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Economic Insights

Reforms underway in Europe, China, and, perhaps, Japan will be critical for the global economy.

 

In Brief

  • The U.S. economy is likely to continue to muddle along. The housing recovery, although not over, probably won’t contribute much to economic growth in 2014.

  • Concerns that the U.S. stock market is in a bubble are overwrought. The price-to-earnings (P/E) ratio on the S&P 500® Index is not much higher than the long-term average, and earnings are probably sustainable. Earnings are higher than normal because of operating leverage.

  • Banks in the eurozone, which have been slow to repair their balance sheets in the wake of the financial crisis, are undergoing a thorough review of their assets in preparation for stress testing later in the year. The bad debts are well-known, so although some banks are likely to fail, the risks are manageable.

  • Excessive borrowing in some emerging markets has come to light since the Federal Reserve began tapering the bond-buying program known as quantitative easing. Currency depreciation in some countries is making the repayment of dollar-denominated debt more difficult. But not all emerging markets are being hurt, and the market is differentiating among them.

  • Japan’s ability to handle its considerable debt burden will depend on the success of structural reforms designed to stimulate economic growth. The country’s interest expense could soar because Japan can no longer depend on high domestic savings to absorb government debt issuance. Rates may have to rise to attract outside investors.


 

Nearly four years after the financial crisis triggered by the downgrading of Greek government debt, the eurozone is getting serious about bank reform. The European Central Bank (ECB) will spend the next several months assessing the quality of the assets in eurozone banks in preparation for stress tests to be conducted late in 2014. Financial institutions all across the eurozone will be held to a uniform standard and, if necessary, will have to raise additional capital. If all goes well, Europe’s banks will be rejuvenated and able to get back to the business of lending, which is needed desperately.

Revitalization is needed in Japan as well, and it hinges on the “third arrow” of Prime Minister Shinzo Abe’s economic program, including broad structural reforms. Along with monetary and fiscal stimulus, these as yet unnamed reforms are intended to spur the growth that will enable Japan to keep from collapsing under its massive load of government debt.

Economic lethargy is not a problem in China, but reforms are occurring there as well, as errant corporate behavior is increasingly allowed to be disciplined by the market. But moves to shut down shadow banking and deregulate the banks may be worrisome. Elsewhere in emerging markets, excessive borrowing is now being exposed by currency devaluations resulting from tapering of the Federal Reserve’s quantitative easing program.  Many corporate borrowers are struggling to pay the cheap dollar-denominated debt they accumulated during the Fed’s accommodative policy of the past several years. But not all emerging markets have borrowed too much, and the markets are winnowing out the imprudent.

Despite the absence of reforms in the United States, the economy continues to muddle along. A surge in acquisitions points to some optimism and the likelihood that the stock market is not overvalued.

Addressing these and other topics are Milton Ezrati, Partner, Senior Economist and Market Strategist; Zane Brown, Partner and Fixed Income Strategist; Harold Sharon, Partner and International Strategist; and David Linsen, Director of Domestic Equity Research.

Q:  The economy continues to plod along. Is there anything to suggest that it will break out of this pattern anytime soon?

Zane Brown: It’s difficult to tell how much of the slowdown is due to weather. In December, many investors had expectations for economic growth of 3–3.5% this year, but it looks like it will be closer to 2.5%. The severe winter weather has made it difficult to know for sure how the economy is really doing, and we won’t know until the end of April, when first quarter GDP figures come in.

Milton Ezrati:  Economic growth is likely to continue at a slow rate. Consumers have repaired their finances, so there is no reason to retrench, but the fear that has persisted since the recession is going to keep consumer spending moderate. And since consumer spending is about 70% of the economy, that means growth is likely to continue, but at a slow rate. But it also means that this growth is durable.

Harold Sharon: This doesn’t respond directly to the question, but I think it’s fascinating that after years of sitting on piles of cash, companies are now gobbling up their neighbors. It is interesting that these acquisitions are not just in one industry. They’re not all technology; they’re also occurring in retail, healthcare, media, and chemicals, for example.

David Linsen: But that does suggest that companies have confidence in the outlook for the economy. They wouldn’t spend billions of dollars if they thought the economy was about to roll over. So I think it’s a signal of corporate confidence. The past several years the market has rewarded dividends and share buybacks; today, the market is also rewarding companies that smartly allocate M&A [mergers & acquisitions] and growth capital.

Q:  Has the housing recovery peaked, and is it running out of steam?  

Ezrati: Housing was a slight drag on the economy in the second half of 2013. But the pace of growth in the first half was unsustainable. It was all concentrated in regions, such as Florida, that had suffered the most. 

