The Day After…

May 5, 2020

In the 1983 movie The Day After, Denise emerges from the nuclear shelter, sees a clear blue sky and concludes that the worst is over. But the field, and the rest of the world, is actually covered with invisible radioactive fallout. It proved more prudent to remain sheltered for a while longer.

At this point, in today’s world, everything is a fast moving target with no dependable playbook and very diverse and uncoordinated responses from political “leaders”. Nobody can confidently predict

• when and how economies will fully and sustainably reopen, how hard and long the downturns and the paths to recoveries will be;
• how low corporate profits will get and how quickly they will recover.

But we know that:

• central banks around the world are clearly in whatever-it-takes mode;
• so are most governments; this is even more true in the U.S. with a contested critical election in 6 months;
• the blame game is on, and it promises to be messy, particularly if polls suggest a change in November. Whatever-it-takes…
• the whole world is focused on finding a cure and a vaccine, but we admittedly still don’t know much about this coronavirus, its ravage and, crucially, whether an infected person is immunised, and if so, for how long?
• a cure could be available before the fall season, along with effective testing equipment, considerably reducing death risk. But the need is for several billions of doses to be manufactured and distributed across the world. Who will coordinate this extraordinary global life saver given the appalling lack of leadership, cooperation and coordination?
• never mind the eventual vaccine!

Given all the fiscal and monetary measures adopted, the world should be able to avoid a depression and can reasonably look for a resumption of (some) economic activity before the end of 2020. But the enemy is not well known yet, not even the enemy(ies) from within…

My current assessment:

GROWTH

• Widespread indebtedness, already high, will reach unprecedented, dangerously high levels throughout the world. Deleveraging will be a necessity, and a drag on growth, for a long time. No country/state/company/individual can risk another shock before having restored debt ratios.
• The deleveraging playbooks will need to protect the lower income segment of the population and call to contribution the higher income groups and corporations which have both greatly benefitted from the last 2 economic cycles.
• Spending on health care will increase significantly worldwide.
• American cities and states, unable to run deficits, will be under severe budgeting stress. Their aggregate expenditures are 60% larger than the federal government’s. Pension funding will become an even bigger problem for them and for their dwindling 19.9 million employees (black line below)

• Globalization, already bruised by the USA-China trade war, will be dialed back even more:
  • China will be seen responsible for the pandemic, if not officially, certainly by a large segment of the population. How will it react?
  • There has been little, if any, global political leadership/cooperation/coordination. In fact, countries have learned that it may be best to be more self-sufficient and self-centered. Who has trusted allies now?
  • Corporations have learned that diversified supply chains are worth the additional costs. Reshoring is on. Lean, just-in-time inventories give ways to just-in-case inventory and distribution management.
  • Low wages are likely to be raised faster than inflation for several years.
  • Pension funding will need to increase.
  • Corporate tax rates could also be raised.
  • In all, corporate margins will be under secular pressure.
  • Non-residential investments will be restrained by lower profits and excess supply.
• China will need to boost domestic demand to offset weaker exports and absorb excess capacity stemming from corporate reshoring.
• Post Brexit Europe will live another existential challenge.
• Trump’s re-election is not a slam dunk.
• The liberal economic and social platform will gain even more popularity.
• Large parts of our lives will be changed:
  • remote work/learning is in;
  • travels for work will decline, replaced by videoconferencing;
  • will crowded public transportation give way to more car commutes?
• The U.S. dollar could strengthen against most other currencies owing to its relative safeness but too much strengthening will slow world growth even more. Emerging markets are particularly vulnerable given their high dollar indebtedness and weakening economies. There will be blood somewhere.

CONSUMERS

Consumers are the key to re-starting world demand. We are in uncharted territory but we can safely say that

• previous employment levels are unlikely to be reached for years as many businesses will shrink/disappear and companies will seek to reduce costs;
• the use of robots will accelerate;
• fear and safe behavior will linger;
• the savings rate will most likely rise as consumers build bigger financial shock absorbers;
• pension angst will increase with ever rising pension deficits.
• Will luxury, ostentatious wealth be out?
  

