Summary: Many observers believe the US is no longer the exceptional country it was at the end of WWII. But the US market and GDP have risen more strongly than elsewhere. The prevailing view on the oil price is that it will remain low for a prolonged period, but I’m still looking for oil to rise between now and the end of the year. In Europe, a recession was looking possible at the start of the year, but the outlook has now improved. In Japan, last year’s tax increase was a blow to consumers but the falling oil price and declining yen are good news for the nation.
Key take-out: The economies of the major developed countries are recoupling with the US, not decoupling. Many portfolio managers agree that these four myths may indeed by myths, but they are fragile and I will watch them closely.
Key beneficiaries: General investors. Category: Investment strategy.
In talking with investors, I find four concepts prevail among the consensus that I believe may be wrong. In the interest of full disclosure, it is fair to say that at various points in time I have subscribed to each of these ideas. They are:
1. American Exceptionalism is a thing of the past.
2. The price of oil is likely to stay low for a long time.
3. Europe’s economy is in a slow growth deflationary trap.
4. Abenomics is not working, and Japan is in danger of falling back into a recession.
I decided to explore each of these to see whether the ideas are sound, or more in the realm of myths that have somehow gained credibility among investors, without significant factual support.
1. Economic Exceptionalism
There are many observers who believe that, from an economic viewpoint, the United States is no longer the exceptional country it was at the end of World War II. There are some good reasons for this belief. In 1947 America accounted for half of the world’s GDP; that percentage has declined to 24 per cent now, but the global GDP is much larger. Europe and Asia, which were devastated after the war, have fully recovered. China has risen to become the second largest economy in the world from being virtually pre-industrial in the 1940s. There is a widespread belief that the mobility of Americans has declined: children born to those in the bottom two quintiles of income are likely to remain there, and the same is true for the top two quintiles.
Even though America boasts many of the best universities in the world, our public school system has produced disappointing results. The United States spends more per pupil than only three other countries (Norway, Switzerland and Luxembourg), according to an OECD study of 34 systems, yet it is in the middle of the pack in reading and in the bottom half in science and mathematics. There are many other measures that would support the view that America is no longer the “exceptional” country it once was, but I thought I would explore whether there were some offsetting positives that might result in a different conclusion.
Looking at the performance of the US equity market, you would certainly think that American companies have a competitive advantage. Since the spring of 2009, the US market has risen over 200 per cent, compared to 108 per cent for the Eurozone, 118 per cent for Japan and 111 per cent for the emerging markets, according to a Goldman Sachs study. The dollar has outperformed every major currency except the Swiss franc.
The Goldman study points out that US GDP is 12.9 per cent above its 2009 trough versus 3.8 per cent for the Eurozone and 8.9 per cent for Japan. Our GDP is 8.1 per cent above its pre-crisis peak, while Europe and Japan are still below theirs. Although emerging markets were growing much faster than the US, this differential peaked at 6.5 per cent in 2007 and has been shrinking ever since, and is now projected to be only 1.2 per cent in 2015. Since 2007, per capita GDP has risen 14 per cent for the US and 185 per cent for China, but the dollar gap with the Eurozone, Japan and the BRICs has actually increased. Both residential construction and exports in the US have outperformed those sectors in Europe and Japan, according to the Goldman study. American economic improvement has been achieved in spite of a reduction in government spending as a percentage of GDP. Unemployment has declined significantly. Energy has been an important stimulus.
Proven oil and gas reserves have increased 55 per cent and 35 per cent respectively, with the US accounting for 80 per cent of the total world increase in energy production. Significantly, the International Energy Agency projects that the US will be the largest oil producer by 2020.
As we have all learned over time, sometimes painfully, an exceptional economy, just as an exceptional stock, does not always mean exceptional investment performance. Markets and stocks become overvalued, and many think the strong performance of the US market over the past several years means that the indexes will have lacklustre performance or even suffer a decline. The bull market has lasted 72 months; the average since 1950 has been 57 months. Investor sentiment is very optimistic, which is usually a danger sign. Interest rates are likely to trend higher, usually a market negative. Finally, earnings are important drivers of stock performance, and overall S&P 500 and company earnings estimates are being marked down. Many companies are guiding analysts to lower their estimates even further. In spite of this, I believe 2015 will be a favourable year for US equities, primarily because market valuation, in my view, is not excessive.
Taking a look at past periods when the price of oil has had sharp declines shows a consistent pattern of rapid, not slow, recoveries. Thanks to the work of Evercore ISI, it is clear that over the last thirty years every major drop in the price of Brent has resulted in V-shaped bottoms, including the recession-related selloffs of 2002 and 2009. The bottom takes several months to form. The prevailing view now is that the price of oil will remain low for a prolonged period because of slow world-wide economic growth and increased production. Since the price of oil peaked, the rig count has declined from 1900 to 1300 units. A low rig count usually means that future production will fall off as existing wells mature.
