Owning Responsibility for the Future
November 11, 2020
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Title: MFS Market Insights Webcast- Q1 2020
Abstract: Jon Hubbard sits down with MFS' Global Market Strategist Rob Almeida and Chief Economist Erik Weisman to discuss the global macro and market environment
John Hubbard: Hi, I'm John Hubbard from MFS Investment Management. Thank you for joining us today for the first quarter 2020 Market Insights webcast. I was fortunate enough to sit down with Global Investment Strategist, Rob Almeida and Chief Economist, Erik Weisman to discuss the global macro environment, as well as market prices. We hope you enjoy what follows.
So as we close out 2019 and look forward to 2020, we're not only closing out the year, but we're actually moving into a whole new decade and it's been an unprecedented decade if we look backwards since 2010 through today. And we've seen an incredible amount of growth in asset prices, particularly if you think about some of the risk assets, you think about equities, high yield, you think about real estate. We've also seen unprecedented action by central banks both in the U.S. and outside the U.S., as well as the rise of a lot of geopolitical tensions around trade. We've seen an increase in populism. We've seen some of the superpowers clashing here just around different trade routes. So I'd like to ask you Rob, how have you seen this cycle unfold from your eyes?
Rob Almeida: As you know John, the way we think about risky assets is pretty simple. Fundamentals drive cash flows. Cash flows drive asset prices. This year, as you remarked, it's been remarkable from an asset price standpoint, but what's been different this year relative to last year was not just the velocity of return, the nominal amount of your absolute return, but also the manner in which it came. It didn't come from cash flow or earnings growth. It came from multiple expansion which makes this year not atypical of late cycle, but certainly different than 2018 as you referenced.
John Hubbard: Right, but as we've looked at this cycle and the beginning and middle parts of it, there has been some pretty good earnings growth and cash flow growth, correct?
Rob Almeida: Sure. This year though was a donut.
John Hubbard: So we've actually seen the last several quarters earnings start to recede and we've started to see some pressure on corporate margins. What are you seeing? Is that a dynamic that is just a fleeting dynamic or is that something you think is going to take hold into 2020?
Rob Almeida: Oh I think it's a little bit of both. So you're going to see earnings growth re-accelerate next year because that's expectations is somewhere along the lines of eight, nine, 10, 11%. And that's been drifting lower in the last couple months and that's evident in asset prices. That's why they've done so well. Expectations are for materially higher sales growth and materially higher earnings growth and margined durability. I don't disagree with the direction. I think what we have concerns about or issues with is both the magnitude and the level. I'm not quite sure we're going to see eight, nine, 10% earnings. That's a big number. That's a really big number. Not only is that above average, but that's wildly above average relative to the last two or three years.
John Hubbard: Sure.
Rob Almeida: So where's that going to come from particularly against a backdrop that I'm sure Erik's going to talk about of wage strength and a 50 plus year low in unemployment. Never mind let's throw in potential commodity price pressure or pressure from tariffs that you mentioned earlier. I think it's going to be something less than that and what I am wondering is next year what will be the reaction function by investors if they don't get that high single digit return? I think it might be disappointing.
John Hubbard: Because a lot of those expectations are already built into the current asset prices.
Rob Almeida: Yes. Exactly.
John Hubbard: Erik, I'd like to ask the same question of you. How have you seen this cycle unfold from a macroeconomic standpoint? Has it been similar to other cycles or has it been quite different?
Erik Weisman: Quantitative easing, negative rates. Just like the rest of the cycles right? That's what monetary policy makers are supposed to do.
So we continue to move down this path where we have monetary policy makers who will find pretty much any lever that they can pull to keep the cycle going, to keep the system going and we don't have enough people asking questions. Is this what monetary policy makers are supposed to do? I think very clearly the answer is no and they think very clearly the answer is yes. So that's what's, I think, most different about this cycle. And we seemingly are getting to the point here where monetary policy makers are running out of room. We have seen most recently where the Swedish Riksbank has decided that negative rates perhaps isn't the best thing to do and they've reversed that. I would imagine other central banks would love to do the same, but perhaps are boxed into a corner. And to me that's the lens through which I look through to see this business cycle. Where are you getting kind of a way to juice the cycle? And, from a macro policy mix, it's from those monetary policy makers.
