Category Archives: Business profits

The “New Normal”: Some reflections on the discussion on US current equity valuations

 

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[Acknowledgment: Thanks to Edward Worsdell for helpful comments on an earlier draft of this post.]

Ever since the publication of the book Triumph of the Optimists: 101 Years of Global Investment Returns by Dimson, Marsh and Staunton (already 15 years ago!), it is basic knowledge that equities, as an asset class, outperform other asset classes in the long-run, in particular fixed income (both bills and bonds). As you can see in the following graph from the Credit Suisse Global Investment Returns 2017 edition, equities on a global basis (and not just US equities) have outperformed both bills and bonds by very wide margins – although this historical advantage seems to have faded away in the last 15 years:

Global Equity Returns vs

Source: Credit Global Investment Returns 2017, p.47

From a theoretical perspective, however, the fact that equities should outperform both bills and bonds over the long-run has a long and distinguished lineage. It was Lawrence Smith, in 1924, in his classic book Common Stocks as Long-term Investments, who was the first to advance the idea (which for many was counterintuitive at the time) that stocks should deliver healthy returns for investors, with the proviso that you should hold them for several years – and over several business cycles. And as it happened, Keynes, who read Smith’s book as soon as it came out, was the first institutional investor (through the King’s College’s portfolio) to introduce stocks as a permanent, core asset in his portfolio allocation (and replacing the core role that real estate had played up to that point). And since then, the rest of the story is better known: from the Buffett’s investment success thanks to his patient approach at the helm of Berkshire Hathaway, to the books by Jeremy Siegel popularising the idea that equities, if bought at reasonable valuations, will do fine in the long-run. Continue reading

Our reading of Pettis’ reading of the FT article ‘glimpse of China’s economic future’

 

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Michael Pettis has recently published a post discussing an article that appeared in the FT some weeks ago, authored by Gabriel Wildau, Yuan Yang and Tom Mitchell, which discussed the economic dilemmas China will have to face in the (near) future given the current high levels of corporate debt and (still) high levels of corporate investment. We found both Pettis’ post and Wildau et al. article very interesting and quite similar in spirit to what we have written several times (here and here), and because we have not published anything on China for several months, we thought it could be a good time to provide a brief update of our views.

But first, it may be useful for our readers to explain briefly the main arguments posed by Wildau et al. and Pettis, respectively. The main goal of the FT article is to go through three different counterfactual rebalancing scenarios, discussing also the extent to which they could happen or not. Although the hypothetical scenarios are discussed in a heuristic way and the article does not crunch any numbers in detail (as we usually do, or for that matter, Pettis), we cannot but agree on the importance of that approach. Because several economic variables are, in principle, politically determined by Beijing, the dynamics of the Chinese economy are more ‘deterministic’ than in any other economy of the world, so the paths that the rebalancing process can take can be reduced to a handful of possible scenarios.

The first possible scenario proposed by the FT article (the most optimistic one by any standard), which we can dub ‘the conventional wisdom up to now’, posits that because consumption and the needs of the Chinese population (holidays, healthcare, education, and so on) are growing, there is an ‘unlimited demand’ for everything. According to this scenario, we are told that the growth in consumption will fill the void left by investment, and that the rebalancing process will proceed smoothly with high GDP growth rates and no major financial disruption. Continue reading

The Meaninglessness of Bottom-up Estimates and a Reverse Engineering Exercise for the S&P500

 

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Last week Deutsche Bank sent an internal note arguing that, well, it may be about time for the Fed to raise rates, claiming that ‘in fact, it looks more and more like the Fed is behind the curve’. For such a claim, the note reviewed a series of inflation indicators (e.g. PCE, CPI), but the really interesting chart was the last one, in which the analysts’ consensus for the S&P500 earnings per share was plotted, conveying the message that because the consensus expected higher earnings in the future, at some point wage growth would also follow suit, thus bringing higher levels of inflation in the future.

Beyond the dubious claim that the Fed should raise rates (which we think it should not), the really amusing part is to look at the analysts’ consensus estimates for the next 8 quarters. They are as follows:

S&P500 EPS and Consensus 3Q16-2Q18

S&P500 EPS and consensus’ estimates 3Q’16-2Q’18. Source: Bloomberg.

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The rebalancing and the flat decade in the Chinese stock market

 

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[this is the translation of an article originally published in FundsSociety]

Some days ago, Bloomberg published an article featuring a comparison between the stock market valuations of the Shanghai Stock Exchange against the valuations of other major exchanges in the world. The key message of the article was that, despite  falling 40% from the peak reached in June 2015, the index was still dear according to the median PER – in China, such a measure reached 60 times, in comparison to 20x and 13x in the US and Japan, respectively. To conclude, the article presented several opinions that stressed the low visibility for corporate profits in the short-run, given macroeconomic uncertainty and the difference in valuations and opportunities between the old economy (raw materials, industrials and real estate) and the new economy (technology, leisure, healthcare, etc.).

