Monday Morning Musings: An International Perspective
Analyst: Tobias M. Levkovich
SALOMON SMITH BARNEY Industry Note
Institutional Equity Strategy Monday Morning Musings: An International Perspective
May 31, 2002 SUMMARY * Foreign investors are fretting about the dollar, Tobias M. Levkovich supposedly higher cost of capital and inflation as well as the typical issues of valuation, earnings, etc. * Inflation has not been a margin/earnings driver for more than a decade * The cost of capital for most companies remains lower today than five years ago * Wage growth is still under control and cyclical recovery should boost returns * Positive 2Q02 pre-announcements are just about even with negative ones in a dramatic shift from prior quarters * Focus on tech continues to distort the much more positive economic and earnings picture that we see emerging * Hence, we maintain our positive equity stance and reiterate that a weaker dollar could hurt bonds OPINION
Having been both across the Atlantic and Pacific Oceans visiting with investors over the past six weeks, we have listened to many of the U.S. equity market worries that international members of the investment community appear to be focused on. Some have been very much in sync with the various issues that U.S. investors cite, including earnings prospects, valuation and interest rates, but a few have their own international spin and add to the "Cliff of Concern" that must be scaled for upside appreciation potential. In particular and not surprisingly, overseas investors fret markedly more about the U.S. dollar given its impact on translating back investment returns into local currencies.
Investors seemed very anxious about future corporate returns on investment in what was perceived as a higher capital cost environment going forward than was the case over the past number of years. Indeed, many seemed to wonder how we can have the same set of positive factors we enjoyed over the past two decades such as the fall of Communism and a return to U.S. budget surpluses as well as disinflation and the impressive benefits of productivity enhancement. The backdrop, it is argued, cannot be as good when we look towards the future.
In addition, there is some feeling (although mainly below the surface) that "imperialistic" America is on a new downward slope as was the case with the various European colonial powers of the past two centuries and Japan after its impressive growth in the 1970s and 1980s. Indeed, many view the U.S. position as sole global superpower having transformed that has become a form of unilateral player as seen via policy initiatives on security (such as the war on terrorism and the axis of evil) and trade (agricultural subsidies and steel tariffs). While this may not be the view of domestic investors, many international investors feel that the resultant U.S. economic trends (and related investment returns) could be quite disappointing in the coming decade, since obvious "big picture" demand drivers are not as easily found.
Interestingly, foreign investors worry about higher inflation despite the knowledge that the previous inflation catalyst (energy shocks) has less impact currently, plus the lower labor cost resources of other regions (such as China) do not seem to be exhausted. Nonetheless, there is fear that an overly aggressive Fed might have utilized all of its bullets fighting the terror repercussions. Moreover, there is a seeming realization that any higher interest rates now might restrain consumer and corporate spending given the heavier burden of debt outstanding. As a result of the need to maintain such an accommodative monetary policy, inflation should evolve, in their opinion. In a strange way, we have listened to other investors bemoan the lack of inflation (or pricing power) in that real economic and nominal economic growth now are much closer (due to the very low inflation rates). Accordingly, nominal earnings growth naturally should diminish, being more in line with GDP- like expansion, since weak pricing power arguably should restrain margin expansion.
While we cannot address every issue out there in the investment milieu, we can look at a few of these issues and bridge the gap between investor assumptions and fact. As one can see from Figure 1 below, the notion that inflation is good for margins may have been very true in the 1970s and 1980s, but that concept seems to have fallen apart in the 1990s. In fact, we can easily understand that much of the margin expansion seems tied to labor cost increases becoming much more controllable and a long expansion that allowed production to continue rising thereby absorbing fixed overhead expense. Plus, the growth of the service sector may have provided some impetus as well.
Figure 1: (Figures can be seen in PDF format)
Source: DRI and Salomon Smith Barney
As can be determined from Figure 2, per unit labor costs, in general, have backed away from the meaningful wage increases of the late 1970s and 1980s. As a reminder, labor costs (direct and indirect) are the largest component of overall corporate cost. Thus, controlling wages and compensation tends to generate very tangible results.
