Welcome to the "New Normal"
Lance Spicer, Editor - Trident Confidential, 12 Aug 2011, 11:01 AM
Bill Gross and Mohamed El-Erian are investment legends and they jointly run the world’s largest bond fund at Pimco in the US. It was Mohamed that originally coined the phrase the “the new normal” being slow economic growth amid high unemployment and a sloppy national balance sheet. He said during a CNBC interview, "The key issue...is that we simply cannot generate enough growth to get us over all these issues," he said. "Therefore, we have these structural headwinds that continue to slow us down. Until we see structural solutions we're going to be stuck on the bumpy road to a new normal."
Well, I thought it may be an idea to have a think about that and what it means for us as investors. As you well know, I have also used the term to describe the post-GFC world. It’s a little bit like the post-depression world of the 1930’s.
Since the GFC, the world has changed, people have changed, you have probably changed. Back in 2006-7 most people would have thought nothing of taking on more debt, higher credit card limits and using their home equity as almost a ”bank” where you could draw down money for a new car, boat or overseas holiday – life was pretty good. The stock market was even quite a pleasant place to invest and everybody had margin loans or borrowed money to invest. Just like us, governments and businesses “over-leveraged”. We all borrowed because we were “certain” that asset prices would continue to rise, as would our incomes and the ability to pay off loans in the future – Life was good.
Then along came 2008.
It felt like the end of the world, or something akin to it. House prices collapsed in the US, bond and stock markets went in to meltdown, your retirement plans were wrecked, nobody was 100% sure about banks anymore and we all worried what would happen next. We saw the collapse of financial institutions like Lehman Brothers, and the possible crash of even bigger financial institutions. It rattled us. Fortunately in Australia we made it through with only our investment portfolios in tatters due several years of fiscally responsible government building up a huge budget surplus that could be used to sure up the economy with stimulus. One wonders what would happen now, if it happened again, now that all that money has been used (wasted?).
Anyway the whole GFC was a shock and it changed attitudes.
We now have a “new normal”.
This new normal means we do not take on excessive debt, we pay off our credit cards each month, we certainly don’t use margin loans for shares anymore, and the thought of a large mortgage worries all of us. We don’t spend like we used to and when we do spend, we don’t go to the shops, we buy online, probably from US online stores like Amazon. In the US, it’s even more acute – they just don’t spend. The New Normal means “deleveraging” or paying down debt. Corporations were the same, they paid off debt instead of paying dividends and if you remember every second company seemed to be launching a capital raising to get rid of debt.
Look at household savings rates, they haven’t been this high in Australia and the US since the 1960’s – we have all become “financial conservatives”. Household debt in the US has been falling steadily since January 2009 and the same has occurred in Australia. We are now at multi decade lows when you compare household debt to GDP.
Corporations in the US and Australia now carry the least amount of debt they have for two decades. American corporations carry $2 Trillion dollars in cash on their balance sheets! This is taking caution and conservatism to whole new level for corporate America.
Now, on the surface, all this financial conservatism is a good thing. We all have less loans, we are saving more and we are careful with our spending.
However, we have created a little problem.
During the GFC, governments all over the world borrowed loads of money (by issuing bonds) to prop up their failing economies. In Australia we saw PM Kevin Rudd running around throwing money at home insulation schemes, school halls were being built and sending us all $900 cheques. According to most people all completely wasteful. In the US, they went several steps further, kept tax cuts in place, and then proceeded to invest $800B in companies including banks, insurance and car manufacturers. In addition, they created debt by flooding the market with bonds and in some instances the bonds were in fact bought back by the government in an attempt to free up credit. This worked, sort of. You see this attempt to get people borrowing money failed – as we now know, we were too busy panicking and paying off debt to consider borrowing more. This process was repeated all over the world. The world didn’t end but the whole experience has made us all go a bit “funny”.
Well, here we are in 2011 and governments have a “little” problem. They spent too much in the GFC and now have to pay it back, which all sound reasonable I suppose, but the only money governments have, comes by way of taxes. But tax receipts have fallen off a cliff because our economic activity has been affected by the “new normal”. You see, if we don’t spend, then the money doesn’t reach other people or businesses who are taxed on it, either by way of a sales tax such as the GST, or at the end of the year in the form of income tax. The money the government thought they would get from a “return to normal” economy has just not materialised in the form of tax receipts. We did this - we stopped spending – this is the “new normal”.
