A businessman is about to arrive at the White House with his crew of business people and a very business-like attitude.
While Trump’s top appointees have less government experience than most administrations since the 1960s, they have by far the most business experience, [Ray] Dalio [whose Westport, Connecticut-based firm is the hedge fund industry’s largest money manager] said. They are “bold and hell-bent on playing hardball” to effect major changes in economics and foreign policy, and their leader “doesn’t mind getting banged around or banging others around.”
It is thus appropriate to analyse this mega cap stock USA Inc. and try to realistically assess its outlook based on objective fundamentals. Can this truly wholesale management change, this potentially “novel” way to run the country, herald a new era of growth and prosperity for what is still the main engine of the world?
Let’s begin by looking at valuation parameters and then see if a sensible and credible story can fit in. The chart below plots the so-called Buffet Indicator which is akin to a Price-to-Sales ratio for the U.S. economy (market value of U.S. equities divided by GDP – blue line) and a proxy for corporate profit margins.
Here’s another proxy for corporate profit margins from the national accounts (for a discussion on secular margins trends, see CETERIS NON PARIBUS) :
USA Inc.’s Price/Sales ratio is at a historical high (ex the internet bubble) but this extreme valuation is accompanied by profit margins that are also historically high. A dollar of high margin sales is clearly worth more than a dollar of low margin sales.
USA Inc.’s P/E proxy (market value of U.S. equities divided by Corporate Profits – red line below) is at the high end of its 60-year range of 10 –15 times (with periods below 10 when inflation is high) but nowhere near the internet bubble years’ valuation. By this measure, USA Inc. is expensive but not bubbly like in 1998-2000.
Nonetheless, we are clearly in “buy high” territory. The main question is the sustainability of this precarious state which leaves little room for unfulfilled expectations from poor fundamentals or bad execution. Investors’ confidence on USA Inc.’s growth and profit potential needs to be constantly nurtured from here on out.
Realistically, USA Inc.’s revenue outlook remains constrained by the rather immutable demographic trends of slow growth in the available workforce and weak productivity (output per worker). In truth, production and revenue growth is highly dependent on productivity going forward.
The aging process is accelerating which will likely exacerbate the difficulties: more and more workers will leave the company and the average age of the remaining employees will keep rising, extending the productivity challenge.
Unless USA Inc. welcomes young foreigners, it will need to invest heavily in automation to sustain productivity growth, something corporate America has not done enough in the last cycle.
USA Inc.’s real top line growth (real GDP) averaged 1.4% per annum since 2006, a big step down from +3.4% during the previous decade. About 40% of the slowdown is due to demographics and 60% from slower productivity growth. Demographics will likely shave another 0.3% per year during the next 8 years, requiring productivity growth to double just to bring real revenue growth to the current consensus level of 2.0% per year. Easier said than done for such a large and well diversified company that has been a pioneer in global sourcing and procurement.
Even with hard-ball managers, USA Inc.’s top line growth, in real terms, is thus more than likely to remain subdued for a while longer.
Higher inflation rates can boost nominal revenue growth but unless inflation on revenues neatly exceeds inflation on costs (e.g. inflation outgrows wages), the impact on profits is zero or negative.
Can profit margins keep rising?
- The secular decline in labor’s share of profits seems to have reached a low point in 2012. Most of the recent cyclical decline in margins has been concentrated in the energy complex but it remains to be seen if aggregate margins will recover along with energy profits. Other than for Reits, sector profit margins have not expanded in recent years in spite of very slow wage growth, a halving in energy prices and rock bottom financing costs.
The growing tightness in the labor market is pushing wage growth rates above inflation which can only squeeze operating margins if productivity growth fails to compensate.
Unit labor costs are currently rising at 3.0% YoY, pressuring margins since nominal GDP growth has averaged a weak 2.7% in 2016.
- Energy costs have declined spectacularly in the last 2 years but this tailwind has all but disappeared lately: YoY, prices are +7.7% for oil, +22.0% for natural gas, +1.0% for coal and +0.2% for electricity which usually trails coal and natural gas prices.
The pressures on USA Inc.’s operating profit margins are intensifying due to deeply fundamental trends: a slowing and aging labor force, a tightening labor market, weak productivity and rising energy costs. Investors have been quick to focus on the potential benefits of deregulation. Strangely, they are totally oblivious to the potential adverse impacts of this new management team’s other policies: openly anti-immigration, highly protectionist and prompt to fight corporate strategies aimed at “optimizing operations”, a convenient euphemism for increasing profit margins, something USA Inc. has been very good at during this cycle characterised by slow demand and low inflation.
