Download the peloton position - Peloton Wealth Strategists

issue 0 3 / n ovember 2 010
p e l o to nwe a l t h . com
THE PELOTON POSITION
forward thinking from peloton wealth strategists
QE - 2 MUCH? /
Alongside the widely anticipated Republican sweep in the mid-term elections, the Federal Reserve
assuaged financial markets with its official unveiling of QE2 — short for Quantitative Easing, Round II. Due to the unsatisfying pace of
the economic recovery and the persistence of an embarrassingly high unemployment rate, policy intervention had become a foregone
conclusion. This round of QE was baked-in months ago, leaving economists only to debate the appropriate size of the package.
Quantitative easing is simply another tool used by central banks when they’ve already fired all of the bullets from their primary policy
guns. The fed funds rate is already zero, so when additional stimulus is deemed appropriate, the Fed purchases long-dated U.S. Treasury
securities – with newly minted dollars – injecting another $600 billion this round and holding down long-term interest rates. At this
point, the numbers are incomprehensible to even industry professionals who are paid to assess the programs’ implications. It is difficult
We certainly do not believe that QE2 is a game-changer in any
simply aren’t viable today. Do they really work anyway? Well yes,
sense. It does not create jobs, nor does it bolster confidence. It is
they do, if they they’re designed well and executed responsibly. We
likely just an incremental effort by the only remaining functional
would like to see the implementation of any number of the fiscal
policy-making body left standing in Washington. And although
stimulus ideas being dusted off and discussed by the incoming
politically the Fed is a devoutly independent group, one senses that
freshman class in Washington. Tax amnesty for repatriated foreign
certain not-so-independent politicians are growing increasingly
profits of U.S. companies, for example, would inject many multiples
uncomfortable with a 9.6% national unemployment rate. In light
of QE2 into the domestic economy, without printing a single dollar.
of the fact that earlier policy actions were virtually guaranteed to
Temporarily reducing or eliminating employer payroll taxes (a
hold the unemployment rate below 8.0%1 you can understand
“payroll tax holiday”) or an across-the-board reduction in corporate
pressures for someone (anyone!) to do something. Dr. Bernanke to
tax rates, more examples, would encourage hiring and make
the White House, stat!
American companies more competitive globally. But we are not
It will not surprise any of our regular readers to learn that we would
have preferred fiscal stimulus to QE2. Heck, even direct government
spending on bona fide infrastructure projects would have been
better. Unfortunately, because of ongoing political infighting
putting the cart before the horse — our leaders won’t even tell us
what our personal income tax rates will be six weeks from now or,
for that matter, how much more expensive it will be for the estates
of anyone unfortunate enough to live to see 2011 but not 2012.
about the last attempt at fiscal stimulus (the Bush tax cuts) and the
Unlike fiscal stimulus, which works but won’t happen, government
American voter’s stubborn insistence on remembering how well
spending happens all the time — it just almost never works.
the prior “infrastructure spending” package worked, these options
The last stimulus package failed miserably because, like the
NY Times 6/30/09: Geithner, Romer, and Summers predicted in January 2009 that the proposed stimulus package would hold unemployment below 8.0%
1
I N D I A N A P O L I S / B LO O M I N G TO N
to determine the economic impact of another $600 billion, in addition to the $1.7 trillion doled out by QE1.
p e l o to nwealth.com
childhood game “Telephone,” by the time the 100th person relays
As the venerable bond gurus at Pimco are fond of saying, “We’re
the sentence, it bears no resemblance to the original. A potentially
not in the business of assessing what we think should happen, but
effective program to rebuild outdated American infrastructure
what is likely to happen.” Early reactions to QE2 provide clues about
was twisted until it was finally implemented as a gigantic set of
the program’s ramifications in 2011 and beyond.
transfer payments, extended benefits, and new entitlements. These
programs certainly help those in need, but they do not create jobs.
What QE is doing:
• Commodity prices are soaring. Gold continues its advance, and
oil is again near $90 per barrel. Other commodities have jumped
much more than the two headline materials. Copper, iron ore,
cotton, and sugar have all rocketed higher. These are primary
inputs for many finished goods industries around the world, and
higher input costs are inflationary.