John Hubbard: And at some point when they run of levers to pull, are the central banks going to be looking to policy makers to have fiscal pick up the baton?
Erik Weisman: Well first I think they're going to continue to do what they've been doing. So there'll be more QE and they'll buy more assets and they'll buy kind of a broader panoply of assets and they'll own more and more stuff that they shouldn't own and certainly we seem to spend a good deal of the 20th century trying to combat communism and the government owning the means of production and now we have monetary policy makers in the western world that own private assets. So we seemingly are going backwards in that sense. But yeah, we'll go to fiscal levers as well. We've already despoiled those balance sheets, but why don't we try and despoil them again and make them worse? And it is interesting that yes, interest rates are lower, you probably can manage to service more debt in that sort of world. But even just a few years ago everyone would have agreed there's too much public debt on the balance sheet. But now that monetary policy makers have run out of room, well, I guess there's plenty of room so we'll do more fiscal.[CJ(1] [M2]
John Hubbard: Right. Rob, as we think about where rates are today and how long they've been this low, it's obviously been a terrific boon for owners of things like real estate and owners of equities, but we've started to see corporations continue to increase the size of their balance sheets with this cheap money. What are the long term effects of that?
Rob Almeida: I think Erik put it aptly. But from a corporate standpoint it's balance sheet financialization. That's what's been happening the last four or five years. And I think for central banks, what was supposed to happen is okay, well if you're going to inflate financial assets that's going to create a feedback loop and increase confidence in the consumer that ultimately will create real demand in the economy. And I'm not an economist, Erik is, but I don't think we've seen that. You're not seeing that in inflation. You're not seeing that in money velocity. You're not seeing that in GDP or other types of proxies for that. So, the benefits of financial market inflation have accrued to the top 1%ers or the top decile of society. So it's exacerbating this wealth effect.
And look, I don't know how this ends and what the long term result is, but I think what the byproduct is, companies aren't putting resources to real economically producing activities. They're putting it towards financialization. Dividends buybacks, share count reduction, et cetera.
John Hubbard: Right. And I know you've talked about the misalignment of some the incentives and how these companies are governed and what type of oversight there is, and it raises the question around capitalism. And Erik, it's a really big question, but has capitalism been working?
Erik Weisman: Again it's a matter of definition. I mean some would make the argument from an international point of view. We have fewer people as a percent of global population that are in poverty than we've ever had. So that seems like it's a bit of a success. We have people who are living better lives along a whole bunch of different metrics. But when you think about it in an individual country, there does seem to be far more inequality. And you look at a system that is producing a lot of financial wealth and that wealth is essentially going to the upper cohorts. So the rest feel like they're left out and in that sense it's a system that doesn't seem to be servicing the vast majority of the population.
John Hubbard: And Rob, how have you seen this play out when we think about incentives, we think about governance, at the corporate level? Are there misalignments that you see getting worse or some that are getting better?
Rob Almeida: Well it's funny, we have a chicken and egg scenario. For the last, I don't know, 10 years here at MFS and I think other asset managers as well, collectively as an industry we've been talking about the problem of investor short-termism. And you've seen that since the democratization of investing. Really the growth of mutual funds beginning in the '70s. So as the concentration of security selection went from individuals to, let's call it financial advisors ... And I mean that in the aggregate sense, anyone who manages risk on behalf of someone else. 90% of the wealth today is controlled by some sort of analyst, portfolio manager, financial advisor, et cetera. So we've been talking about the misaligned incentive investors paid on short term performance, et cetera, et cetera. But I think that's created a vicious cycle where we've trained CEOs, CFOs defacto to do everything they can to produce the best possible free cash flow margin, free cash flow conversion rate, whatever proxy is material to that industry.
So the feedback loop here is as investors have become more short term oriented, they'll pay, they'll resource capital to those with the highest margin. And so I think the last few years what you've seen is quantitative easing, negative rates, the shift in pushing out of investors out of the risk ... Excuse me, not out of, but further down the risk continuum into bond proxies has sent a signal to CEOs, we want you to return capital. And so it's not going into productive assets, where perhaps it should.
John Hubbard: Right. And how do you get it into productive assets?
