Sep 08, 2015

Unfazed by the Turmoil

For the past several decades I have organized a series of lunches on summer Fridays for serious investors who spend their weekends in eastern Long Island.  There are hedge fund activists, long/short heroes, corporate chiefs, venture capitalists, private equity stars and others.  Many are well-known and there are more than a few billionaires.  The goal is not to see how much net worth I can cram onto a shaded terrace, but how much wisdom I can focus on the key investment issues facing all of us. As Howard Marks of Oaktree wrote last year, the danger of this type of gathering is that a consensus of peers has a tendency to be wrong.  I think it's fair to say that last year nobody anticipated the sharp drop in the price of oil, the Greek crisis or the Chinese devaluation, but over the years there have been a number of impressive insights. 

World equity markets were weakening during the four weeks the lunches were taking place, but few anticipated the precipitous decline we have all painfully experienced in August.  In spite of that downturn, most believed that the United States would avoid a recession and grow 2% or better; housing would be the driver.  China would have a soft landing.  If these conditions prevailed, we were only going through a long, overdue correction (it has been more than three years since the Standard & Poor's declined 10%) and the market would recover afterwards.  Many believed the S&P 500 would deliver positive performance at year end. 

In the past I have tried to cover a broad range of investment topics at each lunch. I varied the format this year, asking attendees who were experts in certain areas (energy, Greece, technology, cybersecurity, etc.) to talk about their views and then have others comment on what was said.  The goal was to drill deeper into fewer subjects at each lunch but cover most issues over the four sessions.

Those in the group who were close to operating companies said that the problems in China had not yet had an impact on their business.  They offered that investors were over-reacting to China’s softening.  Only 1% of U.S. corporate earnings came from China out of 38% from all foreign sources, one participant pointed out.  Lower oil and commodity prices were a positive, and U.S. companies were able to borrow at attractive interest rates.  Most economic indicators, such as durable goods orders, supported the view that the U.S. economy was still okay.  The worry was that the problems in Asia would eventually reach our shores even though that had not yet occurred.  The contagion effects of the Chinese slowdown were the greatest concern.  China is a major consumer of commodities, and a high percentage of commodity production comes from emerging countries.  These markets, including China, account for 40% of world GDP.  If 40% of the world were in recession, how could the developed economies not be affected? 

Some complained that overall demand was soft and it was hard to increase revenues.  This explained the vigorous merger and acquisition activity undertaken by chief executives desperate to increase earnings and making strategic acquisitions to do so.  By combining marketing and administrative functions, a new company could improve profits with even modest revenue increases.  The general view was that buybacks and merger and acquisitions activity was a positive for the market but a few worried that the buybacks were occurring at too high prices and companies were only buying their stock back because they had to do so in order to inflate earnings.

Bear markets usually precede recessions, and almost everyone believed there was no recession in sight.  One pointed out that no recession had ever occurred without at least one instance of Federal Reserve tightening.  Perhaps the widespread discussion of when the Fed would raise rates is a substitute for the reality of the actual move, but most observed that the United States was basically a consumer economy, exports represent only 13% of GDP, the unemployment rate had come down and those with jobs were still spending.  At the beginning of August, most attendees thought the first Fed tightening would be in September, but by the end of the month there was much more uncertainty.  A sizeable portion of the group thought the first move would be in 2016 because of the unsettled markets.

One bear pointed out that the only reason the world economies seemed to be doing well was because companies had access to cheap debt.  This may be at the heart of China’s problems because many of the loans there are thought to be in default and the market may sense a credit meltdown is occurring.  In the United States, the Federal Reserve increased its balance sheet from $1 trillion to $4.5 trillion between 2008 and 2014 and this kept the economy growing at a modest rate.  Easing across the world has sustained growth everywhere, but the main purpose of the monetary expansion was to trigger a natural economic momentum that would continue when the central banks became less accommodative.  The data on the U.S. economy turned less robust last October when the Fed stopped infusing liquidity into the system, but second quarter real GDP of 3.7% was encouraging, even if some of it was due to inventory building.  The concern is that the debt accumulated during the easy money period may be difficult to pay back.  This is particularly true in the energy sector where there is a lot of high-yield paper outstanding and some of the weakest companies were heavy borrowers.  The decline in equities may also be reflecting the problems in credit. 

There was good news and bad news on the technology front.  A senior executive at one of the major Internet companies attended one of the lunches.  I asked him my favorite question: “Will developments in the next thirty years match those of the last thirty?”  I just cannot conceive of the next thirty years producing anything comparable to the Internet and the smartphone.  He answered without hesitation.  The advances of the next thirty years will be more dramatic.  He said there are hundreds of entrepreneurs coming up with change-the-world ideas and seeking capital from venture capitalists.  Unlike the period when Google, Facebook and Amazon were looking for money, capital is readily available to those with promising concepts.

He cited artificial intelligence as a fertile area.  Any repetitive function done by a human being can be done by a computer.  This applies to many white collar jobs in the government, law firms and media.  Just as technology hollowed out a large number of jobs in factories, it will eliminate a number of jobs in offices.  This brings us to the bad news.  The elimination of a large number of well-paying positions in offices will add to the problem of middle-class unemployment.  Real median family income has not increased as the economy has recovered and this will be a growing problem going forward.  A second area where technology is poised for a breakthrough is pharmaceutical development.  Rapid access to big data should speed the introduction of drugs to treat and/or cure a number of diseases, including cancer, heart disease and Alzheimer's.  The combination of fewer middle-class white collar jobs and longer lifespans could place a burden on the government to support a growing, less productive population.  The increasing number of people on disability is a problem as well.

