Stan Druckenmiller, one of the best macro mind around, made an excellent, but scary, presentation at the Sohn Conference on May 4th. The full transcript, courtesy of Valuewalk, is available here and the accompanying slides here. Druckenmiller’s point is best articulated in this paragraph:
The obsession with short-term stimuli contrasts with the structural reform mindset back in the early 80s. Volcker was willing to sacrifice near term pain to rid the economy of inflation and drive reform. The turbulence he engineered led to a productivity boom, a surge in real growth, and a 25 year bull market. The myopia of today’s central bankers is leading to the opposite, reckless behavior at the government and corporate level. Five years ago, one could have argued it was in search of “escape velocity.” But the sub-par economic growth we are experiencing in the 8th year of a radical monetary experiment and in Japan after more than 20 years has blown that theory out of the water. And smoothing growth over a cycle should not be confused with consistently attempting to borrow consumption from the future. The Fed has no end game. The Fed’s objective seems to be getting by another 6 months without a 20% decline in the S and P and avoiding a recession over the near term. In doing so, they are enabling the opposite of needed reform and increasing, not lowering, the odds of the economic tail risk they are trying to avoid. At the government level, the impeding of market signals has allowed politicians to continue to ignore badly needed entitlement and tax reform.
The idea that ZIRP and QEs have instigated corporate “mal-investments” is worth exploring given investors and media obsession over the Fed’s next moves. Excessively low interest rates are clearly supporting current high equity valuations in the face of pretty sluggish world economies and lackluster corporate profits. Can the Fed remain successful in buoying equity markets by simply keeping interest rates to or through the floor?
For several years, corporate executives have been able to keep costs in check while revenue growth was decelerating along with demand and inflation. They have also used excess cashflows to buyback shares and boost earnings per share. Druckenmiller argues that the endgame is near: cashflows are now declining while debt keeps rising alarmingly.
Importantly, Druckenmiller asserts that years of excessive Fed benevolence have resulted in poor capital allocations which will, sooner or later, impact profitability:
And if this wasn’t disturbing enough, take a look at the use of that debt in this cycle. While the debt in the 1990’s financed the construction of the internet, most of the debt today has been used for financial engineering, not productive investments. This is very clear in this slide. The purple in the graph represents buybacks and M/A vs. the green which represents capital expenditure. Notice how the green dominates in the 1990’s and is totally dominated by the purple in the current cycle. Think about this. Last year, buybacks and M&A were $2T. All R&D and office equipment spending was $1.8T. And the reckless behavior has grown in a non-linear fashion after 8 years of free money. In 2012, buybacks and M&A were $1.25T while all R&D and office equipment spending was $1.55T. As valuations rose since then, R&D and office equipment grew by only $250b, but financial engineering grew $750b, or 3x this! You can only live on your seed corn so long. Despite no increase in their interest costs while growing their net borrowing by $1.7T, the profit share of the corporate sector peaked in 2012. The corporate sector today is stuck in a vicious cycle of earnings management, questionable allocation of capital, low productivity, declining margins, and growing indebtedness. And we are paying 18X for the asset class.
Troubling, isn’t it? Actually, Druckenmiller’s thesis is downright scary, enough for me to dig further. Is corporate America self-destructing to the point that profits are about to go down the drain even absent a recession?