This management’s policies could effectively deprive corporate America from the very tools which enabled it to keep growing earnings amid a difficult macro environment. It is doubtful that deregulation will be timely and potent enough to offset the fundamental pressures on margins during the next few years.
* * *
Meanwhile, a lady is entering the last year of her mandate at the helm of the powerful Federal Reserve. The “footloose and collar-free” Trump has not shown much fondness for her:
I think she is very political and to a certain extent, I think she should be ashamed of herself.
Nor has he given her much hope for a second term:
She is not a Republican. When her time is up, I would most likely replace her because of the fact that I think it would be appropriate.
Some pundits speculated that Mrs. Yellen would quickly resign (“when the baby moves in, the dog moves out.”) but she rather wasted no time confirming that she will see the end of her term in February 2018.
Three extracts from her post-FOMC press conference of Dec. 14 reveal her true motivation (my emphasis):
- So let me say that our decision to raise rates is—should certainly be understood as a reflection of the confidence we have in the progress the economy has made and our judgment that that progress will continue. And the economy has proven to be remarkably resilient. So it is a vote of confidence in the economy. (…) But, certainly, it’s important for households and businesses to understand that my colleagues and I have judged the course of the U.S. economy to be strong, that we’re making progress toward our inflation and unemployment goals. We have a strong labor market, and we have a resilient economy. (…)
- Well, I believe my predecessor and I called for fiscal stimulus when the unemployment rate was substantially higher than it is now. So, with a 4.6 percent unemployment and a solid labor market, there may be some additional slack in labor markets, but I would judge that the degree of slack has diminished. So I would say at this point that fiscal policy is not obviously needed to provide stimulus to help us get back to full employment.
- I would say the labor market looks a lot like the way it did before the recession, that it’s—we’re roughly comparable to 2007 levels when we thought the, you know, there was a normal amount of slack in the labor market. The labor market was in the vicinity of maximum employment.
The stage is thus set for the year: Mrs. Yellen will clearly not be muzzled, openly saying that the widely trumpeted fiscal stimulation may just not be appropriate at this time. This is her last year and she will seek to make sure things don’t get out of control. In the same presser, she said :
But I do want to make clear that I have not recommended running a “hot” economy as some sort of experiment.”
Let me summarize in my own words:
- She sees the economy as strong, the labor market as solid and most likely to remain so under the current policy environment.
- The labor market is almost at full employment, much like in 2007 when the unemployment rate was 4.5%, wages were rising at 4%+ and the fed funds rate was 5.25%.
- Given these conditions, an expansionist fiscal policy is “not obviously needed to provide stimulus” and could actually become problematic for the monetary authorities.
- She does not favor letting the economy run “hot”.
If Mrs. Yellen’s apprehensions materialize, and she is a labor market specialist, wage growth will accelerate and interest rates will rise more than currently forecast by the FOMC and most everybody, including Mr. Trump.
Mr. Trump vilified Mrs. Yellen for keeping rates artificially low. But it is unlikely he will get more affectionate if she aggressively raises rates to counter an un-necessary expansionist fiscal policy. This story has no script for any kind of romance between these two characters.
Equity investors are salivating at Trump’s pro-growth program but they fail to see the rat out there. Commotion warning!
* * *
Behind the scene, USA Inc. has significantly leveraged itself in recent years given the incentive from negative real rates. Higher indebtedness is seen in all divisions and debt servicing costs will likely jump here, there and everywhere in coming quarters and years, squeezing every division’s profits and ability to invest and expand.
This financial pressure is already operative. USA Inc.’s net interest expense (federal government) currently accounts for 1.4% of GDP from 1.7% in 2008 when the federal debt was half its current $20 trillion. Interest rates pinned to the floor by the Fed hide a potentially significant profit and growth impediment.
The average interest rate on the federal debt was 2.0% in 2016 (per CBO), but the whole rate spectrum has lifted rapidly from the summer lows with rises ranging from +0.3% on short maturities to +1.2% on 10Y Treasuries. The average debt duration is 5.5 years and nearly half the federal debt matures in less than 3 years. A possible 20-30% jump in interest payments in 2007 on its way to “almost doubling” over the next several years (per CBO) would prompt Congress to limit USA Inc.’s spending intentions.
