If one steps back and simply looks at the accuracy of the world’s prominent PhD economists and market pros’ predictions over the past 7 years one can’t help but shake one’s head. And I believe investors have become wise to their ignorance. We’ve seen a record 15 consecutive weeks of net selling of equities despite these expert pundits continuing on in their attempt to deceive investors into believing we are just one or two quarters away from that (now) proverbial recovery.
For several years now I’ve been explaining exactly where these post 2008 crisis policies are inevitably taking us. In 2014 in my first Zerohedge piece I explained why interest rates cannot rise. I also explained that negative interest rates are a certainty. People called me all kinds of wonderful names in an attempt to convince me the Fed was about to ‘normalize’ monetary policy and interest rates would soon be back to historical averages. I held my ground because truth rather than hope was baked into my analysis. Now I don’t want interest rates to be low forever, and I think people mistake my views as my wishes, they are not. My views are based only the realities not the hopes. And this, I believe is where the pundits go wrong.
But I’m not here to say I told you so about so many aspects of the economy and markets. I want to show you that what is taking place in the macro economy is a true demand death spiral and this can be seen very clearly by using Proctor & Gamble’s microeconomic context as a representative model. I’ve explained ad-naseam that the macroeconomic policies implemented in 2008 & 2009 all but guaranteed economic contraction and this is because they incentivize contractionary microeconomic strategies that when applied on a macroeconomic scale perpetuate demand destruction.
Such contractionary microeconomic strategies can only be successful in the short term and on a microeconomic scale as a way to delay value destruction for individual firms while demand is revived at which point expansionary strategies can be re-implemented. But such contractionary strategies cannot be successful when they are applied on a macroeconomic scale (i.e. when all firms are using them). This is because demand can then never be revived and the contractionary strategies continue to realize contraction across the broad economy forcing the continuation of the contractionary strategies across all firms. You can see the circularity or what I call the death spiral of demand.
Think of it this way. Productive assets are the fertile soil and consumers the yielding crop. Now if some exogenous force (macroeconomic policy) is preventing the crop from yielding we will begin to sell off plots of land to finance our farm’s survival until we can solve the exogenous factor preventing our crop from yielding. However, if we never correct the exogenous force preventing the crop from yielding we are forced to sell more and more land until we have nothing left to sell. In the economy the very act of selling off the land becomes itself a secondary force preventing the crop from yielding. And so we are getting further and further away from solving the problem through our very mechanism of short term survival.
P&G is a particularly good example because it is a mature firm selling consumer staples, which is a saturated commodity like market. Meaning producers have very little ability to gain growth through pricing power or product differentiation and very little control over the size of the total product marketplace, which is limited inherently by population growth. So let’s dig into the numbers.
Let’s start with Revenue:
So in the early 2000’s top line growth (i.e. realized demand) was flat for several years leading them into an acquisition strategy presumptuously because how else do you force growth in a mature firm in a saturated commodity like market once you’ve expanded into essentially the entire global population already (appx 130 countries)?
And so they bought Gillette and others and expanded the top line. But then again the growth flattened out over a 5 or 6 year period before moving into contraction. It begs the question why not implement another acquisition strategy to attain the growth? This was during a period of essentially costless borrowing for P&G. What it suggests is that there were no viable acquisition targets. One because size does matter for a firm this large. And two, because top line was flat everywhere. Meaning there was no potential economic value to be gained from acquisition. If one and/or two were not true an acquisition would have been done.
But this is only top line and top line certainly isn’t everything. Most microeconomic decision making is around bottom line and cash flows. And remember Revenue – Costs = Profits. So even if revenue is declining, profits can still grow if costs are declining faster than revenue. And we know that earnings growth drives capital allocation decisions because earnings growth drives market cap and market cap expansion is the end goal for investors which is why executive management compensation is tied to market cap, not firm performance. Let’s have a look.
Now management efficiency ratios effectively depict how efficiently management is using their capital. Efficiency is a function of capital allocation. If capital is allocated efficiently these ratios will improve, if capital is being allocated inefficiently these ratios will deteriorate. Management are the capital allocators and thus these ratios reflect management’s proficiency for efficiency. As we can see in the above chart, capital efficiency is deteriorating across most standards by 50%.