Rob Almeida: Well that's where I think you need alignment. You need alignment between investor, and company, and ultimately end client. So everyone thinking what's the best path for long term value accretiaton. And I'm not suggesting that companies shouldn't pay dividends, shouldn't buy back stock, but it's just an appropriate balance and resource allocation. You shouldn't throw away capital into unproductive projects.
Erik Weisman: And you can imagine a scenario down the road where people say, is it really within the best interest of society to say that it is a CEO's fiduciary responsibility to maximize the value for shareholders without thinking about externalities and the rest of it? And it's a great question. The problem is what would you replace it with? If we're going to start talking about things that are more ESG driven, and we should, now you're opening up a door to all sorts of subjective measures. Whereas, at least this measure is an easy one. We could make the argument that it's too short term in nature, but the goal of maximizing shareholder wealth is pretty easy to understand. Imagine if instead you were saying we want to maximize welfare. Global welfare, domestic welfare. I mean there are more ways that you can measure that than you could possibly think of. And now it will be quite challenging to think about, again, how do you profit maximize in that sort of world.
So making a transition to something that perhaps is better off for society as a whole is fraught with great difficultly.
Erik Weisman: That sort of gets to another broader point and one that Rob and I have sort of tried to discuss before and that is how do you map the macro into the markets? And there's a great frustration I think during this cycle mapping macro, which has been quite weak, into markets which have been quite strong. And I constantly find myself asking a question, should we be at all-time highs when global growth is weak and trending lower and markets are being valued in nominal terms? So not only is real growth lower and heading lower, and there are secular reasons for that, but nominal growth is lower. So you have real growth that's lower, you have inflation that's lower, you're valuing markets in nominal terms and every time you turn around we're at all-time highs in US market valuation and increasingly we're seeing other markets around the world that are breaking out somewhat as well. How do you make those two ideas consistent? Weaker and weaker macro. Your generation of nominal output. It should be the case that markets overall are trying to value the capital stock and the labor stock in terms of human capital, and the ability to put the two together, which is that total factor, productivity, and a forward look on that.
The forward look on productivity, kind of weak. The forward look on the number of people that we're going to put to work, weak. The forward look on real GDP, seemingly is somewhat weak. And again, every time you turn around we're at all-time highs. So there is this cognitive dissonance I think that's really difficult to square right now.
John Hubbard: Right. I know Erik, in the past you've talked a lot about just to summarize some of those thoughts about debt disruption and demography all being global headwinds. Now, there's another global headwind here that we've been facing, most acutely in the past few years, which is this whole idea of globalization in reverse.
So what started out as sort of campaign rhetoric back in 2016 accelerated throughout 2017, became real 2018. And it seems like we were stuck for a while there in terms of the US and many other of the major trading partners' discussions around global trade. So all of a sudden in December we've had a partial phase one US-China deal, we've had looks like the likely passage of the USMCA, which is the rewrite of NAFTA between the US, Canada, and Mexico. So are these breakthroughs going to continue do you think? Or is this whole idea of globalization in reverse just something that investors are going to have to live with?[CJ(3]
Erik Weisman: I think it's the latter. I think we're definitely heading in that direction. If you give me a five or a 10 year window and you ask the question, do you think the US and China are going to be more linked or less linked in terms of trade? I think the answer's no. I think we're already seeing firewalls that are being put up in all sorts of countries around the world, not just China. I think the ability to trade information will probably increase amongst those who want to do so, like the US and Europe and Japan, and will decrease amongst those who don't want to do so. And I could list a whole bunch of countries, but I won't. And I think as you look at these various metrics, what is globalization? The WTO right now basically doesn't function at all so we have no adjudication body to deal with differences along global trade and now it's going to have to be done on a bilateral basis as opposed to a multilateral basis. We haven't finished a global round of the WTO in decades.
So yes, there may be more information flow, but it's more contained. There's more capital flow, but not globally. It's between various countries that still want to play that game. I think we're seeing metrics around labor flows outside of refugee migration that are hitting certain hurdles. There's all sorts of metrics right now that would make the argument that the globalization that we are used to will be different in its manifestation going forward and probably will not be as accretive to valuations in equities as it has been in the past. Doesn't mean it's the end of the world. It just means that it's going from a very significant tailwind to a slow but building headwind.
