Is Disruption Ahead??
This article was written on the 25th of September 2019. The Australian All Ordinaries index is at 6814 and the US S&P500 is at 2984. Australia has cut interest rates twice in the last couple of months, as has the US. “Three cuts and a tumble”- it will be interesting to see what both central banks do in October.
Whilst I am no investing professional, I like to dabble on the side. I also think it is very healthy for a CEO or business owner to be following macro trends broadly, so they can help guide decision making internally.
I must admit, however, I am a bit of a contrarian in my thinking, and most comfortable doing the opposite of what the general consensus is saying. There is however a timing issue. There are two sayings that whilst opposing, I feel are often right at exactly the same time;
“Being early is indistinguishable from being wrong”- James Montier
“It is better to be three hours too soon, than a minute too late”- William Shakespeare.
To be ultimately right, somehow you need to navigate between these two realities.
Most things look pretty good at the moment. We’ve had a few dips here and there, but it is certainly no 2008/09. But is it 2007? Or even 2000, 1990, 1980? Those that follow the markets will know these were very strong years just preceding recessions and stock market dips. Whilst history never exactly repeats itself, it does seem to rhyme. So, is there a familiar tune in the air?
The below article is a summary of charts and data that I find interesting, and that seems to be telling a bit of a story that I think is relevant to business owners and executives. This is not financial advice and should be taken in the spirit it is intended- just to get you thinking.
Firstly, I follow four core sources for macro-economic data, of which the below is mostly made up of:
- Hedgeye risk management: https://hedgeye.com/
- Real vision: https://www.realvision.com/
- Macro voices: https://www.macrovoices.com/
- Twitter: A range of individuals and advisory firms with unique points of view. I have put a list of who I think is top of the class thus far, although I am always adding.
Predicting the Future: A Mug’s Game
You can’t predict the future, but you can prepare for it. Sometimes different data sets start “singing from the same hymn sheet”, but that doesn’t mean anything is guaranteed.
Here are some interesting examples from professional economists and market professionals:
- Wall St Journal Survey from January 2019, before there was a massive selloff of global bond yields that interviewed a range of professional economists;
“Not a single respondent in January 2019 Wall Street Journal Survey of economists predicted the yield on the 10-year Treasury note would fall below 2.5% this year”
- The chart below tracks the forecasts from the European Central Bank, constantly forecasting that core HICP Inflation would suddenly grow in response to their policies;
If people that dedicate their professional lives to this space can’t get it right, what chance do we have? But we can start looking at things in terms of probabilities rather than absolutes. “What is the probability of X happening based on the data”.
The content and data sources I mention above are great in that they don’t really try and predict the future most of the time, just provide you with data and information to help you prepare today for what tomorrow might bring. They help you assess the probability of something occurring, so you can make a good risk management decision.
Relevance to managing your organisation
Like I said above, you can’t predict the future … but you can plan for it. From an organisational perspective, what does this really mean?
We believe investors, business owners and executives can use data to motivate themselves and their organisations that can rapidly respond to whatever may occur. This is summarised by “creating an organisational culture and climate, that can proactively and constructively react to the problems and opportunities created from rapid change.”
Create an environment where, irrelevant of what the future holds, you are able to flow with the times, good or bad.
Late Cycle Employment Data
Low unemployment is often seen as something very good for an economy. But as you approach full employment, it becomes harder and harder to find qualified people. In recent CEO groups I have been a part of, a growing complaint is not being able to find people.
Provided by Hedgeye, here is an interesting index that is tracking small businesses getting few or no qualified applications for job openings. As you would expect, it drops before / during recession and then starts creeping back up as the cycle develops. Given this is one of the longer economic expansion cycles, it is understandably at all-time highs, but how long can it go for?
Tightening labour can lead to higher wages and lower corporate profits
The following chart from Hedgeye shows periods of recession, hourly earnings, and non-farm payroll year on year growth rates. When unemployment drops, wages start to rise which starts eating into profits. Full recessions start with earnings recessions. You may have heard General Motors GM workers are on strike wanting more money. The last time they did that was 2007 … https://time.com/5680563/gm-strike-protests/
Peaks All Around
The following data sets say a similar thing to the above. Jobless claims have fallen to all-time lows, whilst consumer confidence may have peaked (if it keeps falling below the T3Y mean and stays there for a period of time).
Something to watch in the future, as there seems to be a reasonable correlation with these turning points and the potential for the onset of recession.
Hedgeye again provides another interesting data set that I had never considered. The data set below on the right-hand side plots the U6 Underemployment rate SA less Unemployment Rate SA spread with the change in average hourly earnings of Production and Nonsupervisory Workers on a Year on Year basis.
It seems to be showing that the year on year rate of change in hourly earnings is increasing, whilst more and more of the long term unemployed are being enticed into employment. Put in a more crass manner, people are being dragged/ enticed off their couch to come to work as wages increase. But when employers can’t drag people off the couch anymore, wages could really jump.
But go back to the chart of payroll growth versus earnings. This jump will eat into corporate profits. Falling corporate profits means cost cutting…(Robots anyone?)
Another chart saying a similar thing, although shows an additional issue of how corporate profits have been ahead of wages over the last fifteen years. Any wonder why people were angry enough with the establishment to elect Trump who promised was going to make them great again!
