fed undertook what appeared to be an audacious experiment in monetary policy by aggressively adding trillions of dollars to the credit markets.

Numerous observers that the Fed was leading the U.S. down the path of hyperinflation.  However, with monetary velocity plummeting to new lows, inflation rates are running slightly higher than 1%, and recent data points indicate even lower increases.

2. Old Trend:  Interest rates have to move higher.
New Trend:  Interest rates remain low.

At the start of the credit crisis in the fall of 2008, the yield on the 10-year Treasury note was just below 4%. Today it stands at 2.6% despite record amounts of borrowing by both government, corporate and municipal entities. 

Treasury rates remain low despite the credit rating downgrade by S&P in 2011.

3. Old Trend: Gold is the only safe investment in a world of easy central bank policy.
New Trend: Gold prices have moved sharply lower.

Gold prices have dropped by -25% so far in 2013.  While historically gold has been a sound vehicle for protecting wealth, the fact that it has no industrial uses, and that gold coins are not used by anyone to facilitate transactions, makes its value only in the eyes of the beholder.

4. Old Trend:  The euro is a failed experiment.
New Trend:  The eurozone continues to survive.

Despite numerous predictions that the euro was doomed, the countries involved in the eurozone appear to be determined to make monetary union work.  The value of the euro versus the U.S. dollar is around $1.35 at this writing, which is roughly the same level of 5 years ago.

5. Old Trend:  Avoid the stock market.
New Trend:  Stocks continue to be the best way to grow money on a longer term basis.

Over the past 5 years, the S&P 500 has produced a total return of over +60% for investors.  Going back further, investing in the S&P would have doubled your money over the past 10 years, despite the 2008-09 debacle.

Starting and ending points matter.  When the S&P was trading at record high 44x earnings in late 1999 we were clearly in bubble territory. Today the market is valued at around 15x earnings - not necessarily cheap, but in-line with historic averages.

6. Old Trend: Municipalities are in a precarious financial position.
New Trend:  Most municipal issuers are showing significant improvement in finances.

It was only a few years ago that the prediction of "hundreds of municipal defaults" spooked the municipal bond market, and caused investors to pull funds. However, with the exception of several well-publicized defaults, the credit rating of most municipalities has been slowly improving due to higher tax revenues and a reduction in spending.

Lack of municipal bond supply - and not too much inventory - is the major challenge for most municipal bond managers.

7. Old Trend:  America is mortgaging its future to the Chinese and Japanese.
New Trend:  Foreign investors have been net sellers of Treasurys yet rates remain low.

As the Chinese and Japanese have been reducing their holdings of U.S. government debt, Americans have been increasing their positions.

8. Old Trend:  Alternative Investments are for "smart money" investors.
New Trend:  Alternative returns have largely lagged traditional equity returns.

Inspired by the success of the Yale University endowment, many large pension and institutional investors moved away from the publicly-traded markets in recent years in favor of hedge funds and private equity. Unfortunately, the combination of high fees and too much competition have resulted in disappointing results. 

Most funds would have been better off simply using a 60/40 stock/bond allocation model.

9. Old Trend:  America's best days are behind us.
New Trend: America is one of the best places in the world to do business.

The introduction of new oil fracking technology that has unleashed a massive amount of new energy sources in the U.S..  Relatively low energy prices, combined with competitive wage rates and business-friendly infrastructure, has made our country one of the most attractive places for global business.

10. Old Trend:  Health care costs will bankrupt us all.
New Trend: Health spending rates continue to moderate.

The current Washington battle over Obamacare is an obvious sign that not all agree with the direct that government spending on health care.  However, as Smith's article indicates, whether it is new government policies, or simply "stick shock", the rate of growth on health care spending has declined significantly in recent years, and the percentage of health care jobs relative to the overall workforce is slowing shrinking.

There is still much work to be done, but perhaps positive change is in the works.

Should We Be Worried About Deflation?

 

Higher interest rates.

Virtually every strategist I read, every meeting I attend - the assumption that interest rates will be headed higher is almost universally held.