Figure 2: (Figures can be seen in PDF format)
Source: SSB Economic & Market Analysis
At the same time, a long economic expansion, experienced in the 1990s, provided the basis for continued industrial production growth and allowed for fixed overhead cost absorption as evidenced by capacity utilization (Figure 3), such that earnings maintained their upward path. In addition, outsourcing to lower cost centers (Mexico, the Far East and former Soviet satellite states) has helped stem wage inflation pressures.
Figure 3: (Figures can be seen in PDF format)
Source: DRI and Salomon Smith Barney
Most fascinating to us is the perception that the exhilarating returns on capital seen in the past decade (Figure 4) cannot be repeated (and allegedly neither can stock price gains) since the cost of capital was so low over the past 10 years.
Figure 4: (Figures can be seen in PDF format)
Source: DRI, FactSet and SSB
In order to truly measure the cost of capital, we looked at both the inverted market P/E and the interest rates associated with investment grade debt over the past 20 years and found that it has come down markedly (Figure 5), but it is also not materially higher now than it was five years ago; thus, the nominal cost of capital has not necessarily increased as many contend. Indeed, as we delved into the market P/E further, we found that the tech sector's inverted P/E (Figure 6) did generate much lower cost of capital that was only available to this select area, such that dot.coms, the ILECs and telecom equipment startups. Indeed, there arguably may have been negative equity risk premiums for these companies given the $257 billion of venture capital "free equity" that was raised in the 1997-2000 time period. Thus, attributing the bubble to the overall economy's cost of capital seems fairly nonsensical to us and is not backed up by the aggregate data.
Figure 5: (Figures can be seen in PDF format)
Source: DRI and Salomon Smith Barney
Figure 6: (Figures can be seen in PDF format)
Source: FactSet and Salomon Smith Barney
In this context, we stand pretty firm in our view that continued wage restraint, global sourcing, better corporate hiring intentions (seen in the recent Manpower survey) and rising industrial production should all contribute to higher earnings. In addition, a weaker trade-weighted dollar should add to earnings prospects as foreign-sourced income translates into more dollar earnings and local industry is more competitive. The downside of a weaker dollar is potential imported inflation which would impact bonds much worse than stocks since Treasuries do not benefit from earnings growth as do stocks -- as a reminder, since 1915, stocks gave climbed 36 years in which interest rates were rising vs. the 22 years in which stocks appreciated when rates were headed lower. Thus, we consider heavy allocations to bonds as being a fairly offensive posture in a declining dollar environment rather than a defensive stance given stock market worries. Furthermore, as can be seen in Figure 7, foreign investors own more than twice as much in U.S. bonds as they do in stocks; thus capital flight is more likely to come out of bonds. Note that given a current account deficit above $450 billion requires major foreign investment inflows that might require higher rates to entice buyers; in this context, bond prices should fall but stock prices could still rise. Indeed, the above discussion outlining continued negative investor sentiment towards U.S. equities when the data is less than supportive indicates that equities should do well as earnings bounce back.
Figure 7: (Figures can be seen in PDF format)
Source: DRI and Salomon Smith Barney
Our view of better earnings seems to be sustained by the NIPA data, but also via the ratio of 4:1 companies within the S&P 500 that beat 1Q02 ES expectations, not to mention the positive 2Q02 earnings pre-announcement trends that further underscore the shift in profits. As can be seen in First Call data (outlined in Figure 8), the negative pre-announcement warnings vs. positive pre-announcements ratio has waned markedly and is almost even in 2Q02, suggesting that Street estimates are getting much more in line with actual trends and the earnings disappointment issue is fading rapidly. But, the investment community remains preoccupied by cycle-lagging commentary from the likes of Sun Microsystems and Nortel Networks, rather than listening to Lowe's and Borg Warner. Such perception/reality gaps provide informed investors with opportunities, in our opinion, and therefore we remain bullish on the U.S, equity markets. We do not expect a return to the 25%-plus annual gains of the late 1990s, but we think high single digits over the next five years is quite plausible, led by greater strength this year as earnings rebound, negative sentiment reverses and short sellers cover their positions. Hence, 1300-1350 on the S&P 500 is not an outlandish expectation, given that we experienced two 20%-plus rallies in the last 18 months (April/May 2001 and October/November 2001) and they occurred simply on expectations rather than evident earnings.
Figure 8: (Figures can be seen in PDF format) |
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