A similar squeeze will materialize across all USA Inc.’s divisions, including state and local governments, the American consumer and non-financial corporations which have collectively become significantly more indebted in recent years.
Such a squeeze means reduced investment and spending capabilities hampering demand for corporate America’s goods and services.
As of September 30, 2016, total household indebtedness was $12.35 trillion, 2.6% below its Q3’08 peak of $12.68 trillion, but 10.7% above the Q2’12 trough. Low interest rates have brought debt servicing down to a 35-year low but rising rates will rapidly eat into discretionary spending since most consumer debt carry floating interest rates.
- Foreign clients are in the same bath, especially those with debt denominated in USD:
Look at what emerging markets earnings have done while EM debt was exploding: who are the lenders?
Given the consensus real GDP growth estimate of 2.0% for 2017, which is also the average of the last 6 years, assuming 2.0% inflation which is the Fed’s target, we get 4.0% nominal GDP growth, a level not seen since Q2’15.
There is risk to that forecast given that
looking at history books, when U.S. nonfinancial debt-to-GDP is over 225%, average annual real GDP growth is +1.3%. The ratio is now 248% and Trump’s plan will make this number higher, not lower. (…)
For the world’s advanced economies, a similar story. Between a 200% and 225% [debt ratio], growth averages 3%. Between 225% and 250%, GDP growth averages 2.2%. But above 250%…well, that is the inflection point because growth throttles down to an average of 1.1%.
Where is that ratio today? Just below 270%. (David Rosenberg)
RBC Capital calculates that 4.0% nominal GDP growth translates into 4.0% revenue growth for S&P 500 companies, better than the negative growth of the last 2 years and the +3.4% average between 2012 and 2015. Revenue growth was 2.6% in Q3’16 and is currently forecast to hit +5.8% in 2017 according to Factset, a pretty tall order if real GDP growth stays around 2.0%.
Assuming wages grow 4.0% and employment gains 1.0-2.0% (+1.4% in December 2016), labor costs could shoot up 5.0-6.0%, implying operating margins compressions. SG&A costs should follow inflation giving a small offset. But interest expense will bite hard: debt-to-EBITDA has exploded in the last 5 years from 1.6x to 2.3x, meaning that for every dollar of operating profit, there is $2.30 of debt, meaning that for every 1% increase in interest rates, EBITDA is impacted by 2.3%, not counting the effect on top line growth.Assume this P&L:
- Nominal sales: from $1000.00 to $1040.00 (+4.0%)
- Wage cost grow 5.0%: 600.00 to 630.00
- SG&A grow 2.0%: 240.00 to 244.80
- EBITDA: 160.00 to 165.20 (+3.3%)
- Interest expense if rates +1.0%: 18.40 to 22.10 (+20.0%)
- Pretax Income: 141.60 to 143.10 (+1.1%)
If rates rise 1.5%, pretax income declines, again not assuming any further impact on revenues. Tax reform has better come quickly (the last one took 4 years to complete under Reagan).
* * *
A clash between Mr. Trump and Mrs. Yellen seems inevitable. The labor market, already tightening under supply constraints, cannot also absorb the effects on labor demand that a strong fiscal stimulus would likely bring. Mrs. Yellen and her fellow FOMC members are very much aware of this as the recent FOMC minutes attest.
Moreover, their inflation target is finally in sight. Price pressures will likely intensify given the upward trends witnessed in most continents in the last several months, mostly due to supply constraints. The last thing the Fed wants is to fuel consumer demand and exacerbate price pressures 8 years into the recovery with a highly leverage economy. The preferred medicine is gradual, gentle tightening. Trumpism could require something more drastic, not advisable for debt-handicapped patients.
For equity investors, this is crunch time with low probabilities of success. A Trump-fed economy will create too much demand pressures at an inopportune time, higher inflation and rising interest rates. Some experts suggest that this is positive for profits, therefore for equities. Not when valuations are already at peak levels. And not when high debt leverage is rampant across the economy. (RISING LONG-TERM RATES: THE SCARY FACTS! , EQUITIES AFTER FIRST RATE HIKES: THE CHARTS SINCE 1954)
Investors have place strong wagers on Donald Trump since November 9, thinking he will unleash the missing animal spirits in the economy. They may be surprised, the animal could be of the Ursid kind. Perhaps it is time to keep some chips for Janet Yellen. After all, her very powerful tools have immediate direct impact on the economy, corporate P&Ls and financial markets.
Dog days may be ahead!
(Many charts courtesy of J.P. Morgan Asset Management)