There are many reasons for this widely-held belief, including the eventual "taper" of Fed activity in the credit markets.

However, most also assume that inflation will be headed higher than today's rates, which will cause bond investors to demand higher yields.

Problem is, inflation is nowhere to be seen.  If anything, inflation rates are pointed lower, not higher, as University of Michigan economist Justin Wolfers wrote in a column for Bloomberg on September 26.

Here's an excerpt:

...there's one number that caught my attention. The Bureau of Economic Analysis has revised its estimates for the personal consumption expenditures price index. It's an important number, because this is the index the Federal Reserve targets. And remember, it's aiming for inflation of 2 percent.

Instead, the index fell in the second quarter. That is, the U.S. is experiencing deflation.

I won't overstate this. It's just one quarter, and it's evident in just one index, and even when I cherry-pick this interesting number, prices aren't really falling very quickly. The PCE deflator fell at an annual rate of only 0.1 percent in the second quarter.

But it's striking that the Fed's preferred price measure is declining at a time when the main conversation among policy makers is when and how to tighten monetary policy, rather than to make it more accommodative....

Right now, the risk of deflation is greater than the risk of explosive inflation.

 http://www.bloomberg.com/news/2013-09-26/where-is-the-panic-over-deflation-.html

The chart above illustrates Wolfers's point.  If you look at the inflation figures on the right hand side of the chart, you can see inflation is barely above 1% whether you include food and energy price changes (which tend to be more volatile) or not.

Writing in the New York Times on October 1, investment manager Daniel Alpert thinks that deflationary pressures loom due to an oversupply of, well,  just about everything:

...We are in an age of global oversupply: an oversupply of global labor (hence high underemployment); an oversupply of global productive capacity (hence ultra-low inflation); and an oversupply of global capital (hence low interest rates). 

This explains why, around the middle of each of the past three years, activity petered out after predictions earlier in the year that the economy would finally achieve escape velocity. 

The jobs created have been mainly low wage and part time. Growth in domestic manufacturing is still slow, and business spending has fallen, though corporations are flush with profits. Debt-saddled households continue to see real incomes deteriorate (even with very low inflation). Sales of new homes have suddenly reversed course. Rents are falling in several markets where home prices have recently increased. Even the seemingly unflappable stock market has been seesawing because of the uncertain economic signals. 

http://www.nytimes.com/2013/10/01/opinion/the-rut-we-cant-get-out-of.html 

Now, I find myself uneasily with the majority opinion, that inflation rates (and interest rates) will soon begin to rise as the economy improves.

But it seems to be a useful exercise to at least consider the economic and investment implications of a world where prices stay stable or move lower in the months ahead.

Lights Out on Utility Stocks

Merrill Lynch's utility analyst Brian Chin was in town yesterday.  Brian has been following the utility space for 12 years, and in my opinion is one of the better ones on the Street.

I have been generally bearish on the utility group in recent months, but I thought I should go hear if there were any reasons that I should change my mind.

In a word:  No.

Utilities face a number of fundamental challenges.

Demand for power has been declining slightly despite an improved economy.  Alternative energy sources have played a role in supplementing traditional sources for power, and this trend seems likely to continue. 

Meanwhile, utilities are struggling to deal with new tougher environmental rules.

Utility commissions have been gradually reducing the allowed rates of return.  In a low interest rate environment, and with many Americans struggling with little or no real income growth, it is difficult to justify granting 10%+ returns to local utilities. 

Meanwhile, utility stocks are trading at the higher end of their historic valuation range; yield-hungry investors continue to favor the group almost regardless of price.  Brian's work indicates that most of the stocks are overvalued by at least 10% relative to a variety of different metrics.

In our meeting yesterday, I asked Brian if there was any real reason to get interested in the stocks he follows (fortunately he has a sense of humor).  While he favors a few companies in the group (he likes PPL; NextEra and Pinnacle), in general he would agree that the group needs a major re-rating before considering to add to positions.