BANKING

• How will banks behave (lend) given exploding loan losses, near-zero interest rates and a pretty flat yield curve?
• How will enormous bad assets get cleared? Will we need another 1990-type RTC to clear bad debts?
• European banks have not really restructured post the GFC; their structural problem will glare even more.

Corporate strategy and governance will need to focus on operational and financial risk and de-emphasize growth:

• keep debt levels reasonable;
• reduce buybacks, shaving annual per share growth 1-2 percentage points;
• make management more accountable and risk sharing:
  • a quick and easy way is to eliminate executive share options: they provide unlimited upside with no downside, strongly encouraging higher risk taking, short-term thinking and planning;
  • options granted to lower level employees could be a mean to boost compensation/productivity at the lower levels;
  • investors will value more highly less levered companies and those managed by officers with meaningful direct shareholdings, just as it should be;

Fears of rising inflation have little foundation. Over the next 2-4 years, deflation is the riskier probability. Consumer demand cannot be reasonably expected to be strong for many years. Corporations and governments will need to deleverage. Commodity prices, principally oil, will remain weak until demand recovers the lost ground, unlikely for many years.

Sustained low inflation will help keep real spending growth at reasonable, albeit relatively low, levels and interest rates lower for longer.

The rate of growth of U.S. GDP has been 13% below trend since 2009, after the Federal debt held by the public exploded from 36% of GDP to its current 79%. Growth slowed because the household sector (69% of the economy) actually deleveraged in the last decade: consumers reduced their collective indebtedness from 100% to 76% of GDP and did not increase it recently in spite of extraordinarily low interest rates and historically low unemployment rate. In the last 10 years, real GDP growth averaged 2.3%, one third slower than its long-term average of 3.2%.

(Advisor Perspectives)

The CBO’s preliminary projections put the total debt/GDP ratio at 108% at the end of 2021, the highest since the post-WWII record of 106% reached in 1946. But Hoisington Investment’s excellent Lacy Hunt sees the ratio reaching above 120%:

The academic research shows that above a 50% ratio to GDP, government debt has a deleterious effect on the trend rate of economic growth and that this effect worsens as the ratio rises. When government debt-to-GDP exceeds 90% for five consecutive years, the U.S. economy loses one-third of its growth against trend. At the expected levels of government debt relative to GDP, the loss should be considerably larger, but no historical record exists to calibrate its magnitude.

Deleveraging will now need to be done by governments and corporations which have both allowed their indebtedness to rise in the last 10 years. It is difficult to see how government spending would not slow down post pandemic. Same with corporate investments. Net exports should remain a drag unless imports stay very weak, meaning very weak U.S. consumer demand.

That leaves American consumers to keep the engine humming. But with slower population (+0.5% in 2019) and employment growth, it would take a meaningful decline in the savings rate (lower savings and/or higher borrowings) to boost disposable income in order to keep spending growth above 3.0%. It would be surprising if this pandemic made people loosen up, dissave and borrow merrily.

After each of the previous 3 recessions, Americans’ savings rate rose. Following the Great Financial Crisis, the jump was huge and sustained in spite of generally favorable economic and financial conditions.

This apparent secular change can only be reinforced by the current shock which, contrary to previous ones, is equally impacting everybody, everywhere. Baby boomers will become increasingly worried about their pensions, cash flows and asset values. Millennials, already bruised by the two previous recessions, will get even more prudent and frugal. These two generations, totalling some 145 million Americans, will be an even bigger drag on growth than they have been in the past 10 years.

Real GDP per capita has grown 1.2% compounded annually in the past 20 years. Unless population growth accelerates markedly, which would need Americans really welcoming immigrants, real GDP is unlikely to grow much more than 1.5% annually for several years, a substantial slowdown from +3.5%, +2.8% and +2.3% during the last 3 economic cycles respectively . Every recession/crisis since 1990 was followed by a ratcheting down of per capita GDP growth that population growth could not offset.

