Fear not Federal Reserve tapering, lackluster U.S. earnings, oncoming deflation or markets heading into bubble territory, says Francois Trahan. Our economic and market growth will be fueled by structural changes driven by rebalancing in China. Don’t be surprised to see a repeat of 2013’s U.S. equity market performance, according to Trahan, who offered a script for countering clients’ unfounded fears over what might go wrong.
Trahan leads portfolio strategy efforts at Cornerstone Macro, a New York-based economic-consulting firm. He is an economist by training, and he is widely praised for his differentiated insights into the dynamics of the markets and his unique understanding of the business cycle. In 2013, Trahan was voted to Institutional Investor magazine’s All-American Research Team as the #1 portfolio strategist and has been selected as #1 for seven of the past nine years.
At a January 14th meeting of the Boston Security Analysts Society (BSAS) on the challenges and opportunities for investors in 2014, Trahan told advisors how to address client pushback. He provided a compelling explanation for continued price-to-earnings ratio expansion, structural changes and macroeconomic forces that will dampen U.S. inflation and other risks that might quell clients’ optimism.
How inflation rates drives P/Es
Trahan said that the chartered financial analyst curriculum is primarily focused on accounting and earnings and lacks a good explanation for the movement in P/E ratios. Companies focus on earnings and don’t talk about P/Es. As a result, he concludes that investors do not know enough about P/Es.
Trahan notes that last year the S&P 500 began with a forward P/E of 13 and is currently at 15. “As long as inflation is moving lower, we are going to see multiples notch higher,” he said. He expects P/Es to increase to 18 and potentially beyond. In explaining the relationship between expanding P/Es and low inflation rates, he said it is very important to distinguish the differences between the Consumer Price Index (CPI) core versus food and energy rates. “When the Fed talks about inflation, they are really talking about the core inflation,” which includes shelter and other consumption but excludes food and energy, he said. In contrast, he explains that what is generally referred to as the U.S. inflation rate, or headline CPI, combines the CPI core with food and energy. Food and energy are commodities and represent only 24% of headline CPI by weight, but they have a large influence due to their volatility. Therefore the beta of the CPI food and energy component is very high at 5.37. In contrast, the CPI shelter and non-shelter components, representing the remaining 76% of headline CPI, are not very volatile. Each of these components has a beta that is less than 1. Trahan concludes that the US inflation rate is driven by the food and energy component due to its high beta relative to the other components of CPI.
Trahan noted that the U.S. economy “is not like other economies [because] it responds a lot to a change in inflation.” Last year’s decline in core inflation led to a rise in “almost every single leading indicator.” In the absence of wage inflation and credit growth in the US, “commodities have the ability to create or destroy discretionary income.” When commodity prices go up, consumers will pay more for necessities like food and energy. “Additional consumer spending will be reflected in stocks in the form of earnings, and leading indicators will go up,” he said. That will increase P/E ratios, he said, along with fueling strong and stable economic growth and fewer credit delinquencies and bankruptcies.
A strong dollar and China’s rebalancing will lead to higher P/Es
Trahan believes P/Es can move higher if the current core consumption rate can move higher. Consumption is 72% of U.S. GDP. He said that the two greatest influences that will drive it higher would be the strength of the U.S. dollar and the rebalancing of China’s economy. The deceleration of Chinese growth has resulted in and will continue to drive commodity prices lower. Trahan explains that the Fed uses a trade-weighted dollar index, which was up 3.5% last year over 2012. A strong dollar resulted in higher core consumer spending in 2013 than in 2012, and he believes this will continue.
Interest rates are rising in China. Trahan feels this is a “problem, because 48% of China’s GDP comes from investments, and investment is fueled by credit.” This is the cyclical phenomenon in China. Rising interest rates could lead to a slower economy and lower commodity prices. This tightening in China could lead to “easing of conditions in the U.S., because it translates into lower inflation or more money in all of our pockets,” Trahan said.
Trahan outlined underlying structural changes that furthered his thesis. In the late 1990s, China decided that its economic model was going to be based on investments. That has worked until 2103. Last year was the first year that it tried to boost investments by cutting the reserve requirements “and nothing happened,” Trahan said. His interpretation was that “they’ve simply over-built” and they are now left with excess capacity.
Rising interest rates in China combined with its slowing economy will translate into better economic conditions and lower inflation in the U.S., Trahan said. It could lead to a “deflationary boom” over the next decade in the U.S. China’s problems are America’s opportunities, and “the outlook for the U.S. economy is phenomenal,” he said.