Let’s look at some other facts:
- While aggregate net debt continues to grow rapidly, it remains relatively low relative to equity while cash levels are historically high (RBC chart):
- Declining cashflows are primarily due to the Energy sector. Ex-Energy, free cashflows remain on an uptrend (RBC charts):
- Buybacks are historically high but dividends are low; total distributions to shareholders is not cyclically excessive (McKinsey chart):
(…) the trend in shareholder distributions reflects a decades-long evolution in the way companies think strategically about dividends and buybacks—and, more broadly, mirrors the growing dominance of sectors that generate high returns with relatively little capital investment. (…) The shift makes good sense. Empirically, the value to shareholders is the same, but buybacks afford companies more flexibility. Executives have learned that once they announce dividends, investors tend to expect that the dividends will continue in perpetuity unless a company falls into financial distress. By contrast, a company can easily add or suspend share buybacks without creating such expectations. (McKinsey)
Low corporate capex are often blamed for slow GDP growth but McKinsey argues otherwise:
(…) there’s little evidence that distributions to shareholders are what’s holding back the economy. In fact, on an absolute basis, US-based companies have increased their global capital investments by an inflation-adjusted average of 3.4 percent annually for the past 25 years—and their US investments by 2.7 percent. That exceeds the average 2.4 percent growth of the US GDP. Furthermore, replacement rates have remained similar. Capital spending was 1.7 times depreciation from 2012 to 2014, compared with 1.6 times from 1989 to 1999. The only apparent decline is in the level of capital expenditures relative to the cash flows that companies generate, which fell to 57 percent over the past three years, from about 75 percent in the 1990s.
That’s not surprising, given how much the makeup of the US economy has shifted toward intellectual property–based businesses. Medical-device, pharmaceutical, and technology companies increased their share of corporate profits to 32 percent in 2014, from 13 percent in 1989. Since a company’s rate of growth and returns on capital determine how much it needs to invest, these and other high-return enterprises can invest less capital and still achieve the same profit growth as companies with lower returns. Consider two companies growing at 5 percent a year. One earns a 20 percent return on capital, and the other earns 10 percent. The company earning a 20 percent return would need to invest only 25 percent of its profits each year to grow at 5 percent, while the company earning a 10 percent return would need to invest 50 percent of its profits. So a higher return on capital leads to higher cash flows available to disburse to shareholders at the same level of growth.
That is what’s happened among US businesses as their aggregate return on capital has increased. Intellectual property–based businesses now account for 32 percent of corporate profits but only 11 percent of capital expenditures—around 15 to 30 percent of their cash flows. At the same time, businesses with low returns on capital, including automobiles, chemicals, mining, oil and gas, paper, telecommunications, and utilities, have seen their share of corporate profits decline to 26 percent in 2014, from 52 percent in 1989. While accounting for only 26 percent of profits, these capital-intensive industries account for 62 percent of capital expenditures—amounting to 50 to 100 percent or more of their cash flows.
Here’s another way to look at this: while capital spending has outpaced GDP growth by a small amount, investments in intellectual property— research and development—have increased much faster. In inflation-adjusted terms, investments in intellectual property have grown at more than double the rate of GDP growth, 5.4 percent a year versus 2.4 percent. In 2014, these investments amounted to $690 billion.
The Energy recession of the last 2 years has tainted many financial ratios including profits and ebtida growth rates, often blurring the analysis of overall trends. The Energy sub-index profits totalled nearly $43 in 2014 and plummeted to a loss of almost $14 in 2015, costing the S&P 500 Index close to $7.00 (7%) in EPS last year. Even in Q1’16, while Energy EPS collapsed 104% YoY, ex-Energy EPS were unchanged, a pretty remarkable result given revenues growing only 0.9% YoY.
The so-called “mal-investments” are not showing up in corporate results, at least not just yet. The charts below plot data from the CPMS/Morningstar universe of 2153 U.S. companies (green line = average, red line = median, dots = consensus 2016 forecast). Median returns on total assets (ROTA-top chart) and on equity (ROE) have declined lately but remain high in spite of the negative impact of energy companies. The average ROTA and ROE is also holding better than their respective median.
And, even including Energy, net margins have yet to contract meaningfully.
More to the point, The Economist ran an interesting analysis of American business in its March 26, 2016 edition claiming that profits are too high in America and more competition is needed.
The last year has seen a slight dip in aggregate profits because of the high dollar and the effect of the oil price on energy firms. But profits are at near-record highs relative to GDP and free cash flow—the money firms generate after capital investment has been subtracted—has grown yet more strikingly. Return on capital is at near-record levels, too (adjusted for goodwill). The past two decades have seen most firms make more money than they used to. And more firms have become very profitable.
