Warren Buffet famously said during the 1990s dot-com bubble that he did not invest in technology because he did not understand it. Although he subsequently took a meaningful stake in IBM (which may prove his point), we suspect his technological blind spot was in reality his awareness that no matter how much a business might change the world, ridiculous valuations ensure negative returns-on-investment. There is another issue we would bet Buffett understood deeply that kept him away: one cannot make a decent ROI over time by staking a depreciating asset.
In High Cotton we asked will there come a time when we are forced to recognize that borrowing to form capital in the form of deflationary, technologically-led productivity is the macroeconomic equivalent of borrowing to buy a depreciating asset, like a car? We get what we want now, but it is counterproductive if we cannot reinvest our savings at a higher return. This is a big, conceptual topic but one that deserves critical thought and attention from investors.
The easiest way to reduce the concept is to ask yourself whether the success of Amazon and Uber should enhance GDP over time. We argue they will detract from it, but that this is a good thing. Innovation increases productivity. It does not directly increase demand or economic activity. So, if an economy’s economic model is to try to increase output growth by increasing credit (and overall debt levels as a result), then the economy’s growth model is not in sync with how it seeks to form capital. The credit issued and debt assumed may have produced higher contemporaneous GDP through increased investment, consumption and trade, but it did so at the great expense of future nominal revenues, earnings, profit margins, and, ultimately, at the great expense of balance sheet viability.
Much of the capital stock built over the last twenty years has been capital that offers deflationary pricing. Businesses that helped streamline past inefficiencies through innovation grew revenues and employed more labor, for themselves and other businesses that exploited their innovations, but they also reduced the value of labor, which in turn widened wealth and income gaps. We have been left with economies able to economize at a rate that exceeds the natural rate of nominal growth. The debt remains and monetary policy makers have had to step into the breach, manipulating money stocks and markets to keep the whole thing afloat.
Why do policy makers’ econometric models continue to solve for growth? Beats us. One very obvious (albeit unmentioned) rationale might be because all the aggregate debt must be serviced. Nominal growth increases nominal revenues, which in turn makes it easier to service debt today, but far more difficult to repay or reduce it tomorrow. (We do not await such a discussion in next month’s Fed minutes.)
As a result, our economies are caught in a debt-for-debt’s-sake leverage trap where credit is issued and debt assumed merely to tread water. It is like squeezing a water balloon here to make it expand there. Meanwhile, the capital stock is growing in the form of rising capital market prices. Is there a natural conflict? Why would we value equity and credit markets higher if they represent lower future revenues, earnings and profit margins? Perhaps because the market expects all numbers to increase in nominal terms even if businesses shrink in real terms?
Karl Marx was a good thinker. We agree with his view that societies develop based on class struggle, but are unwilling to agree with a socialist prescription, which represses human desire and initiative and sees governments as superior economic arbiters. Capitalism is much more to our liking (and we are saddened that talk of capitalism makes us nostalgic).
We have used the term “financialism” to describe the current economic model endorsed broadly by political economists. Economies do not build wealth when they do not build capital, and capital (as in capital markets) that can only maintain value by becoming more encumbered is not sustainable. It is a mirage. Although economic policy makers can (or think they can) continue this illusion indefinitely, they cannot get around the fact that doing so reduces human desire and initiative. What incentivizes the factors of production to produce when there is no real (inflation-adjusted) wealth to be gained?
Marx argued that capitalism naturally leads to social tensions that ultimately force it to fail as a means of distributing wealth and capital. Juxtapose that view on the social, political and economic environment today. What are the platforms offered by our political elite? How are our economic policy makers proceeding? How do we spend our days? Any objective analysis produces the conclusion that statist ideologies are gaining favor – if not out of design, then certainly out of perceived necessity.
Investors should check their ideologies and personal politics at the door. (For the record, we are registered “unaffiliated”, not Democrat, not Republican, not Independent, not Libertarian.) The fact is, however, that strong and enduring capital markets can only survive in truly capitalist economies, preferably with strong representative governments. With accretive capital formation in question, it occurs to us that the largest global capital markets have become little more than tools for Marx’s “ruling class” – in this case well-funded politicians and their patrons – to socialize the factors of production (so far successfully). We will leave moralizing to others. Whether such a conclusion is good, bad or irrelevant to market performance is the focus of this report.
How that water balloon is squeezed greatly impacts consumption, trade and investment, as well as the flow of funds among equity, fixed-income, FX and commodity markets. Global wealth is finite but it shifts based on collective perceptions of needs, wants and how to measure wealth itself. As long as our capital markets are not producing capital, investors will have to continue playing the equivalent of financial whack-a-mole. Marx argued the game will have to be unplugged one day. As long as global balance sheet remain highly leveraged and irreconcilable in real terms, we see no evidence to the contrary.
There is no doubt that true capital was built in the past as a direct result of excessive credit creation supported by irrational equity valuations. But the cost of that capital formation was steep and was largely borne by investor excitement over whiz bang innovation. Fiber optic cable would never have been laid at the turn of the century without massive balance sheet leveraging and excitement surrounding memories like Webvan.com. Still, fiber bandwidth remains and serves as worthwhile infrastructure.
Contrast that with the nature and distribution of capital formed when a consumer buys an iPhone. A deconstruction of the iPhone 6s Plus by IHS Technology concluded its component costs total about $236 per phone. Tech analyst Horace Dediu further estimated that the labor cost per phone is about $30. This $266 per phone manufacturing cost does not include shipping or warehousing. (The great majority of the phone’s components are manufactured and assembled in China and Taiwan.) Let’s be conservative and assume each phone costs Apple $300. Of that, we assume the great majority of capital created from manufacturing the phone is split among shareholders in Asian component businesses.
Judging by its $750 retail price, there would be about $450 remaining to design the phone (in California), advertise it globally, ship it, and pay mobile phone carriers to retail it. Apple’s free cash flow and retained earnings per phone are not the real point, but rather the process of manufacturing and selling the phone does not seem to spread purchasing power over a broad audience, say, the audience that actually benefits from using the device.
The capital iPhones create is shared by a relative few while its benefits are socialized. Is this a bad thing? This is for each of us to decide, but we do not think it is economic. Apple has the largest market capitalization in the world’s largest equity market. It directly employs about 100,000 people and maybe keeps twice that figure employed around the world. While the market can choose to value businesses anyway they wish, buying a $750 phone on credit destroys current and future wealth among the masses, which, in turn, cannibalizes Apple’s and other business’s future revenues and earnings.
While we all benefit today from capital spending that laid cable twenty years ago, very few of us will benefit in productive terms from Apple’s operations, even if Apple shares are owned broadly in our retirement accounts and pension funds. Maybe capital spending is low and declining today because there is very little capital to be gained from spending? Maybe the cost of capital (interest rates) is zero or negative around the world because capital production is also near zero or negative?