Structural changes in China
The Chinese model is unprecedented. No other economy has anywhere near 48% of its GDP based on investments. India is second with 35%, and the US is at 15%. But the Chinese model is broken, and monetary stimulus can no longer fuel growth. Capacity utilization is at an all-time low, as its current excess capacity has produced malls with no stores in them, airports that have not opened and factories that sit empty. There is no multiplier effect in an empty factory.
The Chinese government’s response to this excess capacity has been to rebalance its economy. Trahan referenced a couple of quotes from government officials where they talked about “getting consumption to similar levels seen in the developed world.” This would mean increasing consumption from 34% to 50% while decreasing investment from 48% to 35%. Even if it achieves this change, it will still be the most investment-centric country in the world.
Trahan cautioned that no country has ever successfully transitioned from a high-investment focus to a high-consumption focus. The majority of the current jobs in China are from investments, and he said rebalancing to a more consumer-based economy would fail. The Chinese economy produces 12 jobs for every $1 million in investments and four jobs for every $1 million in consumption.
Trahan sees a parallel to the U.S. economy 50 years ago, when it transitioned from a manufacturing to a service-based economy. Such transitions inevitably lead to a jobless recovery, as it did in the U.S. following the 1990-91 recession. “We’re staring at an enormous structural shift [in China], and we’re at the very beginning of it.,” he said.
“I am not telling you the markets can go up fivefold from here,” he said, but he does think these structural changes in China could lead to similarly sized increases. He concluded that the continued trend in China away from an investment-based to a consumer-based economy would lead to further drops in commodity prices. He noted that commodity prices are at three-year lows.
China’s rebalancing could provide “a perpetual tax cut for consumers” in the U.S. through lower food and energy prices, he said.
A stronger dollar, thanks to China
The second factor that will drive core consumption higher will be the strength of the U.S. dollar. A stronger dollar benefits consumers via lower costs of imported goods.
The dollar is often misunderstood, Trahan said. He compared where we are currently headed to the 1990s, when both the US dollar and P/E ratios rose sustainably. In response to the view that multiples are already too rich, he said, “if you were to look at the latter part of 1990s, you are going to think this looks pretty darn average.” Trahan’s research focuses on the trade-weighted dollar and its relationship to the decelerating investment-based Chinese economy. “When you sum up all of the emerging markets, look at their weights, which are highly influenced by China, and then you throw in commodity sensitive currencies, Australia, Norway, Canada, you come up with two-thirds of the U.S. dollar that in one way or another is tied to the story taking place in China.”
Conclusions
Success stories for currency, sector and country allocations of the last 10 years are going to be the underperformers of the next 10 years, he said. Trahan’s views on the dollar and Chinese rebalancing will result in “nirvana for P/Es in the U.S.” and he believes “P/Es are going to keep going up, and keep surprising people”.
Although Trahan does not consider himself a permabull, he does believe it is “very easy to defend a 20% rise in U.S. equities this year” based on strong earnings and P/Es driven by low inflation.
He favors the U.S. consumer sector in his model, as it does well when inflation is falling. He believes that consumer rehabilitation since the crash of 2008 is almost complete. He also favors consumer discretionary industries such as airlines and regional banks. He also favors “macro-margin plays,” which are U.S.-centric industries that benefit from a stronger dollar and weaker commodity prices. He believes there are opportunities in “every sector, with things like chemicals, paper and packaging and railroads.” Similarly, he supports exiting late-stage cyclical businesses including energy and materials along with exiting foreign-focused industries.
Trahan dispelled the risks to his bullish views. The first risk is that the Chinese economy improves and becomes “too hot,” leading to higher U.S. inflation and lower multiples. He said the “odds of that happening are virtually nil, with rates where they are in China.”
The second risk is that the Chinese economy slows down to less than 5% growth while transitioning from an investment- to a consumer-based economy and sees higher unemployment. If this happens – and Trahan believes it might be three years away if at all – the Chinese option is to “hit the panic button” and devalue their currency and become an export-based economy. This would improve unemployment and create 17 jobs for every $1 million of GDP.
The third risk is that the Japanese government’s stimulus policies could not to be enough to get Japan “out of its hole,” as the country’s level of debt is would make it impossible to have a successful economic recovery. The fourth risk is another European crisis. Although he did not dispel either of these risks, he stressed that the positive effects to the U.S. from China’s rebalancing offset the negative risks from either Japan or Europe.
Trahan affirmed that we are nowhere near a bubble. Household equity ownership is just returning to the mean of 19% since 1945, which is a far cry from the 29% that has historically been bubble territory. He concluded his bullish presentation by returning to the positive effects of lower commodity prices on U.S. inflation. “Remember, we’re talking about food and energy cost here,” he said. “We’re talking about a good kind of deflation, but it's going to be a very different world, and we’re all sitting here watching the first inning.”
Justin Kermond is the vice president of business development for Advisor Perspectives.
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