FEBRUARY 2014
MARKET AND ECONOMIC CONDITIONS
By Adam B. Landau
Permit Capital Advisors, LLC
Even the best-intentioned attempts to discuss the state of affairs in our country today have a propensity to result in a strident and partisan exchange. The tendency on most topics is to begin a debate by pointing fingers at a political party or its perceived doctrinaire representative, and then to devolve from there. There are, however, certain issues that transcend partisan politics because their rightful remediation is both clear and critical. One of those is the need for our educational system to be recalibrated, so as to better train our population to fulfill the needs of a modern economy.
The US used to be number one in the percentage of young people with a college degree. Now, it is number twelve. With unemployment at 6.7%, but unemployment for those with a bachelor’s degree or higher at less than half of that figure, or 3.3%, reversing that trend is of paramount importance. In an economy where enhanced productivity has eliminated the need for 35 million jobs since 2001, the leverage in the marketplace would seem to rest with training our workforce in the technical skills that result in productivity enhancement rather than training them in the fields that are being systematically eliminated.
This would imply an emphasis on what are commonly referred to as the STEM fields, of science, technology, engineering, and mathematics. Instead, the government has significantly cut its support for basic research in science and engineering. What had amounted to 4.5% of GDP in the 70s is now down to 2.5%. The negative impact is felt today on both our competitiveness and economic growth trajectory. Of course, in a world in which the Fed fears deflationary forces more than those that are inflationary because deflation boosts the real burden of our debt, we can’t escape the fact that we may be faced with less money to spend on education going forward, not more. Even if tapering were to continue, we are still adding to a $4 trillion balance sheet that is five times higher than it was prior to 2008, and is heading to $5 trillion by the end of this year.
With public indebtedness at its highest peacetime level in many advanced economies, solutions to raise cash are in high demand. One area that is being increasingly explored is the privatization of public assets. State owned enterprises in OECD countries are worth $2 trillion, with another $2 trillion in minority stakes in companies and utilities. For governments that are looking for ways to deliver, privatization is a useful tool. It allows governments to cut their debts, shore up their balance sheets, and improve their credit ratings, thus lowering borrowing costs. Historically, it also improves an economy’s efficiency by boosting competition and applying private-sector capital and commercialized skills to newly unencumbered assets. Both Margaret Thatcher and Ronald Reagan used it as a tool to transform utilities, telecoms, and the transport sectors, and recent trends would seem to indicate that their approach has been studied by today’s leaders.
Another issue that engenders general agreement amongst our citizenry is the importance of shifting our external accounts to a more sustainable profile – and the improvement has been marked. At the end of 2005 the current account deficit reached 6.2% of GDP, indicating a society that was living conspicuously beyond its means. By the end of the third quarter of 2013 it had dropped to 2.2%, the lowest since 1998. The two primary factors at work were the surge in domestically produced oil and gas, and demographics. On the latter, as baby boomers age they have a tendency to spend less on imported goods and more on domestically-produced services. With respect to what some are calling an “energy revolution”, the impact is felt on not only our current account deficit, but on capital expenditures as well. According to a study from HIG Global, hydraulic fracturing (or “fracking”) will generate $890 billion to $1.15 trillion in new infrastructure spending – pipes, railcars, storage tanks, pumps, refining equipment – from 2014 through 2025.
The timing for this surge in spending couldn’t be better, as within other industries the flood of central bank liquidity is deterring corporations from investing in real capital goods in favor of financial engineering in the form of recapitalizations and stock buybacks. Corporations spent $500 billion, or 2% of the S&P 500, buying back their shares in 2013. These debt financed repurchases boost earnings-per-share but not growth. This is why metrics like price/sales and market cap/GDP are at levels not seen since the dotcom boom of the late-90s. Also supportive of stock prices has been historically high margins. Much of this stems from controlling labor costs. As noted previously, productivity gains have allowed companies to eliminate jobs, as evidenced by the ongoing skew of national income towards the corporation and away from labor. Corporate profits as a percentage of national wages have swelled to 27%, from levels below 15% in the 80s. Cheap oil and natural gas, a byproduct of the “energy revolution”, has also played a major role in altering businesses margin structure. It’s hard to say whether margins need to naturally come down (one threat would be a strengthening dollar since about half of the earnings of S&P 500 companies come from overseas), but it’s equally hard to see room for much improvement.
The support for earnings that came from a reduction in share count and an increase in margins contributed to gains in equity markets last year, but the real octane that propelled domestic equity indices up more than 30% was the jump in valuations. US equity valuations rose by 20% last year, the largest increase since the tech boom in 1998, chiefly because central banks flooded the markets with easy money and investors became willing to pay more for each dollar companies earned. As a result, the S&P 500 now trades at 15.4x projected profits, up from 12x in 2012. Using the cyclically adjusted price-to-earnings ratio developed by Professor Robert Shiller of Yale University, which attempts to eliminate the fluctuation of the ratio caused by variation of profit margins during business cycles, the market looks even more expensive. The most recent reading of 25.6x is 55% above the historic average of 16.5x.
Facing a landscape in which the traditional barometers of value and risk are tenuous, a vigilant approach to managing exposures will be the key to achieving an investors goals. We believe that taking advantage of premiums offered by illiquidity and volatility, being willing to make investments into parts of the market that most are eschewing, and a focus on an appropriate allocation to uncorrelated assets, will allow investors to continue to build portfolio value in the face of ongoing challenges. One such sector that is worthy of an increased allocation in 2014 is commercial real estate. However, picking the right assets, the right part of the capital structure and the right local operators to invest with is more important today than four years ago when the market was still languishing. While there may be occasional sharp increases in interest rates that reduce the spread between cap rates and borrowing costs, like we saw last summer, the Fed is likely to remain accommodative for several years in an effort to keep rates from rising significantly. Furthermore, trends in capital flows and demand for space are key drivers of commercial real estate performance, not just interest rates. If rates were to rise amid an improving economy, as is typically the case, demand for real estate should have a positive effect on property performance, particularly in an environment of limited new supply that is making rents and occupancy levels less dependent on increased demand. In terms of capital flows, there are two important tailwinds: investors currently have a constructive attitude regarding the underwriting and pricing of commercial real estate assets, and large institutional investors such as pension funds and sovereign wealth funds are increasing their allocation to the space in an effort to diversify their portfolios, both as a source of income and as an inflation hedge. Given the burgeoning risks in traditional asset classes as described above, we don’t look for this trend to reverse any time soon.
About Adam Landau
Adam Landau is Chief Executive Officer and Chief Investment Officer of Permit Capital Advisors, LLC. He has 15 years of experience evaluating investment managers, developing asset allocation strategies, and coordinating the process by which the two disciplines are merged. Visit http://www.permitcapital.com to see how Adam and Permit Capital Advisors, LLC can grow your wealth.