When prices and sales volumes are well below their peak, then the slightest growth can make an enormous percentage difference, and that’s what happened in the first half of 2013. In the second half, the market adjusted to that demand, and mortgage rates rose. 

But three facts -- that those rates rose by about 100 basis points, that the housing sales and construction were essentially flat, and that prices still continued to rise -- suggests the market has not peaked.1

Linsen: Since the credit crisis, there have been five or six years of household formation without much new housing supply added. Job creation is occurring, though not at high levels, mortgage rates are still low by historical standards, and consumers are becoming more confident about their jobs and their ability to purchase a home. These factors suggest an upward bias in the housing market is likely for the next several years.

Last year, housing starts amounted to just under one million units.2 Our housing analyst has projected 10% growth in housing starts this year, and he expects starts to get back to normal, at around 1.4 million a year, in 2016 or 2017. So that’s about an additional 100,000 starts per year over the next four years.

Brown: That’s a little brighter than I would have expected. So, in other words, you’re saying the market hasn’t peaked. But because of the surge this year, I don’t think housing is likely to add meaningfully to economic growth next year as one would expect in a normal recovery.   

Ezrati: I’ll add to David’s comments by saying housing affordability—even with the rise in mortgage rates and the rise in prices—remains very good by historical standards.

Q:  Some observers believe the U.S. stock market is in a bubble. They argue that valuations are too elevated, especially given that corporate earnings are very high and, arguably, unsustainable. Is the market indeed in a bubble?

Ezrati: The M&A boom that Harold mentioned also speaks to that. If it’s cheaper to buy a company than it is to invest in your own growth, then there is no bubble. If corporate America thought the market was overpriced, we would be seeing a lot of IPOs [initial public offerings]. IPOs are up, but they’re certainly not at record levels.

Linsen: That M&A strategy is being reinforced by the market. The acquirer’s stock is going up in many of these deals because there is so much accretion to earnings. So, I think M&As will be a major theme this year because the market is sending the signal that this is a good allocation of cheap capital.

Sharon: So corporate America is saying that the stock market bears have got it wrong because we can buy these businesses, clients, assets, etc., for an unbelievably good price.

Ezrati: As for corporate earnings, they’re more sustainable than people think. They have risen much more than have corporate revenues, but that isn’t unusual. Historically, the earnings of companies in the S&P 500® Index have been much more volatile than the revenues.

U.S. corporations are very capital intensive, and while that enables companies to do more with fewer employees, it also raises their fixed costs relative to their total costs. These fixed costs don’t go away during an economic downturn the way employee costs do. You can’t lay off equipment. Fixed costs must be covered even when revenues decline, so much of that shortfall comes right out of the bottom line. But when revenues rise, much of the increase goes right to the bottom line, once the fixed costs are covered. For that reason, when you look at a chart of historical changes in revenues and earnings, you see that the earnings are much more volatile than the revenues.

As for valuation multiples, historical data show that they are cyclical, and when they are advancing from lows, they will often rise well past the long-term average. The trailing P/E on the S&P 500 is 17.2 [as of March 20, 2014], not that much higher than the long-term average of about 16.5. So, it could show further gains.3

Brown: This also raises the question of whether certain other markets, such as high-yield bonds and bank loans, are in a bubble. High yield certainly doesn’t appear to be. Debt ratios are very low, and interest coverage ratios are very high. Earnings continue to improve, and the cost of debt continues to go down.

When a turn in the credit cycle occurs, it’s normally accompanied by aggressive borrowing, combined with aggressive interest rate increases by the Fed in an attempt to slow an overheating economy. In the current cycle, we don’t see any of these signs.

One development that many skeptics cite is the decline in covenant protection. Covenant-lite loans have increased, but that isn’t necessarily a sign of lateness in the credit cycle. I think it’s a sign that interest rates are so low that some investors are willing to give up certain protections in exchange for a higher yield.

In the last cycle, around 2007, covenant-lite loans increased and were associated with subsequent credit problems. Those credit problems may have been more related to aggressive borrowing particularly to finance leveraged buy outs. In the current cycle, most of the issuance is refinancing that replaces higher coupon debt with lower-cost financing. That means the new borrowing is helping to strengthen companies, not weaken them.

Q:  The European Central Bank (ECB) is undertaking a comprehensive review of the eurozone’s banks, which are heavily leveraged and have not made much progress in cleaning up their balance sheets since the credit crisis. How fragile is Europe’s banking system and how much of a threat is it to financial stability?  

