Tomorrow the Fed will be announcing whether they will continue to raise rates or not and many investors seem to think that a pause is a highly probably outcome. Controlling inflation has been the reason for prior rate hikes and I believe it to remain the key variable. With this in mind, I thought that it would be a good idea to share with you the new GaveKal piece by Louis-Vincent Gave.
As my long term readers know, GaveKal produces some thought-provoking and highly intelligent research on the markets from a global perspective. Louis writes about how profit margins, income disparity and global economics are shaping the current inflationary environment. But he does not stop there, Louis further describes how these market forces are all affected by none other than Adam Smith's old "Invisible Hand."
I found this article to be exceptionally interesting, and, given the fact that the Fed is meeting tomorrow, a timely read as well. I think you will find it to be an "Outside of the Box" point of view.
John Mauldin, Editor
Outside the Box
The Invisible Hand's Impressive Work
Last summer, we published a small book entitled Our Brave New World. In the book (copies can be purchased on http://www.amazon.com/exec/obidos/ASIN/9889879018/frontlinethou-20 or www.gavekal.com), we attempted to show that, because of the rapid pace of change our world was experiencing, a number of the relationships which we, and many other economists, had used for decades were badly breaking down. Following the book, and as so often when we publish a "think-piece", clients were very generous with their feedback. We received hundreds of new ideas, which we plan to organize in a follow up book in the near future.
In the meantime, life goes on, and markets continue to throw more questions than we could hope to have answers. Of particular concern lately amongst our clients has been the apparent pick-up in inflation. Another worry has been the sustainability of the high profit margins evident in most developed markets. And interestingly, these concerns bring us right back to some of the notions we developed in Our Brave New World.
We like to think of financial markets as a massive big puzzle whose pieces are scattered around the table. We also like to think that, if we concentrate hard enough and, more importantly, if we listen to our clients (who work in all different parts of the financial markets and usually hold far more experience than we do), then we should be able to somehow piece this puzzle together.
1- The First Piece of the Puzzle: Very Strong Profit Margins
One of the recurrent questions some our smartest clients have asked us recently is whether profit margins were not set to come back down very rapidly? After all, profits as a percentage of GDP have historically always returned to the mean (as they should-otherwise, given the laws of compounding, profits would end up being bigger than GDP).
The answer, as far as we are concerned is "yes". Profit margins as a percentage of GDP should come back down as our economies go through their mid-cycle slowdowns. After all, corporate profits have historically been one of the first variables of adjustments in our economic cycles.
But having said that, the "mean" to which profits revert to may be much higher than some expect. Indeed, while profits as a percentage of GDP cannot rise forever, we might have witnessed a structural shift higher in corporate profitability.
Let us take the US as an example. With ever-growing shareholder activism, and ever-improving management techniques, an increasing number of companies have become parsimonious with their capital spending. Capital is only deployed on projects which are deemed to bring returns over a certain threshold. Functions in which the company does not add value are either shut down, or spun off and sold to other investors better able to generate value. In the US, what matters first is profits and returns on invested capital. Employment then comes as a natural consequence of the companies' profit seeking activities.
Let us now take China as a second example. Thanks to a low cost of capital and a very low cost of labour, companies have sprung up all around the country and piled into new businesses. Because returns on invested capital are a distant consideration, most sectors are in overcapacity; and yet capital spending continues regardless. The country thus has over 300 auto producers, 3000 ball bearing manufacturers... In China, what matters first and foremost is employment; profits are not really even a consideration.
The US and China could of course each live as islands unto themselves (and if Chuck Schumer had his way, that is probably what would happen). But fortunately, the past twenty years have been characterized by ever greater improvements in communication technologies, port infrastructure, airplanes... Encouragingly, trade barriers and impediments to the movements of goods, and people, have been rapidly collapsing (up until recently).
As a result, we live in a world in which China and the US can increasingly talk to each other. And when they do talk, what do they say? China says "all I want is jobs" and the USA says "all I want is profits". And in that discussion a deal can rapidly be struck. Is it a coincidence that, just as we saw a widening of the US current account deficit, we also witnessed an explosion in the profitability of US corporations? Readers of Our Brave New World will hopefully argue "no".
Would it be a stretch to say that the impressive, and unprecedented, growth in US profits of the past few years is directly linked to Chinese companies' inability to hold on to any recurrent profitability? As the trade between the two economic giants keeps on growing, one question that investors should ask themselves is "who captures the profitability of the trade flows?" Is it Wal-Mart (or some other US distributor)? Or is it the Chinese goods manufacturer?
