Market Commentary
by Byron Wien
 
09/05/2013

A Complacent Group without Table Pounders

Every August for the past several decades I have organized a series of Friday lunches for serious financial professionals who spend their summer weekends in eastern Long Island.  What started as a single lunch for half a dozen people has grown to four lunches at different locations for more than eighty.  Participants include many well-known names, of whom some are billionaires, but others, though widely respected for their intellect and insights, have a net worth that may be more modest.  They are a reasonably diverse group and include hedge fund managers, private equity people, activists, buyout specialists and venture capitalists.  This year I tried to include some younger people who I thought might bring a fresh perspective to the discussions.  Last year the tone of the lunches was correctly positive about the rest of 2012 and 2013 this far, so I was particularly curious about how they viewed the outlook from here.

I would say that the general mood of all of the lunches was one of complacency.  The market had treated all the attendants well during the past 21 months, in spite of meager Gross Domestic Product (GDP) growth, Europe’s recession, a slowing in China and other emerging markets, instability in the Middle East, legislative intransigence in Washington and the prospect of less monetary easing by the Federal Reserve.  Everyone knew that the Fed’s accommodative policy contributed to the performance of the stock market, but there was some debate about how important it was.  There was agreement that whatever “tapering” did take place would put some pressure on equities, but, offsetting this, the economy was expected to pick up its momentum in the second half of 2013 and 2014, helping earnings.

There was some discussion of who would be the next Federal Reserve Chairman.  Most agreed that President Obama favored Larry Summers, but there was significant opposition to his appointment both in Washington and on Wall Street.  Janet Yellen was likely to continue Ben Bernanke’s easy money policy which had been good for the stock market.  Larry Summers was viewed as more of a “wild card” in terms of monetary policy.  At one lunch the group was unanimous in thinking that if Larry Summers were appointed, the market would go down.

Nobody expected the Fed to totally stop its bond buying program.  As long as the Fed was easing, Congress could feel it was “off the hook” in providing fiscal stimulus even though the United States budget deficit has declined from 10% of GDP in 2010 to 4% this year and is expected to trend lower over the next two years.  There could be some federal stimulus if Congress had any appetite for it, but it does not.  Because of low yields in the fixed income market and reasonable equity earnings, stocks were viewed as the most attractive asset class.  Real estate had already appreciated significantly and cap rates were low except for special situations like warehouses.  Commodities had been trending lower for more than a year and showed little chance of reversing that, so you had to be in stocks, particularly U.S. stocks. 

Most of the participants thought the market would be higher at year-end, but not significantly.  I had some takers for 2000 on the Standard & Poor’s 500, but most were at 1700–1800.  Only a few thought the market would be down at year-end from its August level, but there were no real bears.  Federal Reserve policy was considered key to market performance.  While it is true that U.S. stocks have been strong since November 2012, the multiple on 2014 earnings was very moderate by historical standards at about 14x.  Individuals have yet to invest in the stock market in any serious way and that should be a positive going forward.

On the economy many believed the absorption of the sequester in 2013 would enable GDP to do better next year, but most thought real growth of 3% or more would be a struggle.  The slow growth in hourly earnings was keeping inflation low and this was good for fast food companies and soft goods retailers.  There was concern that the Affordable Care Act would encourage companies to move more workers to a part-time status, and nobody had any convincing solution to the longer-term structural unemployment problems in the United States.  Autos, housing, energy, technology and agriculture were doing well, but jobs were still being cut at the state and local government level.  Some felt that the underground economy was vibrant and that the unemployment rate was overstated.  Regarding manufacturing, there was considerable enthusiasm about the importance of low natural gas prices, but low labor costs in the emerging markets were more important. 

Most agreed that economic conditions in Europe were improving and that there would be some growth in 2014 led by Germany and France.  While the continent continued to “muddle through,” there was disappointment in the lack of progress toward structural improvement, but it looked like the European Union and the euro were here to stay.  The Greek restructuring of debt didn’t go far enough and the failure to reach agreement on either a banking union or some form of fiscal convergence underscored the reality that politics is standing in the way of progress.  A plan to forgive some or all of the sovereign debt of the weaker countries was viewed as necessary to a long-term solution, but would be politically unpopular.  With overall unemployment in Europe at 12% and youth unemployment much higher, the potential for social unrest is a serious concern.  In the United Kingdom there is evidence of more political flexibility, but growth is slow there as well.  Europe is not expected to be a negative for U.S. equity performance but it is not likely to be much of a positive factor for earnings or overall world growth.  There was agreement, however, that there were a lot of cheap stocks in Europe.

On China most agreed that real growth would be around 7% this year, but the new leaders had some real challenges ahead.  The banking system needs to be improved.  There are too many non-performing and potentially non-performing loans on the books.  This is true of the shadow banking system as well.  The government may have to renationalize the private banks.  Debt as a percentage of GDP is too high.  The Chinese economy has been growing by providing credit for real estate development, state-owned enterprise expansion and infrastructure projects.  Efforts to rebalance the economy in favor of consumer spending have not been successful, but consumer products companies and technology are the places to invest.  The government must attack the widespread corruption problems.  Over the next decade the renminbi is likely to rise in value.  There was some converting of currency through the gambling casinos in Macau; general convertibility would be an important positive.  All of these factors are likely to put some pressure on the economy, but China is still likely to grow at 6% real or more over the next few years. 

