We’re continuing our new experiment this week running a weekly post each Monday to expand upon the quotes that we gather in our weekly digest. The weekly digest is intended to be an unbiased view of what we are hearing from management teams, and our Monday piece will try to interpret those views and hopefully help steer readers towards insights that can have a real impact on investment decisions. This is a pilot project, so please give your feedback! Click here to receive both posts weekly via email.
1) September economic data could be pretty strong
Readers may have noticed that the macro commentary section of our weekly piece has swung increasingly positive since the middle of the summer. In our July 22 digest we highlighted a quote from Halliburton’s CEO, Dave Lesar, that “animal spirits are back in North America.” While Lesar was primarily referring to the energy sector, there have been plenty of quotes in other industries that support the idea that these “animal spirits” are filtering more broadly across the economy.
Last week we highlighted some quotes from consumer facing companies that also continue to say that the consumer is showing strength. Industrial companies have also noted that inventories have been destocked. Both of these are preconditions to inventory restocking, which would eventually filter into the economic data as above trend growth if it does materialize.
Animal spirits have been missing from the US economy since the financial crisis, but now that we are 8 years removed from Lehman’s collapse, the emotional memory of that panic is fading further away from view. While that does not mean that a burst of speculative fervor or heavy consumption is necessarily overdue, the conditions are right for an upside surprise in the economy. The economy has struggled for the last 24 months and this has led growth expectations to decline significantly. A return to more normal consumption habits would be surprisingly strong.
A strong economic surprise doesn’t necessarily have to fuel a large rise in stock prices though. The level of pessimism about the economy and markets is high, yet valuations are still beyond extreme levels. In past historical periods the levels of pessimism that we currently see would likely have been matched by low teens or perhaps even single digit earnings multiples. Because earnings multiples are significantly higher today, a positive surprise in the economy could actually lead to a decline in securities prices if it is met with rising interest rates.
There is also the possibility though that a better than expected economy could lead to a 1928 or 1999-like situation for markets in which the economic cycle crests with an extreme level of speculation in securities markets. We continue to believe and hope (as citizens) that policymakers will not allow this to happen. However, by continuing to prop up markets, it may already be too late to avoid this.
2) The financial services industry is fatally impaired by low interest rates
Nearly all revenue generated by the financial services industry is in some way tied back to the prevailing level of interest rates. We estimate that the industry is broadly structured for a normalized 5% interest rate environment. In other words, the infrastructure that it takes to run the US financial services industry requires a 5% interest rate environment in order to meet the expectations of the labor and capital that has supplied itself to the industry. Below a 5% interest rate, the amount of revenue that is generated by the industry is insufficient to pay the (inflated) salaries that were expected by those who are working in the industry and also insufficient to generate meaningful returns on the capital that has been invested in it. As a result, the longer that interest rates remain below 5% the more that the financial services industry will continue to shrink.
Last week we highlighted a quote from Factset that shows the symptoms of low interest rates on the industry. Factset is seeing an increasing number of hedge funds and small buy side firms go out of business.
” We had a record growth in new client acquisitions…but it was mixed with an increased cancellation rate that was what I would call market related. So, it was clients going out of business, hedge funds going out of business, some of the smaller buy side where they have been shedding employees…We definitely saw an increase in the quarter of the market-related cancellations in that buy side sector.” —FactsetDirector Global Sales Scott Miller (Financial Data)
While many may point to the shift to passive investment as the underlying cause of shrinking active management, we would argue that the move towards passive is in large part created by the low interest rate environment as well. This is because fees become a greater percentage of expected returns when expected returns are low. In a 10% return environment a client can easily bear a 1% fee. However in a 4% return environment that fee becomes a greater and clearer burden. In other words, if client portfolios had been rising in value by 9% per year for the last 15 years (instead of a level well below that) the passive movement would likely not have gained the traction that it has.
3) The Chinese government wants the cruise industry to succeed
We tend to take note any time that an international government has provided specific incentives to a single industry. When any government puts public resources behind the development of anything, it’s usually a good bet that the government will get what it wants. This has been particularly true in China, where infrastructure construction was highly incentivized for more than a decade. During the early 2000s commodity prices boomed as China built roads and skyscrapers.
Now as the Chinese government attempts to shift the economy towards a more “consumption led” economy, investors should expect that consumption focused companies could benefit as much as construction focused companies benefited in the past. To that end, a statement from Carnival Cruise Lines caught our attention last week:
“cruise is in the 5 year plan for China. So that means the government has committed to developing the Cruise industry. The reason for that is pretty self-evident. We’ll employ, overall with port development and infrastructure, and supply chain, and training as well as ship building that will employ millions, and millions, and millions of Chinese. So the government is very interested and they see cruise as an economic engine going forward. So you’ve got the support of the central government and the various provincial municipal governments, so that’s very important.” —Carnival Cruise Lines CEO Arnold Donald (Cruises)
We are personally skeptical that the Chinese government can shift the Chinese economy without generating serious instability, but some industries are bound to benefit. The Cruise industry could conceivably be one of them.