The answer to that question (i.e.: Wal-Mart), brings us back to the idea that profits need to return to the mean. This is undeniably true of a closed economy. But of course, few economies in the World today could be called "closed economies"; instead, companies are increasingly global, and thus their total profits should probably be compared to global GDP, instead of domestic GDP. Or to stay on the Wal-Mart example, maybe Wal-Mart's earnings as a percentage of US GDP are at the top of their band... But could the same be said of Wal-Mart's earnings relative to Chinese and US GDP. Most likely not! In other words, profits probably return to the mean on a global basis; they may no longer return to the mean at a national level?
2- The Second Piece of the Puzzle: Income Disparity
This new world order (in which rich nations get the profits and poor nations get the jobs) immediately creates a quandary: massive income disparity. Indeed, in the "old days", people sitting at the bottom of the socio-economic ladder could get well-paid manufacturing jobs and ensure decent living standards for themselves and their families. The problem today is that, as the US-China trade of "we take the profits and you take the jobs" gets made, the people who were previously holding those jobs could be seen as losing out.
And, to be fair, one of the more obvious economic developments of the past decade has been the increase in income disparity across much of the Western World. The poor have not gotten poorer... but the rich have definitely gotten much wealthier. And for a simple reason; when we say "we will take the profits" the "we" is usually a somewhat concentrated smallish pool of rich people, i.e.: shareholders in Western companies.
This growing income disparity, one could fear, might lead to political problems and tensions. Are our societies sufficiently mature to cope with such income disparities? Some might be (US? Hong Kong? UK?...). Others, maybe less so (France? Italy? Germany?...).
One might fear that governments might try to redress the balance through taxation (i.e.: France's wealth tax) or even outright protectionism (with both of these measures, needless to say, doomed to only ensure that both the rich and the poor get poorer... a bad deal for the rich but a truly calamitous proposition for the poor). One could perhaps wish that governments would try to redress the balance by promoting share-ownership throughout the entire structure of society (i.e.: Australia's super-annuation scheme, or Singapore's MPF plans...), hereby ensuring that even the workers toiling away at the lowest ranks of the economic ladder benefit from the "we take the profits, they take the jobs" trade. But then again, one might simply hope that the governments will step aside and continue to rely on the good services of Adam Smith's invisible hand.
3- The Third Piece of the Puzzle: Discontinuous Inflation
The ever-optimists in us want to believe that, for any given problem, the market, when left alone, will typically find a solution. The good news is that the birth of the platform company model, and the trend whereas Western companies say "we take the profits, you can have the jobs" has been so recent, and yet so powerful at the same time, that most governments have not had a chance to react to it (yet?). The market has been left free to do what it does best: adjust to new realities.
Assuming that we are right in our statement above that "the rich keep on getting richer". Then it follows that whatever the rich buy should be going up in price much more rapidly than what poorer people buy (for there will be more competition for the goods/services that rich people buy). Incidentally, this has been one of the longest running themes of GaveKal Research (Charles first started grumbling in 1999 that "it has never been so expensive to be rich"!).
As Anatole wrote last summer: "At its simplest, therefore, the disagreement over "true" inflation simply reflects people's tendency to focus on prices that are rising and forget about the ones that are going down. But the extent and persistence of the divergence between service and goods prices in the past decade also suggests a less obvious and more important story in three parts.
The first part of this story relates to China's entry into the global economy. By becoming the workshop of the world, China has pushed down the prices of all mass-produced manufactured goods. The virtually limitless supply of cheap labour and capital in China, and the chronic mis-allocations of capital will ensure that manufactured goods continue to get cheaper, not only in Britain but around the world.
But the relentless downward pressure on manufactured prices from China has resulted in a second effect which is less widely understood, even among economists: cheap imports from China have actually pushed up the prices of many goods and services which the Chinese cannot or do not produce - either because they lack the resources (for example, oil) or the legal infrastructure (financial ser vices) or simply because some things cannot be traded (for example, housing, healthcare and education).
People who see China purely as a source of downward pressure on prices forget that overall inflation in any economy is essentially determined by the availability of money. If monetary policy is successfully run (as it is in Britain) to produce an overall inflation rate of 2%, while the prices of manufactured goods are persistently falling by 3 or 4%, prices elsewhere in the economy must rise faster to maintain the 2% average inflation rate.
In this sense the ever-cheaper consumer goods from China have created more leeway for other prices in the world economy to go up. This effect has been particularly visible in the prices of goods and services which the Chinese are ravenously consuming but cannot produce themselves - for example oil, financial services and luxury property around the world.
