I had the great privilege of attending the annual Strategas conference in New York, which boasts an agenda chock-filled with luminaries from all sorts of fields. We presented some of the treasures gleaned at our recent Monarch lunch, so if you weren’t able to attend, and it was gnawing at you that you missed out, let this piece ease your soul! Dave started the lunch off by wanting to prove I was actually in New York, but also that we Monarchians were now experts at reading tea leaves. Clearly, things on Wall Street are headed in only 1 direction!
A growing thesis on the U.S. economy is that we might be in the infant stage of a “re-industrialization” renaissance. There are obviously many different forms this could take. Our best hope is that the U.S. will take the lead on new manufacturing, by deploying new technologies, best-in-class manufacturing innovation, and taking advantage of our newfound abundant natural gas and oil supplies. One question which arose at our lunch was whether we believed “re-shoring” or “on-shoring” would be taking place. These terms would imply manufacturing moving back to the U.S. from somewhere else; the production had previously moved to somewhere else in an “off-shoring” move.
Norbert Ore is Strategas’ analyst in charge of manufacturing surveys and supply chain analysis. He is an expert in both, since formerly he was the head of ISM, which created the widely-respected ISM surveys; we rely heavily on the monthly survey as a reliable leading indicator to the economy. Norbert is of the strong opinion that a re-industrialization is afoot in the U.S. However, he believes cheap energy is only one aspect (and not the biggest aspect) of the longer-term story, as it especially benefits only a small slice of the economy, namely commodity processors which use a ton of energy (think: plastics converters which can use the natural gas chain as feedstock, energy refiners, fertilizer processors, aluminum refiners, steel producers). Other factors play a role, too, such as rising labor costs in Asia.
But the bigger story is the investment that U.S. companies have made in developing innovation which will provide the next wave of productivity in U.S. manufacturing. His Powerpoint slide deck included 47 pages of examples, which could best be categorized into two types. The first are technologies, such as robotics, 3D modeling/printing, lasers, cloud services, and mobility. The second would be “shop-floor innovation” techniques, which was most exciting to Norbert, and vastly less understood by Americans. Owing thanks to the above technologies, but also to the entrepreneurial American spirit, production can now take place with pinpoint precision, thanks to new tools and better product design. Production can be customized to the customer’s needs thanks to flexible manufacturing and modular product design. Real-time global collaboration can take place, hooking up manufacturers with their suppliers, technology vendors, design partners, and customers, thanks to cheaper data transmission and data storage.
Back to the issue of “re-shoring.” If you ask anyone about the state of manufacturing in the U.S., their first response would probably have something to do with all those jobs that have gone overseas. And millions of jobs have indeed done that. But a realistic look at the numbers is in order. Between 1960 and 2011, the U.S. economy grew at an annual rate of 6.8%. Stripping out inflation, real GDP grew at a 3.2% annual rate. Our services economy, not surprisingly, has grown at a faster rate of 4.0%. But the manufacturing sector has grown at….wait for it….a 3.2% annual rate! Yes, grown! Other sectors of the economy, like agriculture and government (believe it or not) have grown at slower rates.
That 3.2% annual growth rate has come with an annual decline of 0.4% of employment, and 3.7% of annual growth in productivity. So, yes, the U.S. is making more stuff now with fewer people, and that trend did accelerate in the 2000s. But the U.S. remains the world’s largest manufacturer, still ahead of China, and we produce 18.2% of the world’s goods. The issue of U.S. manufacturing prowess always gets lost amidst the fact that it is not a jobs-producing sector. But the flip side of that is a positive–productivity enhancements increase U.S. competitiveness, and create income.
Going forward, if the productivity trends that we are excited about bear fruit in the U.S., production will grow, but not with a lot more jobs. But what about all the innovations and new technologies needed to drive the productivity? Someone needs to dream them, invent them, design them, create them, integrate them, sell them. If the U.S. is still the land of the entrepeneur, the vast majority of those jobs will be here. And therein lies the story of how the U.S. has continually found millions of new jobs, in every cycle, without fail, even as everyone moans at the beginning of each cycle about the jobs lost to recessions and overseas.
I had the pleasure of eating some breakfast with Norbert before the conference began. He shared a very telling story about a trip to visit a large group of investment managers somewhere in Europe. He cited the relative ease with which entrepreneurs can start a business in the U.S., compared with most countries in Europe. The reaction of the investment managers was that they looked at each other and laughed, which caught Norbert off-guard, so he sought the source of their humor. They said no one in their right mind would start a business in Europe!
We in the U.S. are constantly on guard to ensure that our economy doesn’t “turn Japanese.” Japan has endured 20+ years of deflation, low growth, and failed attempts at stimulus, all resulting from the crash of their stock market and real estate market in the early 1990s. This has led to an economy which is now less competitive and compounded by a declining, aging population. Norbert has been of the belief that the U.S. doesn’t need to worry so much about this but Europe is, in most ways, clearly on the Japanese path.