In fact, although making a one-year corporate profit forecast is a tough task, it is less hard if we make a ten-year forecast. Such a claim, although it may sound counterintuitive, is due to the macroeconomic dynamics that China will have to face in the medium-term. By this, we mean the rebalancing process, which implies reducing the investment share in GDP (and increasing the share of consumption) from roughly the current 50% down to 30% or less. That the rebalancing process implies moving resources from investment to consumption is already a well-known fact, and the investment community is starting to benefit from this insight recommending taking positions in consumption-related sectors and shying away from investment-intensive sectors – although, on the other hand, given analysts’ interpretations on the macroeconomic data published in May highlighting the supposedly ‘low growth’ of investment of around 9%, one wonders whether the analysts have yet understood even the basic concepts of the rebalancing process.

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El reequilibrio y la década plana en el mercado bursátil chino

 

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Acaban de publicar en FundsSociety nuestra visión sobre los retornos del mercado bursátil chino durante la próxima década. Puede consultarse aquí. En resumen, creemos que los índices chinos estarán en el mismo nivel de aquí a diez años (en el mejor de los casos, asumiendo múltiplos de valoración constantes), ya que el proceso de reequilibrio no sólo implica mover recursos de la inversión al consumo, sino también de los beneficios a los salarios.

Dado que la participación de los beneficios en el PIB tiene que caer a la mitad si se quiere completar el proceso de reequilibrio, y teniendo en cuenta que en el mejor de los casos el PIB en términos nominales crece al 7% en la próxima década, los beneficios en términos absolutos quedarían igual que hoy. Una aplicación muy elegante de la ecuación de beneficios Levy-Kalecki.

 

 

Una visión macroeconómica de los beneficios empresariales de EE.UU.

 

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[Publicado originalmente en FundsPeople]

Desde que Alcoa diese el pistoletazo de salida a la presentación de los resultados empresariales de las empresas estadounidenses, los analistas económicos llevamos un par de semanas siguiendo con atención los números que al final presentará el conjunto de las empresas del S&P500. En un escenario como el actual de elevada incertidumbre a nivel macroeconómico en todo el mundo, la presentación de los beneficios de los integrantes del S&P500 representa un indicador valioso de dónde estamos y nos da una razonable idea de lo que podemos esperar en los próximos trimestres.

A riesgo de simplificar, para el presente artículo se tendrá en cuenta que hay dos maneras para pensar sobre los beneficios a nivel agregado: bottom-up y top-down.

La visión bottom-up es bien conocida y requiere de poca elaboración. Se suman una a una las estimaciones de consenso de cada una de las 500 empresas del S&P500  con el fin de obtener el número agregado de todo el índice. La principal ventaja del método es que compila las predicciones de analistas especializados en una industria o en un grupo de empresas, lo que hace que las predicciones sean más informadas que las de alguien que no tenga dicho conocimiento granular. Las principales desventajas del método son dos, que es intensivo en información (para llegar a la cifra agregada de beneficios se necesitan las estimaciones de los beneficios de las 500 empresas del S&P500, una tarea nada desdeñable) y, por otra parte, dicho método puede conducir inadvertidamente a falacias de composición no deseadas: si uno hubiese agregado las exuberantemente racionales estimaciones de consenso de finales de los 90, uno hubiese descubierto que tales estimaciones daban números superiores (o similares) a la cifra de beneficios global presentada en las cuentas nacionales. Dado que era de esperar que el resto de la economía estadounidense, una vez excluidas las empresas del S&P500, generase algún beneficio en aquellos años, las estimaciones bottom-up de aquel entonces, aunque aparentemente consistentes a nivel individual, a nivel global daban lugar a resultados ridículos. Continue reading

The Chinese Fiscal Policy for the Rebalancing Process

 

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Chinese policy makers were gathered at the National People’s Congress (NPC) a couple of weeks ago to discuss the economics goals for the next few years. Given the recent turmoil in Chinese financial markets, it was an important meeting for international analysts.

Several issues were addressed at the NPC, but the most important one was the strict commitment of the Communist Party to keep sustainable (and moderately high) growth rates. For this year they have abandoned fixed targets and they have opted for some flexibility in their goals (e.g. 6.5% – 7%). ‘More active’ fiscal policies, through higher current and investment expenditures and tax cuts, were also put forward in order to achieve deficits around 3% of GDP – which is in stark contrast with the government position of the last years. But as we will see in a while, these goals (6-7% nominal GDP growth plus 3% of fiscal deficits) do not meet People’s Bank of China projections for government debt, unless other ‘extraordinary’ government operations (bailouts of banks and local governments in particular) are brought into the picture. Finally, the Communist Party has also suggested higher levels of inflation (around 3%) than in recent Chinese history.