Sharon: I think it’s fairly well known where the bad debt has come from. It tends to be from the slow-growth periphery countries of Greece, Spain, and Italy. It’s also well known that loans to the shipping industry are a problem for a lot of German banks. So I don’t think European banks are a huge threat to the financial system as a whole. But I agree that there are still some troubled institutions in need of raising capital.

Historically, each country regulated its own banking system. This allowed for political interference, nationalistic policies to protect banks, and regulators willing to provide many levels of forbearance over the last five years.  As a result, some banking markets in Europe have been slow in recognizing the full extent of their bad debts and in bolstering their capital base.

But as of this year, the ECB has become the single banking regulator for the entire eurozone. So between now and July 2014, it will conduct an “asset quality review.” That means that one uniform standard for all regulatory definitions and rules will be applied to all banks. So, the value of assets and collateral, for example, will be determined in one uniform way. That alone is uncovering some problems.

One Italian bank, for example, was recently forced to write down massive amounts of goodwill related to banks it acquired 15 years ago. Another Italian bank had to raise capital equal to 100% of its market capitalization. All of this was pretty well known, though the size of the bad debts in some cases was not. But these troubled banks are coming to grips with the new standard as the ECB asserts itself. 

The good news is that the problems are coming to light and that politics will play less of a role in bank regulation. Because it’s the ECB that is conducting these reviews and stress tests, the process will be less subject to political influence.

This is the first time these measures will be conducted by independent, prudential banking authorities, not national banking authorities. So, this is the beginning of the eurozone-wide bank supervisory system. Will a few banks go under? Yes, but they’ll probably be absorbed by larger banks or be wound down with minor systemic consequences. 

After the asset quality review, banks will have to do whatever is necessary to meet the new capital requirements. But the most important change that has happened recently is that the capital markets are open for these institutions. As an example, one of the worst banks in Spain did a share placement recently. A year ago that would have been unheard of. We've seen capital raised in all the troubled European banking markets recently. 

Brown: The outcomes of this process may also be worsened by geopolitical risk. With Ukraine, Syria, and other hot spots, there could be even more bad debt on the books of some banks than was expected. Bad debts could be further aggravated if Russia responds to sanction by declaring a moratorium on debt payments by state-related Russian companies.

Q: Emerging markets have been under some pressure since the Fed first mentioned in May 2013 that it would soon begin to taper the bond-buying program known as quantitative easing. How much of a threat is tapering to emerging markets?

Sharon: Emerging markets are a very diversified group of countries, and the market has been smart enough to differentiate among them. As a result of the Fed’s extraordinarily accommodative policy, some emerging market economies were able to borrow at single-digit rates for the first time, and some borrowed too much. 

On the other hand, borrowers in some emerging markets learned from the Asian crisis in the 1990s. Asian banks, for example, refrained from excessive borrowing this time around because they now understand the risks a little better, and as a result, they have not fallen into the same kind of trouble that borrowers in certain other emerging markets have. When the Fed actually began to taper, it was the countries with large current account deficits—especially Turkey, South Africa, Indonesia, Brazil, and India—that were hurt and saw large portfolio flows out. 

The potential problem this time is largely with corporate debt. According to the Bank for International Settlements, in the three and half years from January 2010 through June 2013, $990 billion in international bonds were issued by emerging markets, and of that amount, $700 billion was issued by non-bank corporate entities. There are large amounts of corporate debt coming due in 2014 in places such as Indonesia, Brazil, and South Africa. We've seen one large Brazilian bankruptcy, for example, so these upcoming corporate redemptions are worth following closely.  

Brown: The problem is that in many cases they’ve already accessed the capital markets. In some instances, they have borrowed a lot, expecting that the robust growth rate of three years ago would continue. They have borrowed in dollars, but their revenues are in the local currency. In many cases, these local currencies are now worth less, but the dollar-denominated debt must still be paid. So, some companies are in a difficult position, and, therefore, may not be able to refinance in the capital markets.  

Sharon: Places such as the Philippines, Mexico, and Colombia are doing better than many other emerging markets. The Central European countries were doing better until recently, and, of course, there is the Ukraine, which has more than $135 billion in external debt.4 That’s a relatively small amount, but it’s big enough that it could lead to contagion.

In Asia, China’s economy is slowing, but growth is still occurring. There’s been a large default recently, and the system hasn’t fallen apart. That has shown that a private default can be done in China. So, not all the signs coming from emerging markets are negative.

Brown: China’s debt problems have scared investors, but I’m more concerned about the moves to shut down the shadow banking system [which provides financing to small companies] and to deregulate the banks. China wants interest rates on deposits to be more attractive. At current rates, depositors aren’t paid even the rate of inflation. This means that banks will, in effect, have to bid for depositors by paying higher interest rates. That is similar to what caused the U.S. savings and loan [S&L] crisis in the 1980s. We allowed S&Ls to pay higher rates, and they had to make riskier investments to pay those rates.