But let’s look at margins to show that inefficient capital allocation generally will drive poor margin performance.
And so let’s see if we can figure out how capital is being deployed or perhaps more appropriately, misallocated.
So we can see that the majority of cash being generated from operations is being pulled off the balance sheet and pushed out to shareholders rather than being reinvested into operations (comparing distributions to income available to common the percentage is essentially all income is being distributed). What ultimately happens to that distributed cash is, according to a WSJ study, 85% of it gets reinvested into the secondary market i.e. into equity markets.
Think about that for a moment. Remember secondary market transactions do not generate economic investment. Secondary markets are financial investments or what some call ‘paper profits’. By draining corporate assets through massive cash distributions in an effort to excite investors and thus boost market cap, we forego potential economic (operational) investments in favour of financial investments unrelated to the business. That is, the capital being generated from operations is being sent outside the firm rather than allocated to generating new profits. And more and more cash must be distributed to entice further market cap expansion, however, this is in the face of a contracting resources.
Looking at it more directly we can see that despite the Fed’s 2008 implemented ZIRP & QE policies (supposedly) to stimulate economic investment, P&G Capex to Depreciation ratio is .58, meaning a contractionary rather than expansionary strategy.
We all know that growth through contraction is not sustainable. And so this begs the question, how long can P&G sustain the perception of potential growth?
It would appear for not very much longer at least without ramping up debt, which would just be used to distribute cash to shareholders. Why? Because what we know is that P&G has no viable options for operational expansion i.e. for growing their top line. They have hit their peak. Demand has peaked with no potential for pushing it higher.
Now this is not an attack on P&G’s management team per se. They are doing what they are incentivized to do, which is to do what they can to increase shareholder value. The key is whether this means short term or long term shareholders. The answer of which will lead to very different decision making. What we see is that short term shareholders are being rewarded and this is because of the effective requirement for QoQ growth, which if not achieved, will result in declining market cap. And thus in management compensation.
And so we’ve really come to the problem. Management teams are expected to allocate capital with the objective of perpetual short term profit growth without regard to long term growth. This is absolutely clear. Now when demand is strong short term profitability does not conflict with long term profitability because it comes from operational expansion. However, when demand is weak short term profitability coming via contractionary strategies does conflict with long term profitability. But the issue upon us is that these contractionary microeconomic strategies have been implemented across the entirety of corporate America. That is, cash is being pulled out of all firms at a record level and distributed to secondary financial investments.
Driving share value through expectations of direct cash payouts rather than operational growth is being done by essentially liquidating assets. And on a macro level this means the very demand deterioration that has forced the implementation of these contractionary strategies is being further deteriorated as economic activity itself declines on a large scale. Remember consumption (a function of wages/salaries) + (economic) investment make up 80% of the economy and these two inputs are unraveling at an accelerating pace.
To bring this all together the economy has hit a point of peak demand as a result of inefficient capital allocation leading to two decades of stagnant and recently declining real incomes. This has lead to an outrageous pace of credit expansion. Remember if incomes are not growing how do profits grow? Well that’s where consumer credit steps in. Each dollar of credit consumed becomes a dollar of revenue. But credit too is a function of income. That is, one can only take on so much credit relative to income. If income isn’t growing then credit expansion is finite and we’ve hit that limit. So then where does earnings growth come from? Well social welfare can also be increased. And we’ve seen welfare expand almost twofold since 2000. But even welfare is a function of income via taxes and so it too is finite (unless as Bill Gross proposed in his latest client letter that we begin UBI or Universal Basic Income, apparently derived from printed money?).
And so in the end, like P&G, where there is simply no viable option for sustainable growth going forward and thus the firm is now contracting (don’t miss the obvious trade there with PG at a 27x P/E multiple), the economy too has exhausted all of its options for growth. This is really a matter of earlier fatal decisions that ignored the absolute necessity of income growth for sustainable profit growth coming home to roost.
Capital allocators for decades believed profits could rise perpetually in the face of stagnant incomes. For a long time these economically fatal beliefs and decisions were being perpetuated by government and Fed policy by way of pushing credit and welfare. What is now becoming undeniable is that credit, welfare and thus profit growth are finite without income growth. But income growth cannot occur unless we break the inertia of this death spiral, which will in all likelihood be a painful exercise.