Rising margins, free cashflows and returns on capital are signs of strong management and efficient capital allocation. Note that the rise in margins and ROIC has been achieved in spite of the large build up in cash from 5% of assets on average in 1995 to 12% currently. Cash returned nearly 6% in 1995, virtually zero nowadays. And while it is true that a larger share of cashflows has been allocated to M&A and buybacks this cycle:
1- M&A activity has not been abnormally high as this RBC chart illustrates:
2- This M&A activity has contributed to a meaningful decline in SG&A costs (RBC):
3- The apparent dearth of capex is primarily the result of the significant structural changes within the economy as McKinsey explained earlier. Capital intensiveness in the digital world is substantially lower than in the physical manufacturing and services economy. In 1993, Materials, Energy and Industrials composed 31% of the S&P 500 Index, five times larger than IT at 5.9%. Today, these ratios are 19.7% and 20.8% respectively.
As a case in point, Amazon’s phenomenal growth has rendered obsolete numerous brick and mortar stores requiring disinvestment from their owners. This “negative capex” is only beginning as the software and sharing economies keep invading our daily activities. For example, car manufacturers must constantly reassess their capital needs in a world where auto sharing becomes more and more popular (Car2Go, UberX, etc.). Tesla is reinventing car manufacturing, selling and servicing with “simpler” vehicles and automatic software updates. SpaceX has found ways to re-use launching rockets thanks to software engineering. No doubt that artificial intelligence will accelerate these trends.
The mixing of computing, data and math will take us to another level. Already, companies with the best software engineers are benefitting from accelerating market share growth and rising market dominance. Others are using M&A to consolidate their industry and strengthen their positioning.
In 2014 the top 500 listed firms made about 45% of the global profits of all American firms, as they did in the late 1990s. Instead they, and other companies, have become more focused. The strategy can be seen as an amalgam of the philosophies of two deeply influential business figures. Jack Welch, the boss of General Electric for two decades at the end of the 20th century, advised companies to get out of markets which they did not dominate. Warren Buffett, the 21st century’s best-known investor, extols firms that have a “moat” around them—a barrier that offers stability and pricing power.
One way American firms have improved their moats in recent times is through creeping consolidation. The Economist has divided the economy into 900-odd sectors covered by America’s five-yearly economic census. Two-thirds of them became more concentrated between 1997 and 2012. The weighted average share of the top four firms in each sector has risen from 26% to 32%.
Over the past 50 years return on capital has averaged about 10% (excluding goodwill) and that is what investors tend to demand, so let that represent bog-standard profits. The excess on top of that—which may reflect brilliant innovations, wise historic investments in intangible assets such as brands, or, perhaps, a lack of competition—is the exceptional bit. For S&P 500 firms these exceptional profits are currently running at about $300 billion a year, equivalent to a third of taxed operating profits, or 1.7% of GDP.
So what Druckenmiller calls “mal-investments” are actually resulting in “exceptional profits” per The Economist which, while raising the idea that competition may be too low, acknowledges “brilliant innovations, wise historic investments in intangible assets”, precisely McKinsey’s point.
Not to say that we should be paying 18x for the asset class. Just to say that U.S. corporations are not self-destructing. In effect, even though there are and will be excesses, American capitalism is working its checks and balances in spite of the Fed’s ZIRP.
Which is not happening in China where the communist Party cannot allow true and complete capitalistic behavior from state-controlled companies. Druckenmiller’s case on China is far more solid and scary:
While we were worried about bank assets to GDP in 2012, incredibly, credit has increased by 70% of GDP in the 4 years since then. Just to put this in perspective, this means that since 2012 the Chinese banking sector has allowed credit to grow by the amount of the entire Brazilian GDP per year! Picture the entire Brazilian production in new houses and infrastructure. Incredibly, all this credit growth has been accompanied by a fall in nominal GDP growth from 15% to 5%. This is an extremely toxic cocktail for companies that have borrowed at 10% expecting 15% sales growth. Our strong suspicion therefore is that a large part of this growth is just credit flowing to otherwise insolvent borrowers. How else to explain the lack of NPL problem in heavy industries hit by lower prices and sales growth? (…)
Two years ago, we had hope the Chinese were ready to accept a slowdown in exchange for reform. Unfortunately, with the encouragement of the G-7, they have opted for another investment focused fiscal stimulus which may buy them some time but will exacerbate their problem. They do not need more debt and more houses.