Which brings us to the third, and most surprising, part of the inflation story. As the prices of financial services and luxury goods are driven persistently higher, service-producing countries such as Britain get richer relative to countries which specialize in manufacturing. And within Britain, the rich, who tend to work in high-end service industries which are relatively unaffected by competition from Asia, get richer, while the poor, who tend to work in industries more exposed to cheap-labour competition, get relatively poorer. For the lucky bankers, lawyers and, yes, even economic analysts, who are benefiting from this seismic change in the structure of the global economy, there is, however, a sting in the tail. While we are getting richer, the high-end services, most obviously housing, travel and private education - on which many of us spend a disproportionate share of our incomes are becoming more expensive, because of the very same global trends which are making us relatively rich.
That is why, even as inflation remains almost nonexistent, the talk in London's bars and restaurants is of galloping prices. As Charles has claimed for years, being rich has never been so expensive. And staying rich is going to get more exorbitant by the day."
Reading the above, our friend David Scott wrote a great report where he stated that "while it has never been so expensive to be rich", it has also "never been so cheap to be poor". And, if we accept the crude simplification that poor people tend to spend more of their revenues on goods (which keep falling in price) while rich people spend more of their income on services (which seem to just keep on rising), then there might be a simple explanation to the impressive discontinuous inflation we have witnessed in recent years and which has baffled us such; the invisible hand is simply doing its work. If the rich people in Western countries are currently capturing an inordinate amount of the World's profits, then those profits are slowly being taken back from them, either through higher service price inflation (see Why It Has Never Been So Expensive to Be Rich), or through higher asset prices (see Art, Wine & Horses).
4- The Fourth Piece of the Puzzle: A Confused & Confusing Fed
If we were in a mood to be self-righteous, we could try to count the number of times that, since he became Fed Chairman, Ben Bernanke "turned his coat" on the topic of future monetary policy tightening. But then again, we might run out of toes; so we won't even try.
Having said that, it is hard not to feel some sympathy for Ben Bernanke. After all, how should policy makers react to the odd inflationary environment which they now confront? As Anatole suggested in Why It Has Never Been So Expensive to Be Rich if policy makers take aim at the galloping service price inflation, they risk pushing the entire system into deflation.
However, given the recent tick higher in the inflation data (see our April 2006 piece, Disturbing Inflation Data), the question needs to be asked as to whether we have moved from an environment of: a) falling goods prices which allowed for rising service prices and an overall benign inflationary environment to b) an environment where the price of goods is no longer falling and service prices are still on the rise?
Now, as Churchill once said, most economists use statistics like drunks use lampposts: for support more than for light. And given that there are so many statistics on inflation one might be able to back-up nearly any kind of pre-conceived idea with scientific sounding data.
Unfortunately for the Fed, however, all the inflation data seems to be pointing in the same way (see Median CPI vs Core CPI): prices are creeping higher. The only question is whether this is a new trend? Or whether the rise in prices we have recently experienced is a short term phenomenon which will roll-over with the economic cycle?
In Our Brave New World we wrote that, until the mid 1990s, we lived in a world of oligopolies. When average costs went up, so did average prices. But as the recent spike in oil, copper, transportation prices has shown, this is simply not the case any more. Thanks to the combination of globalization, industry deregulation, technological progress, the spread of the Internet, and the emergence of the 'platform company model' (which feeds off all the above trends) we are moving towards a world with perfect information and perfect competition. In such a world, prices are made at the margin, and no longer on average.
The perfect examples of such pricing mechanisms can be found in the commodity markets where the information is at the same time available to most, and widely spread. As we all know, commodity prices are far from stable: if there is a shortage of one barrel of oil, the price shoots up; if we have an overcapacity of one barrel, its price collapses. The same can be said of the freight rate for oil tankers, for copper, or for any well published price determined at the margin.
And so today, we are in a situation where a growing number of prices are going up (hence the rise in median CPI) while the "heavy" prices (e.g.: rent) are still in check (explaining why the rise in the core CPI is more modest).
5- The Fifth Piece of the Puzzle: China's Export Prices
In the capitalist world, and barring the emergence of monopolies, competition always leads to the most efficient producer lowering prices in order to drive his output higher. The fall in prices is therefore inherent in capitalism which is why Marx believed capitalism sowed the seeds of its own destruction. A claim to which Bastiat would answer: in economics there is always what you see, and what you don't see. You see the fall in prices, but you do not see the rise in disposable income, or the increase in sales triggered by the falling prices.
This natural capitalist tendency was interrupted by the emergence of the social democrat state, the nationalisation of a wide range of industries, and the Cold War of 1946-90. But it was the prevalent trend between 1820 and 1941, and again between 1990 and 2004. But is it still in effect today?
We believe that it is, if only because important parts of the world are clamouring to join the capitalist world, and in so doing, are using their excess savings (which are often large), to build excessive manufacturing capacity. This, of course, is nowhere more true than in China. A quick example will illustrate this.