Slower GDP growth does impact profit growth:

If on top of slower real top line growth, inflation slows and pre-tax margins are pressured by factors mentioned earlier, corporate profits would rise very slowly, if at all, during the next several years, even more so if tax rates rise.

Corporate profits per the national accounts actually peaked in 2014 while S&P 500 EPS kept soaring. As I explained in THE PROFIT PROBLEMS there are two main reasons for the S&P 500 strong earnings outperformance: foreign profits and share buybacks. More recently, the U.S. tax reform benefitted larger companies much more than smaller firms.

This next chart plots domestic (blue) corporate profits after tax, flat since 2014, against foreign profits, up 37% since 2014 with all of the growth recorded in the last 3 years. Foreign profits account for around 28% of total corporate profits compared with about 40% for S&P 500 companies.

Aggregate operating earnings of S&P 500 companies are up 39% since 2016 but earnings per share are up 48% as buybacks reduced share count. During the last 12 quarters, buybacks contributed 1.9 percentage points to average S&P 500 earnings growth of 11.0%. The lower share count will have the opposite effect in 2020 as large losses are split among fewer shares but we can expect a much smaller, if any, contribution from share buybacks in coming years.

In reality, it is more likely that share counts will rise as companies need to restore their equity base and debt ratios. From the low in March 2009, the S&P 500 share count jumped 4.9% during the following 30 months. This pandemic will prove much harsher on corporate balance sheets than the GFC.

Growth rates in total business sales and nominal GDP have been very similar across cycles (business sales being more sensitive to violent swings in oil prices). Over the past 3 cycles, business sales growth averaged 4.7% outside recessions while nominal GDP growth averaged 4.9%. Annual growth in both series has ratcheted down about 1.0% each cycle, the last one at 4.0% per annum on average.

If real GDP growth is set to slow below 1.5% per year, from 2.3% in the last cycle, and if inflation slows to the 1.0% range (from +1.7%), then nominal GDP growth will be around 2.5% during the cycle post-pandemic. That would mean business sales growth will slow from 4.0% per year between 2010 and 2019 to about 2.5% post-pandemic.

Ed Yardeni links business sales growth to S&P 500 revenue growth. Overall, but particularly since 2003, both series trend very similarly.

Unless one sees S&P 500 profit margins rise in the coming cycle, a rather heroic assumption, investors are in for a long period of very slow profit growth.

S&P 500 operating margins have de-linked from total corporate profit margins before, but recessions have acted are great equalizers. A simple return to the current 8.8% corporate margins would crush S&P 500 profits by 23%. Total corporate margins will no doubt drop near their usual 5-6% lows, another 30% hit. We will see what happens next but both margins series tend to ride fairly closely after recessions until they diverge near the end of the cycle.

NO REPRESENTATION WITHOUT TAXATION

Speaking of great equalizers, we may have reached another extreme in the labor/corporate relative shares of the compensation pie:

The next chart shows that the economic space steadily “liberated” by governments since 1980 has essentially transferred one-to-one to corporate profits without additional contribution from corporations in the form of increased investments and employment. Ronald Reagan would be embarrassed to see how his philosophy of more limited government has failed.

In effect, government “frugality” has not been compensated by larger corporate investments and increased employment. Meanwhile, corporations hugely benefitted from rising worker productivity and slow wage growth:

Swelling corporate profits have not been reinvested in the economy nor have they been used to build corporate financial armors, quite the opposite. The notion that lower corporate taxes eventually end up benefitting the entire economy has been negated by the past 40 years.

This set of charts is rather unflattering for the corporate world:

• Corporate profits have done extraordinarily well since 2002 even considering the 2008-09 GFC (largely caused by greedy/corrupt financial institutions). In effect, corporate taxes paid have been negative throughout the last 12 years, increasingly so since 2017:

• This while Americans individually paid more and more taxes. The federal government’s corporate tax receipts have been flat for almost 20 years, suggesting that state taxes have declined as states competed with each other to attract corporate investments which, as seen earlier, have not been particularly impressive in total:

• U.S. corporate tax rates have declined in long steps, keeping pace with some foreign tax rates set to lure companies away from their home base to the point where the global effective corporate tax rate is barely 10%. (Next 5 charts courtesy of Ed Yardeni)