Now, let’s look at America’s predicament - $14 Trillion of debt (that’s the gross debt, so if you offset inter-governmental debt it would actually be significantly smaller, but anyway), and bound to get bigger before it starts falling. But, you may ask, will it ever get repaid? No, never, well not in our lifetimes. If it did there would be no bond market, but it also shouldn’t be so high that it’s no longer in control. So, what the US government is thinking here is that if the debt grows slower than the economy does, then all will be ok. However, the economy is sluggish and not growing, because, you guessed it, the “new normal” is in effect and consumers aren’t spending. You see the conundrum? It’s a bit like when we take out a mortgage for $200,000 when we are 30 and earning $60,000 a year. At that point in time that mortgage represents 3.33 times our earnings. However, as we get older and inflation gives us pay rises, as well as the odd “productivity rise”, we may find ourselves 15 years later earning say $120,000, and even if we hadn’t paid a cent off the capital, it now only represents 1.6 times our income, half what it was previously. What governments are in fact doing is waiting for time and the discounting effect of inflation to reduce the future value of that debt. In effect, governments need a “pay rise” in the form of increasing tax receipts to reduce the debt as a percentage of GDP. If the economy grows at 3%, then even a 20 Trillion dollar debt in 20 years will be nothing to be concerned about. But if the economy only grows at 1%, then that debt may be a big problem because it’s relationship to the GDP will be high.
Debt is all very good, as long as you can service it and have the ability to reduce it if you so desire. With tepid economic growth everywhere, except Asia and some other emerging economies, those developed nations with high debt are causing some concern.
In relation to US unemployment, I think it will improve, but US unemployment, in my opinion will remain high for possibly another 3-5 years even though US GDP may pick up. There is a real disconnect between corporate profit growth and employment. Corporations will only start employing in large numbers again when they absolutely have to, but technology and other efficiencies are making hiring more employees less necessary to increasing profits. We need to prepare ourselves for this new reality and the markets also have to accept this “disconnect” and focus back on Return on Equity employed when investing and ignore some of the old economic concepts that you need full employment to have robust GDP growth and increasing corporate profits. Sad but true. However, having said that corporate America is hiring and hiring at a rate that will slowly reduce unemployment, but just not as quickly as many would like, due to the changing employment environment.
The “New Normal” is the problem, and the opportunity.
Currently as we have seen, corporate America is doing very well indeed – profits are up – balance sheets are full of cash and low debt – brilliant stuff. Of course, as we know, government balance sheets are not quite as good – debt is high and income is down. In Australia, 65% of the economy is consumer-driven, in the US it’s 70%. So, even though corporate profits are good in the US, they won’t solve the problem – only GDP growth will. I’m not sure, but I suspect the US government expected the GFC recovery to be like all the other recoveries – 4% GDP growth for 1 to 2 years, then 3-4% thereafter. The $14 Trillion dollar debt problem may not even have been a front-page news item had this recovery been “normal”. But it isn’t.
The US government can’t do a thing about the debt, until GDP growth is revived and you can bet that’s exactly what they’ll be trying to do. The first thing on their agenda will be jobs. People working are people spending. Who’ll employ them? Big corporations, that’s who.
Now, to take this thought process another step further, which corporations will be hiring and why? Well, I mentioned that only emerging economies were growing quickly, so obviously companies that are selling to these economies will be doing well. Yes, the big exporters will be doing well, and as we have seen with the latest earnings reports from the US that is exactly what’s happening. Yes, the American economy may be weak, but American companies are not. Take Apple, IBM, Intel, Caterpillar, Cummins and even our own BHP – all doing really well because they have tapped into emerging economies outside tepid domestic consumer growth, although it could be argued that Apple products sell regardless of spending “priority”. While most of these companies are in our portfolio, we also have some very exciting smaller companies in our portfolio that are doing even better despite the economic conditions. In the past we have regularly booked 100+% profits on companies just like them, such as Acme Packet and MIPS
Obviously, focusing on companies that provide products and services to fast growing emerging economies is the way to go, as well as investing in companies who supply to the exporters. So, you look at the whole supply chain that gets, say, an Apple product into Chinese teenager’s hand – that would mean also investing in Skyworks for instance. Now, that doesn’t mean we forget domestic sales altogether, because some products and services will do well regardless of the state of the economy, like the build out and transition to the “Cloud”. Cloud computing will be a revolution in how we use software and data storage and we need to tap into that as well. Companies like Oracle, Google, Intel and Apple will all be significant players.