The argument against history repeating itself is that production from shale has changed the outlook. Shale oil was unimportant in earlier cycles, but it is a major factor now and, as the price of oil moves up, more shale oil will come into the market, limiting the rise. Whereas the lifting cost for shale oil was estimated to be $US80 three years ago, technological improvements have brought this down to a $US50 to $US60 range now. Global (non-US) oil production (OPEC and non-OPEC) has been essentially flat since 2004. At present OPEC is producing above its quota, so there must have been some reduction in output from non-OPEC countries. The swing factor has been US shale production, which has risen sharply since 2010. Looking at a survey of the breakeven lifting costs for the major shale formations cited in a recent J.P. Morgan report, most are above $US50 (20 out of 26), which is higher than the current market price of West Texas Intermediate oil. As a result, shale production is likely to remain modest until prices rise. A West Texas Intermediate price of $US60 would be quite favourable for the shale producers, but that would represent a sharp recovery from the low in the $US40s. A recovery to $US70 would also go a long way to dispel deflation fears. Another factor which could keep oil prices from rising is the lifting of sanctions on Iran as a result of the nuclear weapons agreement. This could cause an increase in oil imports from that country. Also arguing against the near-term rise in oil price is the sharp rise in the long positions of speculative commodity funds. The last time this happened was when oil was $US107. Nonetheless, I’m still looking for oil to rise between now and year-end.
In Europe, the Purchasing Managers Index for both manufacturing and services is currently signalling economic expansion. With the European Central Bank beginning a program of monetary easing, growth should pick up even further. At the beginning of the year it looked like problems in Greece and Russia would push Europe into a recession and the continent would experience deflation as well. I was sceptical that monetary easing by the European Central Bank would change this course. Now, three months later, the outlook has improved. The combination of lower oil prices and a decline in the euro has helped the consumer and increased exports. In Germany, the most important European economy, the Industrial Production Index now is in growth territory. Consensus estimates of real GDP increases for the continent are in excess of 1 per cent, according to Strategas Research Partners. Unemployment is down to 11.2 per cent and German retail sales in January were up 2.9 per cent month to month. Consumer confidence is rising almost everywhere. Even Spain and France are looking better.
Two developments have taken place over the past month that have improved the European outlook. The first is that a ceasefire has been declared in Ukraine which looks reasonably firm. That is because Russia has, in effect, taken over the eastern territory the separatists have gained in battle. The second is that a Greek default or defection from the European Union is more clearly not going to be the catastrophe it was thought to be in 2010. That is because much of the Greek debt that was on the books of Greek and European banks has been transferred to institutions like the European Central Bank, reducing the risk that Europe’s banks would be in serious trouble if these loans were not repaid. Much of this good news has been reflected in the performance of the European equity markets, but the rise in the dollar has diminished the impact for US investors.
The increase last year in the value added tax in Japan dealt consumers a powerful blow, but the drop in the price of oil was the equivalent of 2.1 per cent of GDP, and this was, according to a study by Observatory Group, bigger than the impact of the tax increase. The decline in the yen versus the dollar has given a boost to Japanese exports. Wage growth should result in modest inflation (1 per cent) and encourage Japanese consumers to start spending their $10 trillion cash hoard instead of parking it in bank deposits. This will take the pressure off the Bank of Japan to provide additional monetary easing. In addition, Japanese corporate profits were strong in 2014 and look even better for this year. Finally, the second increase in the value added tax planned for this year will be postponed.
The Japanese Financial Services Agency has put an improved governance plan into place, according to Observatory Group. This plan should reduce cross-shareholding and cash hoarding. At annual meetings this year, CEOs will have to demonstrate how they are complying with the new code or explain why they are not. The outlook for the Japanese economy and its stock market is favourable.
According to 13D Research, Japanese return on equity has risen to 8.3 per cent, up from 5.7 per cent two years ago. The number of bankruptcies of small and medium-sized companies is at a 24-year low. More than 80 per cent of college graduates have unofficial job offers. Last year saw the largest wage increases in the past 15 years. Share buybacks in 2014 were at a record and they are continuing. Japanese equities have also responded to the improved economic conditions and the rise in the dollar has had less of an impact than it has had in Europe. Judging from data from fund flows, investors have not embraced Japanese equities with the same enthusiasm that they have shown toward Europe.
The positive view of Europe and Japan indicates the economies of the major developed countries are recoupling with the United States rather than decoupling, which was the view at the beginning of the year. In my talks with portfolio managers during the past month, many agreed that the Four Myths might, in fact, be “myths” and the last three of them were “actionable.” One pointed out, however, that they were “fragile” and that I should watch them closely because events could transform one or two of them from a myth to reality very quickly later in the year. I will.
Wien is vice chairman of Blackstone Advisory Partners LP, where he acts as a senior adviser to both Blackstone and its clients in analysing economic, social and political trends. This is an edited version of his latest report.