Response to Doug Kass's 'Bearish Arguments' and 'Nontraditional Headwinds'
Sep 15th 2009 10:20AM
Updated Dec 3rd 2009 2:58PM
"1. Deep cost cuts have been mainstay of corporations over the last few years. Cost cuts are a corporate lifeline (like fiscal stimulus), but both have a defined and limited life. Ultimately, top-line growth is needed"
True and true. Companies finally did what they should do in a recession: they quickly cut costs, slashed inventories, and fired people.
But did they go too far? As now know, GDP growth will be flat to slightly higher next year and towards the last half of this year. Look at the picture below: companies slashed inventory as if, literally, there was no tomorrow. With flat GDP growth, companies simply have to regrow inventories. In order to regrow inventories they have to spend on input costs and they have to rehire at least some of their employees. Business spending will drive topline growth in the beginning of this economic cycle.
"2. Cost cuts (exacerbated by wage deflation) pose an enduring threat to the labor force. The consumer remains the most significant contributor to domestic growth. Unemployment should remain high, exacerbated by many retiring later in life because their nest eggs have been reduced."
As businesses replenish inventories, they will need to do some basic rehiring (unless productivity growth continues at its current 10 percent clip, which is unlikely. My guess is: unemployment will go down ½% per quarter for the four quarters starting Q1 2010.
"3. The consumer entered the current downcycle exposed and levered to the hilt, and net worth (and confidence) has been damaged and will need to be repaired through time and by higher savings and lower consumption. (The consumer is hurting. Last week I met with a midsized bank's lending team. The bank is seeing a big mix change toward rising use of their debit cards (where money is in the bank) at the expense of credit cards (where money is then owed).)"
True. But savings are at a multi-year high right now, which will lead, as it always does, to pent-up demand. Once hiring restarts in 2010 that demand will be released.
"4. The credit aftershock will continue to haunt the economy. The unregulated shadow banking industry is dead, as is the securitization market. All signs indicate that banks will likely remain reluctant to lend to individuals and small businesses. Just try to get a jumbo mortgage today."
Very true. Will banks begin to lend again? At some point, with the steep yield curve they currently have, they will want to start lending again simply to make the enormous profits available to banks in a steep yield curve environment. Particularly if unemployment starts to tick down, which I expect it will by Q1 2010 (although probably not until then).
"5. The effect of the Fed's monetarist experiment and its impact on investing and spending still remain uncertain."
Really? The stock market is 60% higher and it looks like we are out of a global recession.
"6. While the housing market has stabilized, its recovery will be probably remain muted. More important, there are few growth drivers to replace the important role taken by the real estate markets in the prior upturn."
True about the housing market remaining stabilized. But in the short-term the growth drivers will be business spending (see #1 above) and the continuing effects of the stimulus package as $100bb+ of shovel-ready projects begin over the next year. Those projects will have a multiplier effect on the economy, particularly in the housing arena.
"7. Commercial real estate has only begun to enter a cyclical downturn. It might not be as deep as many expect, but it won't provide much of a contribution to growth."
Commercial real estate is a mess BUT it's a much smaller part of the economy than residential real estate. Also, the commercial borrowers that are in trouble will have a much easier time refinancing in this environment than the residential guys did a year ago.
"8. While the public-works component of public policy is a stimulant, the impact might be more muted than is generally recognized. There may be less than meets the eye -- most of the current fiscal policy initiatives represent transfer payments that have a negative multiplier and create work disincentives."
The bulk of the stimulus was in tax benefits and plugging the holes in municipal budgets. This will have long-term effects as local governments plan their next budget cycles and will no longer have those holes to fill. However, the public works component, (throw in energy and you have $150bb+ in the stimulus package) will have a legitimate multiplier effect (as money gets spent in those areas, they will get respent several times as they trickle through the system) that could add significantly to GDP growth. Part of the reason I'm not in favor of a second stimulus package is that if the economy was meant to already recover on its own, as it appears to be doing, the first stimulus package might severely overstimulate the economy, leading to inflation.
"9. Municipalities have historically provided economic stability during times of economic weakness -- no more. They are broadly in disrepair. State sales taxes are being raised all over the country, and so are sin taxes (to shore up municipal finances) on cigarettes, booze and maybe even sugar products."
True again. BUT, I'm encouraged by Wilbur Ross taking a significant stake in municipal bond insurer Assured Guarantee (NYSE: AGO). Ross helps run investment giant, Invesco, which manages the assets of $300bb worth of state and local pension funds. If anyone is likely to know the state of municipal finances its Ross. Hence, it means something when his largest investment of late is a municipal bond insurer. Clearly he thinks the local governments are in good shape. I own AGO.
"10. The most important nontraditional headwind is the inevitability of higher marginal tax rates. How will higher individual tax rates affect an already deflated consumer? How will corporations react to higher tax rates? Will rising taxes be P/E multiple benders?"
Yes, this is THE headwind I'd be most worried about. But higher taxes aren't a fait accompli yet. Lets see what happens.