The Long Run Quarterly Letter: April 2010
"The areas of consensus shift unbelievably fast; the bubbles of certainty are constantly exploding."
-Rem Koolhaas
In our last Long Run, we pointed out that consensus opinion at the beginning of last year saw stocks falling across the board – dragged down by a broken global financial system. And yet investors enjoyed extraordinary results in 2009. We noted also that the consensus view at the beginning of this year had shifted to an expectation of strong continuing gains in global equity markets for 2010 – an abrupt turnaround and, to us, cause for concern. Now, as we enter the second quarter of 2010, the drumbeat of good economic news and the piercing of 11,000 on the Dow have created an atmosphere among economists and market watchers that can only be described as giddy. Analysts are extrapolating the powerful, stimulus-induced GDP growth from late 2009 out over this year and next, and starched Wall Street economists have resorted to the unrestrained use of exclamation points.
Without a doubt, the current news is very good. GDP growth is stronger than expected, manufacturing has come back to life, and – perhaps most importantly – the United States saw job growth in March. Second quarter earnings numbers are likely to be very, very impressive against last year's comparisons. But such strength may actually bring us to a critical inflection point more rapidly than most observers expect. We have said for some time that job growth in the U.S. would be the critical arbiter in determining the timing of interest rate tightening by the market and the Fed. Six months ago, when economists estimated that we would not see job growth until the end of 2010, the ten-year U.S. Treasury yield hovered below 3.4%. The Monday after the March jobs report was announced, the ten-year U.S. Treasury note yield broke above 4%.
Of course, a return to normalized interest rate and credit policies will be a necessary and healthy part of any lasting economic recovery. We cannot dine forever on stimulus and accommodative policy. The historically steep yield curve must flatten when the recovery begins to look sustained. And borrowers must, once again, pay for the privilege of borrowing. Belt tightening has already begun in other parts of the world. China has reigned in credit in fear of overheating, India initiated rate hikes last month to dampen advancing inflation, and Australia just pushed through its fifth rate increase in the last six months. As the door is opened for interest rates to rise and for government stimulus to be drawn back, investors must recognize that, going forward, growth is likely to face headwinds. This suggests that we are most probably heading into a period of growth moderation rather than a period of growth acceleration.
Whenever economic policies begin to shift around the globe, we become wary of the potential for dislocation – even (or perhaps especially) in areas where investor conviction is the most assured. Over the last decade, emerging market investments have become hard-coded into endowment and pension investment strategies and into the investment policies of individual investors. Consensus has built on the certainty that emerging market economies will sustain their extraordinary GDP growth and that direct investments into emerging market securities will continue to provide outsized returns. This has led to extraordinary money flows through multiple pipes, including direct investments, ETFs, private equity and credit facilities. In 1995, allocations to emerging markets in endowment and foundation portfolios ranged from zero in most cases to perhaps 5% in the most progressively managed accounts. Today, base allocations are significantly higher. Yale's current target for emerging market investments is 10%. Harvard's (not to be outdone) is 11%. And, according to a Pyramis Pulse Poll, which surveyed 109 of the largest endowments and foundations in the U.S. at the end of 2009, 42% planned to strategically increase allocations further into emerging market equities. The dominant majority of flows into public equity mutual funds in 2010 have been into emerging market funds.
After such an historic movement of capital into one asset class, is now really the time to advance investments into emerging markets? While we have long believed that the growth of the middle class in emerging economies will drive significant demand growth for decades to come, we remain suspicious of less mature securities markets and of the general lack of transparency in these markets. Shifts in speculative money flows have historically had a powerful impact on emerging market investments – for better and for worse. After the last speculative push into emerging markets in the late eighties, investors paid a brutal price. In the 1990s, though GDP doubled in China, Chinese securities returned only 0.18% annually for the decade – a negative real return.
Recent insights into the character of GDP growth in China suggest caution. We discussed our concern that the extraordinary expansion of credit in China was creating unsustainable asset price inflation in our Long Run of last October. In a recent white paper published by GMO, Edward Chancellor (author of the excellent book, Devil Take the Hindmost: A History of Financial Speculation) argues effectively that "China today exhibits many of the characteristics of great speculative manias." Among other concerns (including rising labor and energy costs), Chancellor points toward government-mandated GDP growth targets reminiscent of the unsustainable revenue growth targets that drove terrible decision-making during the tech boom in this country. To maintain GDP growth at 8% or better, China is expanding capital investments even at a time of modest capacity utilization, developing massive wind farms that are not tethered to any electric grid and building enormous ghost cities that sit empty – with apartments owned by speculators and not occupants. China is spending more and more for ever-decreasing advances in GDP. Such inefficiencies have led to market busts in Asia before. For those who would look to China's enormous reserves as an impenetrable defense, Chancellor points out that only two other countries have previously amassed such large foreign reserves in relation to global GDP: The United States in 1929 and Japan in 1989.
So we begin to question whether we are facing a "bubble of certainty" surrounding China and whether the dominant macro investment themes of the last decade – a broad dependence on vibrant emerging market GDP growth and expanded commitments to investments in industrial commodities – will succeed over the next decade. Expecting an extended period of deleveraging and moderating global growth ahead, we turn our attention to innovation once again as the critical driver of earnings expansion – uncovering opportunities in areas of dynamic change that include technology mobility and cloud computing, agriculture and water, carbon efficiency and personalized medicine.
We also remain focused on investments in assets that can adjust to changing conditions and continue to progress in even the harshest market conditions. The ability of a company to consistently raise its dividend is an important indicator of a company's financial health. Between 1926 and 2008, studies have shown that dividends represented approximately 33% of the total return delivered by the S&P 500. The fourth quarter of 2008 and the first quarter of 2009 were the two worst periods for dividend reductions in the history of the S&P 500. Nearly 16% of S&P 500 members cut or eliminated their dividends in 2009. We found a much different situation when examining the dividend growth rate of Reynders, McVeigh Capital Management's 25 largest holdings. There were no dividend cuts among this group. In fact, 15 of the 21 dividend-paying companies in this group increased their dividends during 2009. Over the past two years, the S&P 500 saw dividends fall by 20.9% while the payout for RMCM's top 25 holdings increased by 18.5% &.
With policy shifts on the near horizon and unchecked consensus creating investment "certainties" in many popular corners of the global market, we continue to seek a path of stable, sustainable growth away from the stimulus-fed stampede.