Rob Almeida: Well, and I think we talked about this in the last webcast. Maybe it was the webcast prior. But globalization in reverse and what does that mean. So ultimately the market values a company based on its steady state value. If you liquidate property, plant, equipment, et cetera. Plus their future IP. So their future cash flow is discounted back. But the extent that you have companies earning X percent margin because they benefit from a lower COG than their competitor, well maybe it's really not a better product, a better business, but they've got a better global supply chain. So in a scenario like Erik's laying out here, investors need to get back to focusing on it's a stock market. Do their homework and is this sustainable? And it may not be because you don't have a better widget, you just have a better mousetrap in how you construct the widget, and if that goes away, you're not going to be able to pass those price pressures along through and that's going to be a bad stock.[CJ(4]
John Hubbard: Right. And what can companies do if they can't pass them along? Do they just have to let their margins erode? Do they have to go out and expand into new territories? What are their options?[CJ(5]
Rob Almeida: Well I think you've been seeing that and that's why this quantitative easing ... The design of QE was to get capital into the hands of producers to generate economically producing activities. Instead, it went to, not just buybacks, but M&As. So just like you described. So if I don't have a good enough widget, I'm going to go buy that widget.
John Hubbard: And capital's cheap so it's easier to do that.
Erik Weisman: And this feeds into two ideas that we've talked about over the last few years and that is the rise of zombie companies. So when you have interest rates that are this low-
John Hubbard: And zombie company is a company that's just sort of sustaining off of the bond market. It's not really producing enough to self fund.
Erik Weisman: That's right. So it basically can't cover the cost even of its own interest cost let alone anything else. And we have measures that are showing us that the percent of companies that fall into that bucket are increasingly rising. Now they're not the big companies that we think about. These are small and medium sized companies that do their business oriented more towards domestic activity. But nonetheless, that shouldn't exist at all and Joseph Schumpeter of creative destruction would be spinning in his grave because what you're supposed to do is if you have a company that can't cover its own interest costs, let alone anything else, you're supposed to release that capital and release its labor so that it can go to more productive uses. So that's one aspect. And the other is the winner take all. So you have this increasing divergence with companies that are at the forefront, they're at the envelope, they're doing the right things. They're the ones that don't go away when you see that the emperor has no clothes. And then you have these companies that really should die, and they don't die.
And both of those things actually can result in lower inflation, lower growth, greater stasis, more calcification and it just kind of creates this vicious circle. All of which I think comes about as a result of monetary policy makers that have given us lower and lower and lower hurdle rates for companies to put really bad ideas to work and to continue to survive.
Rob Almeida: Yeah. And that's the beautiful irony. So you're printing capital, printing money to create velocity, to create inflation, and what it's doing, it's creating zombie companies that are producing widgets that we don't need. So that excess supply offsets a fixed demand and so there you go. One to whatever inflation is today.
John Hubbard: And what impact does that have on productivity and innovation?
Erik Weisman: So along with this idea of zombie companies. So you have capital labor that aren't doing anything. That's low productivity. Then you have the winners. What are the winners doing? Well the winners are doing things that are quite productive, but they're also sitting on an enormous amount of cash. So when we talk about inequality, we usually talk about inequality between people or households. And as a result of the top quintile, the top cohorts having so much wealth, they are amassing a great deal of savings and that savings doesn't do anything. Right? You'd like those who have higher marginal propensities to consume to go out and spend that money. But the higher cohort doesn't need to so high levels of savings, that savings isn't doing anything, zombie companies have capital and labor that's not doing anything, and then the winners, these large corporations that keep winning in their field, they have enormous amounts of cash that they're not doing anything with.
So we're creating this world where you have these three distinct pockets. Households in the upper cohort saving a lot of money, not getting into the system. Corporations that are winning, saving a lot of money, not getting into the system. And zombie companies that should release capital and labor that are not being productive. And again, this has all sort of been created by the monster of the macro mix that we have created here. Much of which is predicated on very low interest rates.
John Hubbard: And when and how does that all end? I know it's an impossible question to answer, but it seems like the central banks, through their practices, have really been underwriting this idea of investors getting riskier and riskier with their portfolios. And they seem very concerned around stability. And just to pull a quote from Hyman Minsky that stability breeds instability. So at what point do all of these dynamics start, which now seem to go in a very stable place from an economic standpoint, if not high growth but at least stable. At what point does that all end?