• Corporate boards and executives used the tax windfalls to boost dividends and share buybacks…

• …to the point where the combined dividends and buybacks irresponsibly absorbed virtually all operating earnings during the last 5 highly profitable years:

• With the Fed setting interest rates very low to spur economic growth through corporate investments (wishful thinking), CFOs saw better in borrowing to finance even higher payouts…

• …to the point where debt levels reached a record 25% of cash flows…

• …120% of book equity nationally…
  

• …and more than twice the median S&P 500 company’s ebitda, 35% more leverage than at previous peaks:

And now, the same financially careless corporations desperately seek financial support by governments, even central banks through twisted ways and means, themselves having little/no accumulated fiscal ammo because they abdicated their taxation privilege in exchange for elusive marginal economic growth.

This is the second humongous corporate bailout in a single decade!

The constitution of the United States was born after the colonists realized they were paying taxes to Britain without any government representation. Maybe “We the people” are about to realize that corporations benefit from full representation without taxation and that the trickling down theory has proven to be but a theory.

We the People of the United States, in Order to form a more perfect Union, establish Justice, insure domestic Tranquility, provide for the common defence, promote the general Welfare, and secure the Blessings of Liberty to ourselves and our Posterity, do ordain and establish this Constitution for the United States of America.

After our eventual day after, conservative capitalism will need to reinvent itself if it wants to survive.

In the meantime, equity markets will have to deal with slow demand, slowflation, pressured operating margins and potentially higher tax rates.

Not a great diet for bulls.

Especially considering that corporate buybacks, the main and fastest growing source of demand for equities over the past 10 years, could decline significantly.

Here’s what former Trump-appointed SEC commissioner Robert J. Jackson, Jr said in a speech on June 11, 2018:

(…) On too many occasions, companies doing buybacks have failed to make the long-term investments in innovation or their workforce that our economy so badly needs. (…)

Even more disturbing, there is clear evidence that a substantial number of corporate executives today use buybacks as a chance to cash out the shares of the company they received as executive pay. We give stock to corporate managers to convince them to create the kind of long-term value that benefits American companies and the workers and communities they serve. Instead, what we are seeing is that executives are using buybacks as a chance to cash out their compensation at investor expense. (…)

So we dove into the data, studying 385 buybacks over the last fifteen months. (…) First, we found that a buyback announcement leads to a big jump in stock price: in the 30 days after the announcements we studied, firms enjoy abnormal returns of more than 2.5%. That’s unsurprising: when a public company in the United States announces that it thinks the stock is cheap, investors bid up its price.

What did surprise us, however, was how commonplace it is for executives to use buybacks as a chance to cash out. In half of the buybacks we studied, at least one executive sold shares in the month following the buyback announcement. In fact, twice as many companies have insiders selling in the eight days after a buyback announcement as sell on an ordinary day. So right after the company tells the market that the stock is cheap, executives overwhelmingly decide to sell. (…)

Now, let’s be clear: this trading is not necessarily illegal. But it is troubling, because it is yet another piece of evidence that executives are spending more time on short-term stock trading than long-term value creation. It’s one thing for a corporate board and top executives to decide that a buyback is the right thing to do with the company’s capital. It’s another for them to use that decision as an opportunity to pocket some cash at the expense of the shareholders they have a duty to protect, the workers they employ, or the communities they serve. (…)

Mr. Jackson went on discussing ways and means by which the SEC could address the problem, once more…

But the main issue is that the bulk of stock-based compensation schemes are through stock options, thereby providing unlimited upside against zero financial downside to the executives. Until the options become deeply in-the-money, executives have no skin in the game. And when they are in-the-money, when they have “free skin” in the game, FOMO (fear of missing out) gets in play fostering even more short-termism and, eventually, opportunistic and often debt financed buyback programs, followed by another round of option grants, yaddi-yaddi-yadda…

Let’s all prepare for a new era of less spectacular equity markets where companies steered by financially careful and risk-sharing managers get valued more highly by more discriminating investors.