• The dollar is falling. A weaker dollar is a conspicuous goal
of QE, and to the extent it aids US exports, the domestic
economy benefits. However, in an environment in which the
Administration all but labeled China a “currency manipulator”2
— the monetary equivalent of poking a playground bully in the
chest — QE2 stokes global protectionist tensions at a time when
QE2 won’t work either — at least not as billed as an economic
stimulus package. No one has hired a new employee because
the Fed plans to buy $600 billion in Treasuries; unless perhaps the
Fed hired runners to shuttle wheelbarrows of dollars to hock for
Treasuries. That QE2 won’t work is the bad news. The good news
is that the economy doesn’t need it. When the Congress passed
the American Recovery and Reinvestment Act of 2009, we had our
doubts. We wrote that the economy would recover in spite of all
government efforts to help it — it always does. The Fed’s latest actions
are not as overtly problematic as the so-called stimulus package.
After all, QE2, unlike the Reinvestment Act does not crowd out
private investment or add entitlements that are nearly impossible
to cut later. It does, however, have its own set of consequences
which will have to be addressed. For one, at some point the Fed will
I N D I A N A P O L I S / B LO O M I N G TO N
have to mop up all these extra dollars.
we desperately need to support global trade.
Both of these points are particularly important because the Fed
has vocalized its discomfort that the domestic rate of inflation
has fallen below the desired level. In other words, we are going
to worry about deflation now and inflation later. To the extent
that merely the threat of QE2 increases inflationary expectations,
markets are driving up asset prices before a single wheelbarrow
of cash is spent. Markets are doing the heavy lifting for the Fed.
This scenario is likely welcomed by Chairman Bernanke, but this is
risky. If materials prices rise too much or if the falling dollar sparks
widespread protectionist trade policies, the recovery (which is
in place and gaining momentum), will struggle with new and
formidable headwinds.
What QE is not doing:
• Credit is still not flowing. QE2 is a liquidity solution to what we
EARLY READ
have argued is most certainly not a liquidity problem. Banks and
Markets, being the immediate arbiters of all manner of great
transmission mechanism, which we generally term “confidence,”
debates, are not waiting to see what two-point-three-trillion dollars
is still impaired.
of QE means. Following the announcement, virtually every broad
investment asset class responded with a swift and definitive
directional move. Stocks and commodities were beneficiaries, and
the dollar fell. And contrary to the most direct purpose of QE2,
yields on long bonds moved defiantly higher.
corporations have more cash than they can lend or spend. The
• Employment is not improving (enough). Actually it is, slowly, but
not as a result of QE2.
• Congress is not acting. Normally this would be great, but the
looming sun-setting of the Bush tax provisions make this
congressional inaction ironically unsettling.
China pegs its currency to the US dollar, thereby keeping it from appreciating against other currencies despite a widely-held belief that China’s much higher
economic growth rate justifies a much higher Yuan.
2
2
issue 0 2 / n ovember 2 010
QE2 is generally having the desired effect on asset prices and
earnings yields of 6%, 8%, and 9%, respectively, they are neatly
inflationary expectations in the short-term. But it is not impacting
selling expensive debt and buying cheap earnings.
the real economy. To quicken the pace of the domestic recovery,
business confidence must be restored. Unfortunately “confidence”
is not the Fed’s job. Instead of leaning on the Fed to “do something,”
Congress and the Administration have plenty of their own to do —
the sooner, the better.
Also showing confidence, many companies consistently raised
their stock dividends throughout the financial crisis, and remain
committed to regular future increases — signaling visibility into
end markets and future cash flow generation.
Transactional activity requires considerably more confidence than
merely buying stock or nudging up a dividend payout. It is one
DROWNING IN CASH
thing to believe your own company’s stock is inexpensive, but to
The only thing anyone is confident about is that somewhere on
the horizon is a looming crisis. It is either a deflationary spiral
or ‘70s-style hyper-inflation; a defunct dollar or a double-dip; a
Chinese economic collapse or a Chinese global takeover; higher
taxes or ballooning deficits; or a sovereign default in Greece, wait
Spain, no Ireland, err Portugal. This is a complex, interconnected
world with a constant litany of potential worries. What does QE
believe another company is cheap enough to buy it outright and
assume the challenges and costs of integrating an entire company
is truly risky. Acquisitions not only commit capital, but when stock is
used, often the acquiring company’s stock falls. Despite these risks,
“strategic” M&A activity, in which a company buys a competitor or
seeks to add a product line, integrate a supply chain, or access new
geographies, has been absolutely booming.4
mean for future inflation, for example?
From an economic standpoint, the actual excuse for inaction does
not matter. Corporate decision-makers are cautious. As a result,
cash is being amassed by corporations with very little incentive
to invest in new employees or facilities. Apple, Google, Microsoft,
and Cisco together have more than $100 billion on their books.