The same thing could happen in China. Allowing rates on deposits to rise will compress banks’ profit margins, which could lead them to make fewer but riskier loans in order to maintain profit margins. So that could become a problem.

Ezrati: By shutting down shadow banking, China is reducing liquidity and access to funds, and so if companies lack access to capital, the economy will slow down and some companies will go into distress, as one large real estate developer did recently. That’s more likely than in the past because as part of the economic reforms, the government is no longer going to stand behind these quasi-government companies if they run into trouble. The government may ultimately still help them, but there would be fear that it would not.  

Linsen: This could all be good for U.S. consumers and the U.S. stock market. Slower growth puts less pressure on commodities prices, and that puts less pressure on inflation, which puts less pressure on the Fed to raise interest rates, which puts less pressure on U.S. consumers. That could contribute to an environment of sustained growth for some years.

Brown: Investors should understand that the impact of Fed policy on emerging markets is indirect. Often it is reported that the Fed created money, and that that money flowed into emerging markets. But it is not that straightforward. The Fed creates the money, and that lowers our interest rates, including those on high-yield bonds. That enables higher-risk companies, such as those in emerging markets, to issue debt at lower rates.

Linsen: Harold, the Japanese stock market has been under pressure this year. Are you concerned about the inflation that the government’s policies could create?

Sharon: The inflation rate is still not quite 1%, so maybe the central bank will become more active. That’s the expectation for later this year, when the consumer tax increases by a couple of percentage points in April.

The stock market has been stalling because GDP growth has been weak and there is less of a tailwind from the weak yen boosting corporate profits. So we’re in the difficult part of the economic restructuring  plan because now it’s necessary for the government to make the structural reforms needed to keep the economy growing.

One bright spot has been that corporate sales growth on an annualized basis is about 3.8%, according to the Ministry of Finance. Hopefully, corporations will pass some of that along in the form of wage increases. But at this point, the economy really has been disappointing.

Brown I think that without structural reforms, Prime Minister Shinzo Abe’s economic plan [known as “Abenomics”] will fall apart. When the new consumption tax takes effect in April, that likely will boost inflation and, at the same time, slow economic growth. The government’s fiscal stimulus will also end in April. So, Japan could be on the brink of slower growth without the reforms that would have improved its global competitiveness and increase in exports.

Ezrati: The Japanese are well aware that the economy needs structural reforms, such as changes to bring more women into the workforce. That’s necessary for Japan to deal with its demographic problem. But the Abenomics strategy of driving down the value of the yen in order to boost exports is misguided. One person in five is over the age of 65, so Japan is running out of workers, making it difficult to continue being the “workshop of the world.”5

Linsen: As Japan’s population gets older, with more people beginning to live off their savings, what is that likely to do to Japan’s access to low-cost debt?

Ezrati: It compounds the debt problem. The savings rate is already much lower than it has been historically. For years, the Japanese had a very high savings rate, and it mostly went into the postal savings system, which paid very low interest rates. So the Japanese government was, in effect, getting the debt almost for free. And now those savers are beginning to draw down on those savings.

Brown: So Japan will have to pay higher interest rates in order for new investors to lend the money that has come from Japanese savers in the past.

Linsen: And what does that do to the interest expense on the debt, which amounts to 250% of GDP?6 That would seem to be one of the risks that could bubble up in the next few years.

Sharon: That would create a debt spiral. That is the argument that Abe makes for the structural reforms. That is, if Japan doesn’t achieve some reforms, the economy won’t grow, and then the huge debt burden will become a problem.

Ezrati: Japan has an extremely top-down economy, and it needs to turn from an export-based economy to a consumption-based one [the same way China’s economy is]. So, Abe should probably be talking up the yen so consumers can buy more overseas.

Japan should also encourage a more entrepreneurial culture and break up the Iron Triangle, which consists of big business, the Japan’s dominant political party, and bureaucrats in the government. In an economy dominated by this Iron Triangle, entrepreneurs won’t be allowed in.

Thank you.
 

 

1 Sources: mortgage rates: Freddie Mac; existing home sales: National Association of Realtors®; home construction: U.S. Census Bureau; home prices: Case-Shiller Home Price Index.
2 U.S. Census Bureau.  
3 Source: Bloomberg. 
4 National Bank of Ukraine, as of October 1, 2013.
5 Ministry of Internal Affairs and Communication of Japan.
6 International Monetary Fund.


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