Altus Insight: December, 2016
The Altus Insight
Market news, commentary and relevant topics for today’s alternative asset investor
Date: December 31, 2016
FR: Forrest Jinks
RE: The More Things Change…
In full acknowledgement of my economic nerdhood, I realize that I may be one of the few people that find such great irony and humor in the events within the world of US economics since the early fall. If you will remember back to around the time of the Fed’s September Board of Governors meeting, economists from across the spectrum of economic schools/religions were bemoaning the state of interest rates, calls for a recession were increasing, and the Narrative that was the Federal Reserve was quickly losing credibility. To most observers the Federal Reserve had backed themselves into a corner, not only being in danger of being blamed for the upcoming recession caused by rate changes but also not having any ammo left in the tank to combat that same recession. Deflation and negative interest rates were discussed more than possible inflation and a spike in borrowing costs.
Meanwhile, anyone who was anyone…the elite, the establishment, high level politicians (from both parties), Wall Street, big banks, big business, the media…gave little chance to a Trump victory but predicted horrible financial market destruction if he did win. We know what happened next with the election and last month discussed the market reactions immediately after the election. While the stock market soared the following day, the bond market tanked, with 10 year treasury rates doubling over the course of the few months around the election. Instead of economic destruction, commentators are now discussing the coming economic prosperity. Based on October commentary, the Fed’s December meeting was vital. Instead, the December meeting came and went and no one really cared. With market rates having increased as much as they have, the Fed increasing its overnight rate had little real impact.
Stock market performance decoupling from Fed comments and inflation expectations increasing is exactly what the Federal Reserve has been trying to make happen for 7 years. Success only came when what they wanted least occurred. It is just another reminder that while we might be able to understand possible outcomes, no one can predict the future. Least of all a certain ex-economist turned political commentator…Ironic and funny!
Paul Krugman, 12:42 a.m. November 9, 2016 (just after the election):
“If the question is when the markets will recover, a first pass answer is never…so we are probably looking at a global recession, with no end in sight.”
Paul Krugman, 1:20 p.m. November 14, 2016 (only 5 days later):
“…don’t be surprised if economic growth actually accelerates for a couple years.”
And…almost two months later we are still talking about Trump. Since the election the stock market has loved him and his proposed economic policies. As mentioned previously, all of a sudden the establishment economists and talking heads are forecasting strong growth into forever (or at least for the next couple years). With acknowledgement to my bear versus bull tendencies, I think it is at least worth reviewing this assumption. I actually like many (but certainly not all) of his propositions, but am not sure the outcome achieved will be nearly commensurate with what is currently anticipated.
Trump’s Plans as Communicated:
1. Reduced Corporate Taxes: This is one of the ones I like. Reduced taxes don’t lead immediately to increased earnings before taxes and interest, which is the most watched measure of profitability, but does lead immediately to post tax profitability and certainly post tax cash flow. Outside of share buybacks, which is just financial engineering to produce the illusion of increased profitability, more cash in the economy should produce more growth in the economy. Economic growth is dependent on population growth and/or productivity growth. Population growth is unlikely to change in any meaningful manner, but productivity growth benefits from investment. Cash funds that investment. Cash may also be used to increase dividends. This puts more money into the pockets of investors, either for spending or reinvestment.
I can see justification of higher stock prices due to the possibility of lower tax rates. Using make believe numbers, a 20 PE ratio means the invested company is earning 5 cents for each dollar of stock price. If the tax rate is 30%, the net earnings are 3.5 cents for each dollar of stock price (70% of 5 cents). We can call that a post tax PE ratio, and a true measurement of return on investment, of 28.5. If the tax rate drops to 20%, then the post tax earning are 4 cents for each dollar invested, or a post tax PE ratio of 20%. The stock price can then appreciate 14% and still provide the same post tax earnings as prior to the decrease in tax rates.
2. Reduced Regulation: Readers will know that I love this one. We can speak from experience about how burdensome the existing regulatory structure is across federal, state and local regulations. It is enough to make some people quit and keeps plenty of others from not starting at all. The idea of removing 2 regulations for every one new regulation enacted is completely reasonable. It will take years of trading 2:1 just to clean up redundant and/or conflicting regulations. However, the beneficial effects of decreased regulations will take years to flow through to the economy. New regulations can kill innovation on the spot, but the lack of that regulation doesn’t mean innovation suddenly springs up and can go from thought to fruition without the normal business/development cycle.
Many are bullish on oil due to the expectation of decreased regulation. I don’t see it as affecting the oil patch much. There will be some marginal increase to profitability tied to a reduction in compliance costs but this isn’t the issue in the oil world right now. Right now there is more supply than demand with a considerable amount of additional supply that can be brought back on immediately if demand should increase.