As mentioned above, in China today, one can reportedly find over 300 car manufacturers. Unfortunately, the Chinese market is probably big enough for ten car manufacturers. This means that 300 car manufacturing company CEOs wake up every morning and wonder: 'how do I get to be one of the ten survivors?' Being the most profitable is good, being technologically advanced is also a plus, as are political connections, but at the end of the day, one gets to survive by being the biggest; by employing so many people that, when the down phase of the cycle occurs, the government can not afford to fire hundreds of thousands of workers. One becomes 'too big to fail'.
This of course means that, when capital is offered up, all three hundred car manufacturers (following their 'too big to fail' business models) will grab it and spend it with both hands. Competing with each other for: a) raw materials, b) labour and c) allocations on the overstretched power and transportation grids.
In previous cycles, Chinese manufacturers would, in this way, end up with excess capacity that no-one would buy from them at any price. Today, the situation is very different. After the recent Chinese capital-spending boom (Chinese capital spending has grown from 32% of GDP to 45% in the past five years), most Chinese manufacturers now produce goods that are competitive on the international market not only on price, but also on quality.
This is a very important change, whose ramifications help explain China's continuous disinflationary impact. Because of the excess capital spending of recent years, Chinese producers have little choice but to export their overcapacity aggressively (hence the era of the US$5,000 Chinese car... despite rising steel, aluminum, rubber prices...). Chinese goods will attempt to gain market share by undercutting any other producer out there. Which, of course, then explains why goods prices have been under pressure in most economies in the past decade.
With that in mind, measuring China's propensity to export its excess production and put pressure on the prices of "goods" around the World becomes very important. And fortunately, there is a simple way to do this: studying the changes in Hong Kong's re-export prices (blue line on chart next page). Indeed, Hong Kong is still an important port of transit for Chinese-made goods; and the data that the Hong Kong government compiles is trustworthy.
And this is where it gets interesting: according to Hong Kong re-export prices, China's deflationary impact seems to have been the greatest at the end of 2001- beginning of 2002. It then took a little over a year for the world to really start to worry about deflation (and the "China price"). Of course, by that point, the deflation that China was exporting was already abating.
Then, for the first time in a decade, China's export prices started to rise meaningfully in 2004 and 2005. For a short while, China was exporting inflation; but once again, it took a year for the world to notice (and now people everywhere seem as concerned about inflation as they were about deflation three years ago). Today, Chinese re-export prices are back into negative territory. In other words, a year ago, Chinese companies had pricing power (which might help explain the great performance of the Chinese equity market... and even the Japanese equity market - see our January 2006 piece, The Japanese Market Sells Off); but this pricing power has now disappeared. China is back to exporting deflation.
6- Conclusion: The "Invisible Hand" at Work
At the risk of sounding Panglossian, we will admit that we are in awe at how Adam Smith's "invisible hand" works in strange and funny ways. If anyone had told us a decade ago that a "trade" would be put in place whereas China would say "give us all the jobs" and American companies would say "we'll take all the profits" and that this trade would lead to greater wealth, and greater social harmony in both countries, we most likely would have been very skeptical. Of course, we would have been wrong, for we would have forgotten to put our faith in Adam Smith's invisible hand which somehow has a way to make things work out in the end.
One interesting factor about the above developments is that they have occurred so quickly that politicians have not really had a chance yet to interfere with the invisible hand and turn gold into lead. However, listening to the rhetoric currently prevalent in the US Congress, some US politicians (Graham, Schumer...) seem very keen to catch up.
To conclude, we would like to leave the reader with the following points:
- Inflation, at this stage, does not seem to us to be a viable threat. The current increase in prices we are witnessing reflects the past years' easy monetary policies and increases in China's export prices. These factors are now behind us. In front of us, we have the fact that China is once again exporting deflation (a fact which might help explain Japan's weak equity market performance) and the tighter monetary policies of recent quarters.
- In a tighter liquidity environment such as the one we are now facing, owning the guy that says "I'll take all the profits" makes a lot more sense to us than owning the guy that says "I'll take all the jobs".
Before you go, I would like to give an update about a new offering from the GaveKal team. For years they have provided insightful work on global economics and are now seeking to expand their coverage into some new fields through a new medium, The Liberal. The Liberal is a UK magazine that is "committed to the cultivation of liberty in every sphere, at home and abroad." GaveKal intends for the magazine to provide a space in which philosophical, political and economic issues may be discussed in a bold, accessible and wide-ranging manner, offering in-depth analysis and an international perspective.
The magazine will feature contributions from many of GaveKal's friends from around the world as they seek to take more of a back-seat approach to the discussions. Their vision is to restore the meaning of the word "liberal" from its misuse and promote its true meaning of all legitimate freedoms. For more information, click on the following link: www.theliberal.co.uk.
Your waiting to see what the Fed will do analyst,