There was a positive attitude toward Japan.  Everyone agreed that Shinzo Abe had embarked on a high-risk strategy, but it seemed to be working.  The increase in the sales tax from 5% to 8% next year would hurt the economy, but it can probably be absorbed.  Going the next step to 10% (which is planned) is probably a bad idea.  The big question is whether Abe will move forward on the “third arrow.”  The first two were fiscal and monetary policy.  The third is regulatory reform, which would primarily be directed at diminishing the power of agricultural interests.

In contrast to previous years there was little interest in the developing markets.  Brazil was thought to be uncompetitive, India dysfunctional, Russia dangerous unless you can operate in a remote area away from government attention.  Some frontier markets are attractive, like Vietnam and Colombia.  Many liked Mexico in spite of its poor equity market performance this year.

On commodities, the unsettled conditions in the Middle East had driven oil prices higher, but reduced demand and increased supply might bring West Texas Intermediate oil down to $90 a barrel over time.  Marginal production (fracking) is high-cost, perhaps $75–$80 a barrel, and the half-life of fracking wells is short and that will keep prices from falling further.  Demand from China and India will offset the reduced consumption in Europe and the United States resulting from conservation and slow economic growth.  Low pricing for natural gas in the United States compared to the rest of the world was an important positive, especially for the chemical industry.  There was not much enthusiasm for gold even at these levels.

I thought one conversational sequence in the sessions was particularly notable.  A major real estate developer talked about a project he has underway in the Williamsburg section of Brooklyn.  He said that young professionals are living differently today; they use their apartment as a closet and a bedroom.  They live their lives outside of their home; they work late, exercise at a gym, go to a cultural event, eat at a restaurant with friends and go home to sleep.  They don’t accumulate possessions, so they can live in 600 square feet rather than 1200.  At the office they only need 200 square feet because files and other information resources are accessed from their computer.  The computer reduces the need for support personnel as well.  As a result more people are being crammed into less space, putting strains on elevators and other service functions.  They also have little interest in working in suburban office locations, reversing the trend of thirty years ago.  This phenomenon may not be relevant everywhere, but it is clear in New York, Chicago, Boston and San Francisco.

Following his remarks, a technology expert commented on the entrepreneurial zeal of young people.  They don’t see themselves building a long career over time with a big corporation.  They want to get some experience and then start something of their own like a small business, a hedge fund or an Internet company.  One of their goals is clearly to achieve financial success at an early age, but another aspiration is to have a more flexible lifestyle.  These changes are bound to have an impact on consumer spending.

Almost everyone agreed that education was the most serious problem in the United States but it had proven almost impossible to fix.  Charter schools had helped, but our public school system, particularly in large urban areas, was not performing well.  Graduation rates were low and many of those who did graduate could not do serious college work.  The teachers union was part of the problem, but probably more serious was the breakdown of the family unit which created circumstances at home that made it difficult for the child in school.  Middle class education was still good, however, and we still had outstanding institutions of higher education, so there was hope for our ability to maintain innovative leadership in a competitive world, but the gap between the “haves” and the “have nots” was likely to widen.

I always try to devote some time to a discussion of “cosmic issues.”  The violence in Egypt and Syria was on everyone’s mind.  One participant said that he worried about the potential friction that he saw developing between the Moslem world and the Judeo-Christian world of the West.  The root of this is youth unemployment, which was one of the key triggers for the inception of the Arab Spring in North Africa.  If a good part of the Moslem world continues to live in desperate economic circumstances while Europe and the United States enjoy a high standard of living and moderate growth, tensions are likely to grow.  Where China, India and Saudi Arabia fit into this is an open question, but it is clear that the world has pockets of instability that have investment implications.

Other issues that the participants considered important were environmental pollution, corruption by authoritarian governments, a lack of availability of water for drinking and agriculture, global warming causing the oceans to rise and adversely affecting the weather, epidemics, and a lack of food for a growing world population.  The advent of 3-D printing was believed to put more pressure on job growth.  One participant quoted a chief executive survey which found their greatest concerns to be taxes, terrorism, cyber security and regulation.  Clearly the people running companies are worried about issues that are likely to have a more immediate effect on their day-to-day operations.  Perhaps they are tired of hearing about the major problems facing the world with so little being done about them.

There were concerns that the big American cities couldn’t afford to maintain their infrastructures and would become dependent on the federal government.  Some were frustrated that they couldn’t repatriate their profits that had accrued abroad, but they already had plenty of cash on their corporate balance sheets waiting for profitable investments in the U.S. to appear.  It made sense to keep the money abroad because that’s where the opportunities were likely to be.  One participant suggested that the government could provide tax relief to companies bringing profits back if they invested in domestic infrastructure projects.  Another complained that the government had set up too many hurdles to repatriation.

My conclusion, reflecting on the four lunches, was that there were some significant tail risks lurking out there.  The unintended consequences of sending missiles into Syria or not sending missiles into Syria may be one of them.  The inability of Europe to make the structural changes necessary to ensure the long-term survival of the European Union and the euro could be another.  Iran’s nuclear threat might be a third.  The major long-term problems had not held equities back over the past two years and most of the attendees thought the downside risks were overshadowed by the upside opportunities.  A dull market rather than a difficult one was more likely.  Greater-than-expected downside risks could be the non-consensus surprise.

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