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On the Chinese rebalancing timetable: a reply to professor Pettis

 

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Professor Michael Pettis has recently published another brilliant post on the Chinese rebalancing issue. We regularly follow Pettis’ views on the Chinese economy, which we consider valuable if one wants to understand the macro management dilemmas China will have to face. In his post, Pettis does not address how the rebalancing process should be ideally done (something which he has explained on several occasions), but rather how much time China has in order to accomplish it successfully. Pettis says that:

Credit growth in China is too high as are current debt levels, and the sooner Beijing gets credit growth under control, the better. This latter statement in itself is not controversial of course, but my simple debt model shows just how urgent it is for Beijing to get credit growth under control. It clearly does not have ten years or even seven years. It might have five years, but only if the markets – Chinese investors, businesses, and savers, both wealthy and middle class – are convinced that it is moving in the right direction.

In other words, the current high levels of debt can derail the rebalancing process if it is not done quick enough. In order to understand the link between debt levels and GDP, Pettis proposes a simple model that captures their dynamics over the long run (up to 2023). In his baseline scenario, Pettis assumes (following the trend of the last few years) that nominal debt initially grows twice as fast as nominal GDP (notice the use of nominal values), but gradually converging in a linear way to the growth rate of GDP by the end of 2023 – at that moment the economy reaches a steady-state position, and GDP and debt grow at the same pace. Depending on the GDP growth rate assumed, Pettis’ model projects debt-to-GDP ratios from 251% (with a 3% growth in GDP) to 274% (with a 6% growth) by the end of the period, too high in comparison to other economies. He then proposes alternative scenarios, but the result is the same: unless Beijing advances more radical measures to curb debt growth and improve the efficiency of the financial system, the growth in debt will derail the rebalancing process.

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The Levy-Kalecki profit equation in action: the Spanish case

 

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Martin Wolf has recently reminded us the role that corporate surpluses played during the ‘Great Moderation’. He reports the well-known fact that while corporations saw how their gross savings (i.e. current revenues minus current expenses, capital expenses excluded) rose during this period, the level of corporate investment remained stagnant. This means, as a matter of logical necessity, that corporations were accumulating net assets over the entire period. Wolf concludes that ‘it has to be accepted that, so long as the corporate sector runs a structural financial surplus, macroeconomic balance is likely to require fiscal deficits’, something which I can hardly disagree with.

At the same time, the Spanish press (here, in Spanish) reports that non-financial corporations have seen a growth in profits, during the first three quarters of 2015, of 28.6% (in comparison to the first three quarters of 2014), due mainly to ‘an improvement of the economic activity’ and the impact of some one-off (non-recurrent) revenues. Both articles have nudged me enough to provide an update of the Spanish macroeconomic profit series and to explain their implications for the Spanish macroeconomic performance.

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Some unpleasant arithmetic for the Chinese economy

 

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[this is the translation of a previous post]

As you may know, in September 1973 Salvador Allende’s socialist government was overthrown in a coup d’etat. What is less known is that with that government one of the most interesting applied projects in the history of economics came to an end: Cybersyn. Cybersyn was a centralised management system for the Chilean economy devised by the British scientist Stafford Beer, whose theoretical work up to then (in the field of cybernetics) focused on how to develop complex systems that could be self-regulated in a natural way, using the human nervous system as a model. Beer’s works were known worldwide, so in the midst of the Cold War and the centralism vs. market debate in its heyday, the Chilean socialist government thought that it would be a good idea to have the most advanced theoretical arsenal for socialist planning on its side. At the peak of the Chilean system there would be 7 men, who, through an operations room receiving data in real time, would be in charge of most of Chilean economic life. Take a look at this photo to realise how advanced the system was despite being barely in existence for two years – and, even if you don’t believe it, the photo doesn’t come from Star Strek, but surely Spock would have been very proud to call it his workplace. Although we will never know if the system could have worked for long (personally, we don’t think so, but we do think that the system was far more superior than the one used by the USSR at the time), the project can be considered the paradigm of centralised planning in an economy – and the Walrasian auctioneer became flesh, or rather, circuits.

The Chinese economic performance in the last two decades and its possible evolution has become a crucial point for any debate on the future of the global economy. Lately (let´s say, for the last 4-5 years), the debate has been gaining momentum, with (at risk of simplifying) two sides clearly identified: those who think that the current Chinese economic model is sustainable, based on the fact that, after all, it has been a success story and  that there is no reason why it should not continue to be so, and those who believe that the model will come to a halt, and that the sooner Chinese authorities accept this fact, the less painful the subsequent adjustment will be. The debate, as one can imagine, has been influenced by the implicit Western collective perception (and the implicit belief of many western economic analysts) that China is a sort of huge Cybersyn. While Western economies have been suffering from lacklustre economic performance and recurring financial crises in the last few years, public opinion has perceived China as an example of economic success, in part due to what is thought to be detailed and controlled economic planning. Although both sides of the debate agree on the extent of the success of the Chinese strategy so far, we are on the sceptics’ side and think that China has a tough decade ahead and that, furthermore, Chinese government will face severe economic restrictions when conducting economic policy. Therefore, this post will put some numbers to support such an intuition and to better understand which constraints the Chinese economy will face in the next decade.

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