I also invited a person knowledgeable on the Greek financial situation to one of the lunches. He acknowledged that the economic prospects for the country were bleak, but he thought Europe would keep the country afloat.  The reason is that they don't want to take any action that would threaten the “European project.”  He views the forthcoming election as a positive because it would enable Alexis Tsipras to separate from the more radical elements of the Syriza party and be in a position to implement necessary reforms like work rule changes and pension modification.  A key to Greece making progress is Angela Merkel's support, and the risk is that she gets into political trouble at home. 

Greece was expected to muddle through over the next several years as a member of the European Union using the euro as its currency.  The alternative, default, would create chaos for Greece that might spill over to the rest of Europe.  Certainly the flow of migrants would increase because Greece’s border would become more porous.  Europe seems to be willing to pay the price of keeping Greece in the fold.  How long that will last is still a question, but a Greek exit from the euro and the European Union was thought to be at least three years away.  The European Union may be in trouble in the longer term, but will be okay until then. 

An expert on cybersecurity said that the risks of a terrorist incident or the serious hacking of a financial institution are increasing.  Thus far we have been able to protect our infrastructure and our information systems, but it takes a combination of luck and manpower to do it.  Metropolitan police organizations have hundreds of people working on this around the clock, and the risk of being overwhelmed by the growing efforts of computer invaders is real.

As for China, the group seems to have been skeptical all along.  Almost nobody thought real growth there was 7%, so the slowdown was not unexpected.  Some believed the situation was much worse than in 2008.  Attendees were also suspicious of the stock market, questioning valuations and accounting.  Since fewer than 10% of the Chinese people have equity investments and the market, even with its sharp decline, is still up over the past year, there was not much concern that the decline in equities would lead to a recession.  The worry is what impact the stock market weakness and economic disappointment will have on China's leaders, who encouraged investors to buy Chinese stocks.  Xi and Li were committed to reforms that would reduce corruption and rebalance the economy away from investment spending on state-owned enterprises and infrastructure and more towards the consumer.  The revaluation of the currency was long overdue and the question is, “Did they do enough?”  The renminbi has been tied to the dollar, causing it to appreciate 10% over the past year. The 4% downward adjustment to date may not be enough to boost China's exports meaningfully, particularly if there were competitive devaluations in the region. 

The group believed China has enough resources to avoid a hard landing now and that it will be successful in doing so.  What may come out of this turmoil is a more cautious Chinese leadership.  They may move slowly on their rebalancing efforts, and they are almost surely going to pull back on any territorial expansionist efforts to concentrate on keeping the economy growing. China's authoritarian government depends on strong central leadership.  An escalation of civil unrest would challenge that and they will do everything possible to avoid it.  The consensus of the group is they will be able to maintain stability. 

A chief executive of a major oil company participated in one of the sessions.  He said the drop in the price of crude had really hurt smaller exploration and production companies around the world.  Many companies have suspended their efforts to find new deposits, and energy capital expenditures are down substantially.  In spite of the drop in price, companies have stepped up production from existing wells.  The result is that there is plenty of supply on the market now, depressing the current price, but several years from now there may be a shortage of crude.  In addition, production from existing wells is eroding by about two to three million barrels per day out of ninety-five million total, and demand from the developed and emerging markets will continue to increase as long as we do not go into a worldwide recession.  So, while the price may stay at present levels or go somewhat lower for a while, if you can be patient until the end of the decade, we should see West Texas Intermediate crude back around the $70 level or even higher.

We spent some time at each session discussing the Donald Trump phenomenon. In the first session at the beginning of August, most thought he would implode somewhere along the way, but in the last session at the end of the month, he was being taken more seriously.  The attendees believed his success so far was more than a result of the American tendency to revere celebrities or name recognition.  There was a feeling that three quarters of the population is dissatisfied with the direction in which the country is heading, and they want an outsider in Washington who is committed to changing the status quo.  His positions may be impractical, but he gives people the feeling he will get something done to put America on a more positive track.  He benefits from the fact that the other Republican candidates are unexciting.  Jeb Bush has to move away from the Republican mantra of lower taxes, reducing regulation and limiting women’s reproductive rights and come up with his own ideas.  Most believe that Hillary Clinton is in trouble because of the private e-mails, but the election is fifteen months away and she is likely to survive the controversy because other Democratic potential candidates cannot raise her kind of money.  We will talk further about who is going to win in November 2016 at next year’s lunches.

In order to focus more deeply on some key areas, we covered a number of subjects quickly.  The group was about evenly split on the nuclear agreement with Iran with those negative saying we couldn’t trust the Iranians and we should have stepped up the sanctions.  By doing the deal we are giving Iran money to fund terrorist activity.  Those positive believe it will delay a bomb many years, during which the younger people in the country who are more pro-American may have increased their influence.  No surprises here.  Most thought the dollar would strengthen over time.  There was almost no interest in gold either on the buy or sell side.  There was no enthusiasm for accumulating emerging market shares, especially Russia.  One thought the Russian economy is in really bad shape.  The price of oil has dropped, the ruble has plummeted and Putin is in trouble.  The threat of a major escalation of military activity in Ukraine had passed.  Some thought real estate in the U.S. is doing well, but it is dependent on low interest rates and continued economic expansion.  Most believed inequality would worsen no matter who was elected President, and most were in favor of raising the minimum wage to $15 over the near term.

In reading my conclusion in last year’s essay about the lunches, I noted the optimism of the attendees, but I wondered if they were too complacent about possible disruptive events abroad that might have a negative effect on the outlook.  It took a year, but that worry finally materialized and hit the markets hard.  The fact that it happened in China was a surprise to many in spite of their skepticism last year about its real growth.

Overall, my sense of this year’s lunches is that the participants were still basically optimistic, as they generally are.  I wonder if there were something big and negative brewing out there, whether the group would be able to anticipate it.