Unemployment Rate and Official Interest Rates
Provided by FRED Economic Data, this chart confirms the falling unemployment rate, but also includes the Effective Federal Funds Rate.
Raoul Pal introduced me to the idea of “3 cuts and a tumble” which this chart seems to support. Rates rise until there is a short pause, and then they start to cut. Once they have cut twice, they tend to have to keep going. The share market often goes up during the first two cuts (which it has this time – we are at all time highs in the S&P 500), but then tumbles when they no longer believe interest rate cuts will do what was hoped.
So, with 2 cuts already, it will be interesting to see what happens in October 2019.
Maybe all is not well?
Despite the low unemployment rate, there are a few interesting data sets showing some stress may be building with consumers. Below shows a sustained uptake in delinquency rates on consumer loans.
The Inverted Yield Curve
We’ve heard a little bit of chatter about the inverted yield curve. This is where short term interest rates are higher than long term interest rates. There should be a nice “curve” upwards to the right as interest rates increase as the term gets longer. But it “inverts” when the short term rates are higher than long term rates, meaning the bond market is saying problems are around the corner.
Here are some charts to make your own assessment. I must admit, there is a lot of “this time it is different” communication coming out from well known gurus, so it will be interesting to watch.
Australia has had the benefit of China’s demand for what we have for a long time. The world also got the benefit of massive economic stimulus drives in 2009 and 2016. Can they do it again? I have no idea. But it is a big question. Can China come to the rescue and buy us out of trouble?
In the chart from Alhambra Investments below, you can see the results of the stimulus on 2009 and 2016. It is starting to look a bit sick again. Can they pull a rabbit out of a hat?
Industrial production growth is not looking crash hot either, falling to a seventeen-year low. If they could resolve this, wouldn’t they have done so already?
If you believe credit is a driver of an economy, the below is not good either. Again, you can see the 2016 efforts peak and then drift down. Can they do it again?
This seems to correlate with the FIRB (Australia’s Foreign Investment Review Board) data showing a significant drop off in real estate applications from China from the 2016 peak. There are lots of other things occurring such as China stopping citizens from taking money out of the country, shortage of USD, trade war etc.
I don’t fully understand it, but more and more of what I read is talking about a USD shortage causing issues in the Chinese economy. They need USD to fund lots of their stimulus and development, and reserves have been falling.
To me it seems the conditions of 2009 and 2016 no longer exist for China to do what they have done in the past. It is above my paygrade, but something I am keen to learn more about.
Is It All Priced In?
The above might all be true in terms of indicating troubles ahead, but maybe it is all priced in by the market?
So, we are at record highs by a range of measures, and since 2016 we have had the following major items:
- Chinese stimulus of 2016
- US tax reform
- Continued growth of share buybacks
The below picture indicates that the final part of this late stage rally has actually been in the face of flattening corporate profits. How long will this be acceptable especially if Q3 and Q4 really start to slow?
Tax Reform and Share Buybacks
In 2017 the US passed the Tax Cuts and Jobs Act which significantly changed the US tax law. The Act drastically reduced corporate and personal income taxes. The corporate tax rate was slashed from 35% to 21%, dramatically increasing corporate profits. There is also an ability to repatriate profits held abroad at lower rates. This has provided a significant boost.
Where has the money gone? A range of places, but one area of interest is corporate share buybacks. Previously used as something for savvy CEOs to buyback undervalued stock, it seems to have come a nice way for executives to meet earnings per share targets.
The following chart shows the ramp up in buybacks since 2009, and their previous cycle peak in 2007.
For the purpose of a quick analysis, let’s look at Apple Inc (https://investor.apple.com/investor-relations/default.aspx). Their effective tax rate has dropped from 25.6% down to 18.3%. Their earnings (income) since 2014 is up approximately 50%, but earnings per share is up approximately 117%. How? Share buy backs. In the last four years, USD$210 billion in shares were purchased, with an additional USD$100 billion approved on the 1st of May 2018.
Another interesting point is Apple has nearly USD$9 billion of short-term debt and long-term debt of USD$104 billion at September 2018. It had no debt in 2012, with the first debt entering the balance sheet was in the 2013 annual report.
Panic? Run For The Hills?
The message I am giving to my clients is not that we can predict the future, but we can prepare for it.
All we are talking about is potential change. This potential change will create problems and opportunities you need to manage. To manage them effectively, you and your teams will need to make good decisions quickly and implement them.
So, this is where we believe CEOs and business owners should concentrate. Be aware of what is happening around you, and ensure you are creating a culture and climate that can respond rapidly.
Refer back to the Adizes map. Invest in the ingredients that will create the culture required to rapidly respond to the change loop. Invest in these areas now, so that if major issues do occur, you will have the muscle in place. And if all the above turns out to be a different story? Your organisation will be stronger for it.
Copyright Dr. Ichak Kalderon Adizes, 2019
If you want to just survive, you’ll need to manage the problems and opportunities as fast as they pop up. If you want to be the market leader, you’ll need to be ahead of the change loop and be proactive. Concentrate on this, and the rest will look after itself.
- Twitter following list;
- Alex Gurevich
- Daniel Lacalle
- Dr Pippa Malmgren
- Danielle DiMartino Booth
- Bill Fleckenstein
- Luke Gromen
- Professor Steve Keen