While most of us occasionally wonder how the Fed’s experiment of printing money will turn out, so far (given that inflation is still low, 4 years into the expansion) the Fed hasn’t been wrong yet. The chart below shows how the Fed has expanded its balance sheet since the financial crisis. More importantly, it also shows how the Fed is not alone in pumping money into the global financial system. The Bank of England and Swiss National Bank make the Fed look like hawks! The European Central Bank (ECB) has so far been able to stave off numerous crises among their member countries, by making a lot of purchases of bonds and by saying things like “Believe me, it will be enough,” which in our world is as quotable as anything uttered by Arnold Schwarzenegger. The Bank of Japan has just recently (like, in the last 2 months) signaled an intent to start buying bonds. The actual numbers are indexed to 100 as of the start of 2007, so with the Fed at 364, that means it holds 3.64 times as many assets on its balance sheet as it did then. In $ terms, the expansion has been from under $1 trillion to $3.2 trillion (and headed to $4 trillion).
Another of the presenters was an energy policy expert, Jason Bordoff, who was (until January) Obama’s senior director of energy and climate change policy. Now he’s at Columbia University. His presentation centered on the incredible increase in U.S. energy production. In 2005, the EIA (the government’s energy research arm) forecast that natural gas IMPORTS would rise from 3tcf at that time (which was pretty much all from Canada) to 8tcf by 2020. To meet that need, we would need to build LNG terminals to import liquified natural gas from all around the world (which is very expensive). Instead, thanks to new drilling techniques, the U.S. is awash in natural gas, and now we have the ability to EXPORT LNG around the world to places which are starved for it.
As for oil, our imports were supposed to increase from 13 million barrels/day in 2005 to 17 million barrels/day. The new forecast for 2020 is for imports of only 6 million barrels/day, and most of that coming from Canada. What an incredible turnaround!
The concern most of us (especially those of us who are not particularly fond of the administration in Washington) have about fracking is whether the government will continue to let drillers run unabated. Naturally, the presenter addressed this, and indicated that “this is happening, and pretty much is unstoppable.” It would seem that if Obama really wanted to shut down fracking because of concerns regarding water quality, he could, but the quote is more indicative of the fact that Obama realizes its importance to the future of America. He also realizes natural gas sounds better than oil (to environmentalists), and both are fracking beneficiaries, and that coal is worse than either. In fact, U.S. greenhouse gas emissions peaked in 2005, and have dropped 13% since. This drop reflects only part of the shift of electricity production from coal to natural gas; this change has really accelerated since 2012.
The Keystone pipeline is often viewed as the litmus test for Obama’s true energy ambitions. The presenter suggests you need to look elsewhere, because Obama’s FERC (which is responsible for approving pipeline construction) has approved thousands of miles of pipelines, multiple Keystones. Keystone is simply the political bone Obama has chosen to throw to environmentalists. It should eventually get passed, but there are workarounds if it doesn’t.
Speaking of pipelines, they can’t get built fast enough in areas of rapidly expanding production. In the Bakken fields of North Dakota, where oil and natural gas often come out of the same wells, the shortage of pipeline capacity and storage capacity is severe. Oil is highly-priced and dense enough that it can be shipped out on rail or truck, but natural gas cannot. So, drillers have had to “burn off” the natural gas, a process called “flaring.” This has become so prevalent that on nighttime satellite pictures, the Bakken looks like a large metropolitan area because it’s generating so much light:
Another speaker was head of a Chinese research team called China Confidential, which is a joint venture with the Financial Times. He helped to fill in some knowledge gaps, such as what hukuo means to the Chinese who migrate from the country to the big cities. The bigger question most Americans have about China is whether it can continue to grow its economy at rapid rates. When the 2nd largest economy in the world is growing its GDP at at least 8% every year, that’s a strong buoy to the rest of the world, but especially its neighbors and trading partners.
That kind of growth rate has long been viewed skeptically. In a separate presentation, Jason Trennert (the head of Strategas) said, “I tried to analyze what China’s growth rate is, but after looking into it, decided it was best to just let them tell us what the growth rate is.” When you examine the infrastructure they’ve built, the businesses they have created, and the vast expansion of consumer income and wealth (even if the state has taken the lion’s share of the spoils), it starts to look believable.
The primary driver and enabler of China’s rapid growth in production is its urbanization drive. This means convincing people to move from the hinterlands of the country, where many subsist as poor farmers, to the big cities. You might think that since this has been going on for so long, there’s not many people left in the rural parts. You would be wrong: in fact, the urban population just passed the rural population in 2010. The urbanization rate has been 3%/year for a long time (so, 3% of the population migrates from rural to urban every year) and the presenter believes that rate will slow to 2%/year, but this is still a lot of people. And while it doesn’t seem like there’s all that much room left to put people in the huge cities like Shanghai and Beijing, and so much air pollution in the latter, the government is hell-bent to keep moving people in. It will be putting more emphasis, however, on expanding small and mid-sized inland cities into big cities. Following is a chart from the presentation, which shows the expected growth in population, in millions, of many Chinese cities, from 2010 to 2020. Again, that’s just 10 years of growth! Apologies in advance for the overexuberant doodle; I looked on the web for this but couldn’t find it anywhere:
In 20 years between 1990 and 2010, the San Francisco-Oakland-San Jose metropolitan area, which would include all of Silicon Valley, grew by only 1.2 million. The Phoenix metropolitan area, while basically doubling in size, grew by only 2.1 million.