Erik Weisman: I think we'll continue down this path. Again, I think policy makers are very uncomfortable changing course entirely and you would have to do just that I think to see all this stuff reverse. And there's a great fear that if you wind up putting forward policy that you're not comfortable with, that we have no experience with, that you're going to wind up creating other problems that are worse than the ones that we're trying to deal with right now. So I fully expect when we go into the next recession, monetary policy makers are going to do more of what they did last time around. It will be less effective. Fiscal policy makers will get back in the mix and will probably make a mess of it and we'll have a whole new set of problems or the same problems that are deeper, and trying to untangle. But in terms of how do we get into a more rational place? How do we live in a world where rational macro policy, in a world where demography continues to decline and productivity may be in a weaker state? I have no idea.
Rob Almeida: Yeah. And along those lines, just look back at the last three episodes. So what was the catalyst for the global financial crisis? It's hard to pinpoint, but I just remember the summer, July of '07, when the first CDOs and CLOs started to crack and default and that sent a signal to the levered asset owners that were high on margin that okay, well housing prices do go down, or Americans do default on their debt and then that cascaded into the GFC. And in the late '90s, pets.com at 300 times earnings. I'm making that up. I don't remember exactly what it was, but it was something outrageous. It's an internet concept that is not going to work. And that manifested itself.
Today you have bond investors buying assets for capital appreciation. You have equity investors buying assets for income. That's a symptom to me that things are imbalanced.
John Hubbard: Yeah. Sure, I'm mean currently the dividend yield on the S&P 500 is about the same as on the 10 year treasury right?
Rob Almeida: Yeah.
John Hubbard: So that says something.
Rob Almeida: Yeah.
John Hubbard: And Rob, as we think about some of these companies that are continuing to maintain high degrees of leverage, how on a going forward basis if interest rates start to climb, are they going to be able to unwind and de-lever?
Rob Almeida: Yeah, I think that's a risk. Although, that's on the lower end because they termed it out. Most of them have really termed it out. Most of them have really termed out.
John Hubbard: So they push it out to the longer maturity dates?
Rob Almeida: Exactly. I think the bigger risk though is the E. So what we tend to look at is debt to EBIDA, or debt to EV, or debt to profits, or debt to some sort of income, which is how you're supposed to look at it. When you take a mortgage from a bank, they're going to look at your income and your income for the last three years. So it's debt to income. So today leverage looks high. It is high. That's based on income of yesterday. What I'm worried about is, well, we take out those zombie companies, or you take out those companies that really don't have truly something unique, distinguishable in the income or the profit starts to erode or deteriorate. What will be the reaction function by Moody's, S&P, the credit rating agencies? And so then as downgrades start to happen what will be the reaction function by passives that can't own a below investment grade issuer, or an insurance company, or any portfolio? And so then that that's when it starts. When you shut down the financing mechanism for companies that are dependent on it. And that's what happened in the energy space this year. That's a microcosm of a real unwind.
John Hubbard: Yeah. Erik, any closing thoughts for us today? I mentioned before negative rates and was kind of looking at the landscape of negative yielding sovereign bonds the other day and comparing that to five and 10 years ago where obviously there was none. And I do think that one of the big questions that we have to answer on the bond side is are negative rates here to stay or is this just sort of a one off where central banks got ahead of themselves? They didn't need to go into negative territory. The ECB, the Bank of Japan, the Swiss, the Danes, and the Swedes. And it's seen as just a mistake and they unwind it. So to the extent that we wind up seeing all negative yielding bonds go back into positive territory in 2020 or 2021 then there are an awful lot of losses that would need to be taken. And that would be a world that would probably be challenged on the equity side as well in that you just have higher interest costs in general.
On the other hand, if negative interest rates are here to stay, then the question is well, who falls into that camp next? Is it New Zealand? Is it Australia? Is it eventually the United States? And again, how do you think about a world where the discount rate is negative? And to go yet one step further, and we're talking about this idea of capitalism, if you're living in a world where you're punished when you save and you're rewarded if you take on debt, then I would say one of the founding pillars of capitalism is no longer in existence. And it calls into question, I think, the entire enterprise.
John Hubbard: Right.
The views expressed are those of [the speaker] and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.