The mal-investments in China are readily apparent on these charts from Citic Securities (via CLSA) showing the rapidly declining profitability at China’s state-owned enterprises and the latters’ recent debt-financed investment surge amid already excessive capacity.
CLSA’s strategist Chris Wood details the rising NPL risks in China (chart from The Economist):
(…) if analysts are now competing to come up with estimates of the real level of stressed loans in the China banking system and related shadow finance cycles, a good starting point can be found in the IMF’s latest Global Financial Stability Report published in April. This, based on a sample of 2,871 listed and unlisted nonfinancial Chinese companies, calculates that 15.5% of total commercial bank loans to the corporate sector are “potentially at risk”. This debt-at-risk ratio is defined as having an interest coverage ratio (EBITDA dividend by interest expenses) of below one. Assuming a 60% loss ratio, the IMF puts potential bank losses at 7% of GDP, a level which it still considers as “manageable” while noting that for this to remain the case “prompt action” to address excess capacity and the like needs to occur.
All this is perfectly reasonable. Still Francis Cheung [head of CLSA’s China-HK strategy] makes the valid point in his report that the IMF has relaxed its criteria from when a similar exercise was done in 2014. Then the debt-at-risk estimate was done using an interest coverage ratio of less than 2x. Now it is 1x. If the same 2x threshold was employed in 2015 the debt-at-risk estimate would rise to 28% of total corporate loans. Meanwhile, Cheung estimates, using the latest listed A-share company data for 2015, China’s bad-debt ratio or NPL ratio at 15-19% based on companies’ interest coverage and debt sustainability.
China’s “bridges to nowhere” problem and the related looming NPLs are well known but the fact that the large Chinese banks are government controlled probably helps mitigate the risk for many investors. What is not as well known is that Beijing’s control on the banking system has been diluted over the years. CLSA calculates that the Big Four banks’ share of total bank assets has fallen from 56% at the end of 2003 to 36% at the end of 2015.
Concomitantly, and unsurprisingly, Chinese banks have used their excess cash to make investments that are “less transparent and potentially more risky than loans” according to Deutsche Bank:
The conventional wisdom focuses on debt in the non-financial sector and the potential NPL problem in the banks. Such risks may take many years to fully materialize. What we highlight is a new source of risks. It comes from the financial sector itself and may lead to disruptive adjustment quickly without proper regulation.
Economic growth slowed in H1 2015. The government loosened monetary and fiscal policies in mid 2015 and intensified such easing in Q1. The financial sector is flooded with cheap credit which drives down market interest rates. Investment opportunities in the real economy remain limited due to excess capacity. Under this macro backdrop some financial institutions may have leveraged up to chase for higher returns.
A gap widened between rapid bank credit growth and moderate M2 growth (Figure C1). This suggests the current stimulus through credit growth did not fully transmit into lending to firms and households.
This credit expansion to NBFIs likely takes the form of investment rather than loans. For the 12 listed banks other than the Big 4, their investment assets increased RMB5.5tr during 2015 and 2016Q1, much bigger than the net new loans they lent, which was only RMB3.3tr (Figure C3).
The current round of stimulus is much less effective than the 4-trillion stimulus in 2009, when credit growth and M2 growth jumped in similar magnitude. The rapid credit expansion within the financial sector has led to asset bubbles and made the financial sector more fragile. A fragile financial sector constrains the effectiveness of monetary policy.