If the China miracle continues, the infrastructure buildout will continue. And it could be just as costly, because it will take a lot more infrastructure to build out an inland city than a coastal city. There’s no guarantee it will work, because China needs companies to locate inland, in spite of the obvious logistical deficiencies of doing so. It’s alarming to see cities that have been fully built, but virtually no one has moved there yet (are you thinking about Field of Dreams right now? “Build it, and they will come….”). One key component of success will be the lower wages inland versus the coast, but more infrastructure buildup will be necessary too. Most companies require more than flat ground, working utilities, and housing stock for workers. If suppliers are hundreds of miles away, and there’s nothing more than a 2-lane highway between, that’s a deterrent. If there’s no social life there, foreign managers won’t want to live there.
The lunch speaker was none other than Nassim Nicholas Taleb, philosophical essayist, scholar/professor at NYU, and author made famous by his book The Black Swan. This book’s premise was that even though many events are statistically extremely unlikely, they can still happen. Published in 2006, it asserted that our financial system was not unassailable, and could be vulnerable to….a meltdown of the subprime mortgage market. His new book is called Anti-Fragile, and discusses how we have made so much of our lives vulnerable, when we should be setting out to do the opposite. Dave is knee-deep in reading the book already.
On the greater subject of the stock market, we pointed out at our lunch that stocks remain underappreciated, underloved, underowned, and undervalued. Yes, even with the S&P 500 finally hitting a new all-time high yesterday, this is still the most hated bull market ever. The work done this year by investors to rectify that situation (+12% so far in 2013) has put only a small dent into undoing the hatred. The “Great Rotation” from bonds to stocks looked like it was about to start earlier this year, until weaker economic data and the Cyprus issue in the last few weeks pushed bond yields back down again. So, we still have that ahead. Again, there’s no set timeline on when this will take place. Even Linus, despite his optimism for the Great Pumpkin, didn’t know the time or place of his arising, and knew he needed to be awake and on guard every Halloween. So it should be with bond fund managers, who need to be on high alert. [side note: I excitedly shared this Great Pumpkin corollary with my daughter, who concluded that Linus is analogous to the stock market bulls, always getting sneered at by the doubters. That’s so true I had to mention it.]
In the meantime, even though dividend payouts are very low as a percent of earnings, they keep on rising. Coupled with reasonable stock valuations and ridiculously low bond yields, more than half of the stocks in the S&P 500 now have dividend yields above the yield of the 10-year U.S. treasury bond. So, you don’t need to go fishing in the small pond of high-yield stocks to get decent relative income. The chart below shows this is a historical anomaly:
The economy continues to grind out meager, Goldilocks-like growth. Most recently, it appears that the sequester’s psychological effects and the payroll tax cut might be finally starting to dent growth in the 2nd quarter. The 1st quarter looks very solid, thanks to an inventory buildup, but resilience is still the underlying theme of the economy. The potential positives for the economy–the housing rebound, low energy prices, a drilling boom, and re-industrialization, haven’t contributed much yet to GDP, but their prospect for greater contributions looking out a few quarters has helped the stock market ignore the weak near-term data.
Jason Trennert sat with 2 other Strategas analysts on a panel which concluded the day. As usual, Jason had some choice comments. On just how anti-business the Obama administration is: “even a kind word for businesses might ignite an investment boom.” On the Fed’s strategy to exit its Quantitative Easing program of buying trillions of dollars of bonds, quoting Mike Tyson: “everyone has a plan until you get punched in the face.”
Jason has in recent months been referencing Margaret Thatcher, using her favorite “There is No Alternative” catch-phrase, which earned her the nickname, “TINA” (an acronym of the catch-phrase). He believes U.S. stocks have finally earned a TINA designation, given that there is no other asset class which is nearly as investable, for the combination of safety, growth, and yield. We believe the shaky global economy (especially Europe) and the tenuous financial conditions worldwide (especially Europe) have made the U.S. the “best house in a bad neighborhood” (to quote Jason again). And there’s no doubt these factors have brought a lot of investor money into the market, probably from overseas. But it’s a trickle when compared to all the money that has left the market, courtesy of the retail investor and the institutional investor alike. The TINA stock market has certainly been enjoyable, although we acknowledge that its risk rises simultaneous with the market’s rise. As George wrote in our most recent newsletter, trying to time the peak and get out is a sucker’s game, but being out of the market altogether over the long-term is even riskier.