One area that more reasonable regulation could definitely be helpful, but again not in the immediate short term, is in banking. Since the introduction of Sarbanes Oxley, and accelerated by the addition of Dodd-Frank, small banks have been hard pressed to stay in business. This is why there have been so many mergers and acquisitions in the space over the past several years. Small banks simply can’t afford the cost of regulatory compliance. I know from experience how much easier small banks are to work with than large ones, especially for small business or small investment needs. Getting small banks reintroduced into the main street economy would be hugely beneficial.
An increase in small banks will likely mean some lost business for large banks. This small versus large dynamic is true across most regulated industries. A reduction in regulation reduces the percentage cost of compliance for small companies more than it does for large companies, allowing small companies to more directly compete with large companies. Over time this is a good thing for the economy, but maybe not such a good thing for the stocks of the large companies.
3. Keeping Jobs in America: When it comes to trade, I am a globalist. Over time and space, the world (and nearly all countries individually) benefit from free trade and goods and services being produced by the low cost supplier. Within that framework I am 100% in favor of keeping jobs in the US when it makes sense to do so. Reducing the regulatory cost of business and corporate tax rate will increase the competitiveness of the US as a place to do business. This is a good thing. But this isn’t what is behind the recent victories for US jobs. We have seen US companies commit to keeping thousands of jobs within the US since Trump was elected (Sprint, Carrier, Ford, etc.). Those jobs staying home are great in a micro sense. How those jobs are staying home provides the concern. Carrier, for instance, was offered incentives to not leave. This is troubling. Crony capitalism had a large hand in getting us to where we are today and the general populace’s dislike of crony capitalism, backroom deals, and politics as usual were a tailwind in Trump getting elected. Now, with the way these companies are being convinced to stay home, we have a new type of crony capitalism, just administered by Trump versus previous administrations. Is it fair to Bob’s Heating Units Inc. and his 50 employees that their competitor Carrier now has a reduced cost of business? You can bet Bob didn’t get that same incentive. Uneven playing fields hurt innovation. Regardless of who is in charge of the administration of such actions, crony capitalism is a long term loss for the economy and the country.
4. Deficit Spending: Trump has big ideas on where he wants to spend money. Frankly, many of the places need investment. However, the US debt is no laughing matter. Study after study have shown that once government debt passes a certain threshold as a percentage of GDP that the debt becomes a drag on growth. The threshold percentage is more up for debate but most agree it is somewhere around 100% of GDP. US GDP is roughly $18.5 Trillion and the debt is $19.5 Trillion. We are already nearing the danger zone, if not already in it. Trump’s deficits will add to the debt further creating a drag on growth.
Nothing happens as fast as we expect it to, and there is plenty of opposition in the Senate and Congress to many of Trump’s plans. The stock market is priced historically high, borrowing cost are increasing, it has been decades since a president following a two term president didn’t have a recession within their first term, and we are already well past the average economic recovery length without a recession. These are all headwinds to the economy and stock prices (though technically the stock market and economy are not dependent on each other). There is also the little matter that net long bond positions have drastically increased in quantity over the past few weeks, indicating bond investors are expecting bond prices to increase (interest rates to decrease). Since bonds are what is purchased in a rush to quality and the bond market has historically been a far better indicator of the future than the stock market, what are the bond investors seeing?
On the flip side of the growth discussions there are two very strong arguments why the economy should gain speed over the next several months. Consumer confidence is the measure of consumers’ optimism about their situation and their future. With all due respect to the First Lady, there hasn’t been this much hope about the future in over 15 years. The last time consumer confidence was as high as it is currently was July 2001, four presidential elections ago. This doesn’t mean everyone is confident of course. There are many, across the political spectrum, and to some degree myself included, that are more pessimistic. The consumer confidence indicator is a measurement of total optimism including the confident and the not so confident. Business confidence has also soared over the past few months. As much as there are so many reasons for economic pessimism, there is no force within economics as powerful as consumer confidence (and to a lesser degree business confidence). There is probably also no single force as fickle as consumer confidence. Should consumer and business stay hopeful, then I feel it likely we will see a continued strengthening of the economy. This won’t solve the underlying structural issues and we will eventually have to pay the piper, but growth, at least for the time being, will cover many ills.
Despite all this economic change, Altus is in much the same place as we were before the election. We are still looking for undervalued real estate through which we can capture a strong interest rate/cap rate spread for long term cash flow. We don’t see the real estate market as having any beneficial inefficiencies so buyers should be cautious in their purchases, but with prudence, patience, and the willingness to turn over enough rocks, there is still opportunity.