International experience shows warning signals. Credit growth outpaced M2 growth persistently in Korea and Thailand before the Asian financial crisis. Academic research shows higher non-deposit liabilities of the banks raises the chance of financial crisis in other countries.
This fat tail risk is augmented by the inexperience of Chinese leaders in identifying and dealing with these deficient capitalist behavior as DB warns:
(…) we believe many credit circulating activities could be actually “joint efforts” by banks and NBFIs to pursue higher returns through financial leverage. Such activities often took place in regulatory vacuum areas where none of the financial supervisors alone could exert effective supervisions. In this sense, the fact that this problem has grown so rapidly over the past two years or so also exposes the deficiency of current financial regulatory framework in China.
The credit boom within the financial sector is more alarming than the leverage problem in the equity market in 2015. The deleveraging of the equity market did not cause a significant macro impact, as the leverage was more related to brokers rather than banks. The credit boom we discuss in this report is about the banks themselves. The aggressive behavior of some smaller banks in China should cause macro concerns.
This is akin to a huge sandwich composed of layers of known and unknown risks piled haphazardly on top of each other and loosely framed by slices of various regulators oblivious to each others and served by inexperienced and clueless chefs to blind and anosmic investors.
China is a good enough reason why we should not be paying 18x for equities. China caused the boom in commodities and is now causing the bust. Its significant slowdown is impacting every economy and its opacity is blinding central bankers. Clearly, the risk is that China slows much more than current expectations of 6.5% GDP growth. A March 2016 IMF paper investigates empirically how shocks to GDP in China are transmitted internationally and the spillover effects of a materialization of domestic financial sector risks.
Overall, China’ size and its centrality to global value chains mean that any economic slowdown in China will entail global spillovers, especially through trade channels. These trade effects are both direct (reduced bilateral imports by China from its trade partners) and indirect (impact on commodity prices and third-market effects as China is one of the main trading partners (top ten) for over 100 economies that account for about 80 percent of world GDP).
Overall, the results show that following a permanent 1% negative Chinese GDP shock, global growth reduces by 0:23% in the short run. There is also evidence for a short-run fall in both global inflation and short-term interest rates (…).
(…) one standard deviation shock to the financial stress index (FSIt) translates into a short-run lower overall economic growth globally. Specifically, our estimates suggest that world output falls on average by 0:29% below the pre-shock level in the first four quarters after the surge in global financial market volatility, with this effect being statistically significant. Not surprisingly we also observe that this shock causes oil prices to fall (-6:5%) and it has a negative short-run effect on global equity prices (-3:7%) and long-term interest rates (-0:03%), reflecting increased risk aversion (the numbers in the brackets correspond to the peak effects in the first quarter). Moreover, a widening of the output gap and lower commodity prices likely moderate global inflation slightly.
It was one thing to experiment with “controlled capitalism” during the acceleration phase. Everybody benefitted from China’s emergence as an economic force. It remains to be seen whether the Party can steer this behemoth during the slowdown phase, especially given the known excess capacity and the known and unknown financial excesses.
When equity valuations are on the high side like is the case now, there are two levels of risks to consider: the basic fundamental earnings risk and the valuation (P/E) risk. In the U.S., the earnings risk comes from very slow revenue growth rates coupled with accelerating labor costs (see MARGIN CALL NO MARGINAL RISK). Until there is relief on one of these two factors, the earnings risk will remain high. The valuation risk is more dangerous because stretched P/Es can drop precipitously from anything that spooks investors.
Pity Mrs. Yellen and her fellow FOMC members. Not only do they have to live with the “uncertain” U.S. economy, they also feel they must contain anything else that might cause a market correction, including
- uncertain China, the elephant in the room which nobody can really size up;
- uncertain OPEC, assuming it still exists;
- uncertain Eurozone after June 23;
- uncertain Japan with its Abenomics experiment;
- uncertain currencies which nobody really understand;
- uncertain U.S. politics, with or without Trump.
Uncertainty is especially undesirable when valuations are elevated. Or is it the other way around?
I’m not certain!