We are now seven years into both an economic recovery and a bull market. Because the 2008 Great Financial Crisis and the subsequent economic recovery were unlike any other since the Great Depression, it makes sense to look back and see from whence we came and to look forward and try to see whether current trends can be sustained.
For starters, the Great Financial Crisis of 2008 was a balance sheet crisis, not a typical business cycle downswing. The housing bubble that led to the 2008 crisis was a debt-fueled mania and, as such, involved pretty much the entire financial system. Over the preceding two or three decades, banks and other financial institutions significantly increased their leverage and then, during the housing bubble, aggressively piled on loans of the most dubious credit worthiness (i.e., sub-prime). When these loans started to sour – as sub-prime typically does – the very existence of many financial institutions was threatened. If a lender is levered 20:1 and 5% of its loans default, its equity is wiped out and the lender goes bankrupt. Numerous companies either failed or had to be married off in government-sponsored shotgun weddings. The potential for a complete meltdown of the financial system was palpable.
Fortunately, the authorities did step in to rescue key players and pump needed liquidity into the system. The system survived. But in the aftermath of the crisis, a number of things changed. First, banks and other financial institutions were forced to de-lever. This caused banks to restrict credit, thus reducing the velocity of money and neutralizing much of the monetary stimulus the Federal Reserve was using to pump up the economy. Second, the consumer also needed to de-lever. So did businesses. This great de-levering was a major factor in assuring that the post-2008 recovery remained anemic and sluggish by historic standards.
Today, seven years after it began, the de-levering is pretty much complete, but neither consumers nor businesses are rushing to take on more debt, although larger public companies have been borrowing to buy back stock. An air of caution still permeates the economy.
Over the past seven years, businesses have grown profits quite significantly despite the anemic growth in the economy. Early in the recovery, profit margins expanded dramatically as corporations enjoyed the benefits of productivity gains following major post-financial crisis cost-cutting layoffs. They also benefitted from the ability to refinance high-cost debt at ever lower interest rates as monetary stimulus drove rates to historic lows. Today, both the productivity gains and the effect of cheaper financing have run their course, so the big question is whether corporations can sustain their current high profit margins or whether they will see them erode.
For the consumer, conditions are relatively favorable. Employment has grown steadily over the past seven years and the economy is approaching full employment. Fuel costs have dropped, thereby freeing up funds for other purposes. Moreover, wages appear to be rising in more and more industries, so the consumer should be able to sustain and, perhaps, even increase spending levels. We say this knowing full well that labor participation rates are lower than in the past, that many manufacturing jobs are lost forever and that there is a widening gulf between higher paying jobs requiring advanced skills and lower paying jobs requiring little skill. The point is that the consumer’s financial health is improving and this should benefit the economy over time.
Offsetting these favorable trends for consumer spending, however, is the perverse impact of low interest rates. To some extent, instead of stimulating growth, low rates cause consumers to save more, because in a low-interest-rate, low-return environment, one needs more assets (i.e., savings) to generate a given target income level.
Furthermore, the record low level of interest rates has had a similar perverse effect on business spending. Instead of borrowing to invest in new plants and equipment, businesses appear to be borrowing at ultra-low rates to repurchase their stock. Their borrowing costs are often lower than their dividend payouts, so companies can save cash by leveraging up to repurchase shares. This helps the stock market but does nothing to generate growth in the real economy.
Outside the U.S., economic growth appears subdued. China has clearly entered a slow growth phase as it evolves from an export- and infrastructure-driven economy to more of a consumer- and services-driven one. This has had spill-over effects in nearly all industrial commodities and in commodity-dependent economies such as Canada and Brazil. Developed economies such as Japan and Europe are all in slow-growth mode. So relatively speaking, the U.S. economy is looking pretty good. Both consumers and businesses are financially healthy, but neither seems inclined to spend wildly. A new sobriety has taken hold.
In sum, our mantra of slow-growth, low-inflation remains unchanged. While rising wage rates pose some risk to corporate profit margins, they may also lead to higher consumer spending. There is clearly a trend (discussed in previous Outlooks) toward a “winner take all” economic structure in which the dominant company in any industry or niche will enjoy better profits, faster growth and greater dominance than its competitors. This is becoming an increasingly important investment theme that is likely to play out over many years. Additionally, based on our outlook of slow growth, low inflation and low interest rates, we believe the market will continue to reward companies with solid, growing dividends and those that can sustain above-average growth rates independent of macro conditions. As always, we are looking for companies with well-advertised but solvable problems, which, as issues are addressed and recede, will allow those businesses to emerge as successful, growing enterprises able to command higher valuations.
© Osterweis Capital Management