The aggregate S&P 500 is hoarding two trillion dollars! Banks are
However, the sheer number, size,
and diversity of recent deals suggest
executives are seeing value everywhere.
More importantly, they are finding the
courage to act.
holding massive excess reserve balances at the Fed. Again, liquidity
is not the problem. Until capital allocators feel secure enough with
the regulatory and policy regimes impacting their profits, such that
they can invest capital and anticipate an attractive after-tax return
on their money, they will not act.
Corporate insiders know their companies (and often their
competitors) better than anyone else, so they are in the best position
to make valuation calls and to pursue strategic acquisitions. Often
the combined company. Therefore, we do not generally regard
near zero and cash yielding nothing, pressure has been mounting
strategic M&A activity as the best indicator of inexpensiveness
on executives to deploy capital in meaningful ways. Anecdotal
(or value) in the marketplace. However, the sheer number, size,
evidence of chieftains’ willingness to commit capital has been
and diversity of recent deals suggest executives are seeing value
trickling in for some time, starting with the lower risk uses of cash.
everywhere. More importantly, they are finding the courage to
Stock buybacks are particularly low risk because a company can
act. Further out on the risk spectrum, we are also seeing more
control the pace of the buyback, and to some extent, the prices
speculative deals such as insider LBO’s, private equity, and portfolio
it pays for its own shares. Many companies with fortress balance
acquisitions.5 These buyers clearly must see value to act. In many
sheets and no need to borrow are tapping the debt market simply
cases, unlike strategic deals, they also need extensive financing. An
because cash is so cheap for them. McDonald’s, IBM, Microsoft,
increase in speculative deals suggests that not only is risk-taking
and others have issued bonds (at a ridiculous rate of 1% or less for
back, but credit also is more accessible.
three years) and plan to use the proceeds to buy back stock. With
3
In addition to prudently managing their capital structures, these companies have overtly stated that domestic debt issuance allows them to avoid repatriating
foreign earnings, therefore avoiding additional tax.
At the time of this writing, Caterpillar announced a takeover of Bucyrus, a $7 billion mining equipment company, and on the same day EMC used $2.3 billion of its
cash to buy Isilon Systems.
5
Warren Buffett’s Berkshire Hathaway acquired Burlington Northern last year without any existing portfolio assets that are complimentary, indicating that Buffet
merely saw compelling value.
3
I N D I A N A P O L I S / B LO O M I N G TO N
these deals offer chances to wring operating inefficiencies out of
But lo and behold, some are acting. With short-term interest rates
4
3
p e l o to nwealth.com
When corporations spend on personnel, plant, and equipment,
cash will be deployed. The next and most important level on the
profit margins are pressured from the cost side of the ledger.
capital allocation risk spectrum is cap-ex and hiring — the Holy
However, current equity valuations suggest only paltry earnings
Grails of sustainable economic expansion. Demand is gradually
growth is being forecasted for 2011. We believe this ignores
strengthening, and at this point in the cycle companies have
the positive revenue impact of a self-sustaining, job creating
extracted maximum productivity from their current ranks. Some
expansion. One thing is certain. When corporations get back to
are spending in spite of ongoing regulatory uncertainty. Simply
prudently risking capital to grow operations and profits, CEOs will
put, there are some operation-critical areas that require continuous
not cite QE2 as the impetus.
underinvested in many areas for years. Others are still awaiting
clarity from Washington.
I N D I A N A P O L I S / B LO O M I N G TO N
Risk tolerance is slowly returning to the C-Suite, and as it does more
reinvestment regardless of confidence levels, and companies have
4
The Peloton Position is a compilation of original insights and
writings by Peloton Wealth Strategists. This issue features
articles by Matthew K. Bradley, Executive Director and Chief
Investment Officer.
We are accepting new clients and appreciate your referrals. If you are not currently a
client and would like more information about our customized approach, please visit
our web site. Or contact us to schedule an introductory meeting.
8888 Keystone Crossing Blvd. #1316
Indianapolis, IN 46240
101 W. Kirkwood #239
Bloomington, IN 47404
P 317 863 0311
F 317 324 0119
P 812 332 5259
F 812 961 4424
MATTHEW K. BRADLEY
KENNETH W. KACZMAREK
Executive Director
Chief Investment Officer
Managing Director
Chief Economic Officer
[email protected]
[email protected]
STEPHEN P. CARR, CFA
BRENDA R. HILL
Director of Research
Administrative Assistant
[email protected]
[email protected]