In summary, the advent of the “new normal” will mean less discretionary spending growth than we have seen in the past, less credit growth, less inflation, lower interest rates than the mean and greater use of technology in our everyday lives. That technology won’t just be about communications either, it will include online shopping, data storage, health care and the way we use media and entertainment. As investors, we have to recognise that the world has changed and that the leaders of the stock market boom up until 2007 won’t necessarily be the leaders from now on. The new leaders of the stock market will be the companies that best embrace the new normal and understand the world has changed, and possibly forever.
However, having said that, I do expect that once significant deleveraging has been done, we’ll see a return of consumer-lead growth, but not consumer growth driven by borrowing as we saw up till 2007. It may just take another year, before we see it return that’s all. In the meantime, we’ll see banks and traditional non-online retailers struggle.
The stock market indices may only slowly creep up over the next few years, but that doesn’t mean that all stocks will do the same, at some stage they will become the new leaders due to continued increased earnings and revenues. As subscribers of Trident Confidential have seen recently, the stocks we recommend have not only beaten expectations, but raised guidance in a difficult economy and I expect that due to the positioning of their products and services, they’ll prosper in the “new normal” and their share prices will reflect their success in time.
We have proven year after year, regardless of market conditions, if you invest in the right stocks, you will make money. 2011 is no different.
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Just writing you a note of appreciation. Last week my whole portfolio got wiped-out, but I had the Trident Protection strategies in place! It wasn't fun to see my whole investment drop in one swipe. However, taking your advice (as usual), I re-invested the cash I had and in two days it returned 17%. I'm basically 7+% ahead as where I was last week. You all are legends in my book, which is a very small book by the way. Just to be clear I have tried to outsmart Lance on various occasions, I'm a stubborn Dutchman after all, but it's not working. So the biggest accolade anyone can give someone in this world you just achieved: you convinced a Dutchman. Regards,
Jan, 12th August 2011
I've been a subscriber of Trident Confidential for over two years now and I consider it the best investment I have ever made. Not just for the sound investment recommendations and for the insight you have into the investment world and world economics but more so for the truly considerate and compassionate person you are.
The Flash alerts over the past week of market turbulence have shown what a truly understanding and compassionate person you are towards your subscribers. In a moment when we all could have panicked, you have been stable and steadfast and an anchor for all of us to hang on to.
I commend you for your effort in the past week to help us keep our fears at bay and remain soundly focused on the long-term investment prospects. I have been buying bargains this week but probably would never have had without your Flash Alerts. I know for me the past week has been a week of great growth as far as the investment world goes and starting to understand the bipolar nature of the beast. We can benefit financially from this bipolar nature by keeping our head when all those around us are losing theirs.
A recent quote I found says it all "To be a true investor, then you must think about a business and its long term prospects, not short term prospects for its price or things that may influence it." - Value-able by Roger Montgomery, an excellent book on investing in companies. Once again, thanks Lance. Cheers,
Howard, 12 August 2011
Dear Lance & team,
I just wanted to thank you for your daily flash alerts over the last week. I am a young(ish) investor and still fairly new to investing in the stockmarket and that is the first time I have been through a drop like that. Your alerts were reassuring and made me feel like I wasn’t in it alone. That much writing and research was obviously a massive investment of your time in what was surely a stressful period for you too and I just wanted you to know how much I appreciated it! Your ability to cut through all the crap is actually quite amazing. I feel very lucky to be a subscriber to Trident. Many, many thanks,
Megan, 10 August 2011
Dear Lance,
I have been a member of Trident Confidential Newsletter since its inception and I have to say it is one of the most outstanding performing newsletters around, I have tried a number of so called investment letters and have to say they are a league unto themselves, what I am trying to say is they are out of your league.
Thanks for your efforts much appreciated, and now like the GFC it is a great buying opportunity especially with the prices of shares well below current evaluations. I have learnt to keep composure, keep calm and go against the herd, I AM BUYING! Keep well and I look forward every week to your TC newsletter.
John, 8 August 2011