Technology Indices and Creative Destruction – When Might the Bubble Burst?

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Macro Letter – No 33 – 10-04-2015

Technology Indices and Creative Destruction – When Might the Bubble Burst?

  • Publically traded technology stocks trade on modest multiples compared to 2000
  • Private sector overinvestment may, however, be cause for concern
  • European technology companies have outperformed US this year – it may not last
  • Technology and growth stocks remain highly correlated to the major indices

I adhere to the belief that technology and other such improvements in manufacturing are the key to delivering productivity growth, which thereby improves the quality of life for the greatest number. Of course, as Joseph Schumpeter so incisively illustrated, the process is often cathartic. For the technology investor this increases both the risk and potential reward.

Technology is affects all industries. In an attempt to be more specific, here is a table taken from a February 2015 report by Brookings – America’s Advanced Industries:-

Americas Advance Industries - Brookings

Source: Brookings

The report goes on to describe the scale and importance of these industries to the US economy:-

As of 2013, the nation’s 50 advanced industries employed 12.3 million U.S. workers. That amounts to about 9 percent of total U.S. employment. And yet, even with this modest employment base, U.S. advanced industries produce $2.7 trillion in value added annually—17 percent of all U.S. gross domestic product (GDP). That is more than any other sector, including healthcare, finance, or real estate.

At the same time, the sector employs 80 percent of the nation’s engineers; performs 90 percent of private-sector R&D; generates approximately 85 percent of all U.S. patents; and accounts for 60 percent of U.S. exports. Advanced industries also support unusually extensive supply chains and other forms of ancillary economic activity. On a per worker basis, advanced industries purchase $236,000 in goods and services from other businesses annually, compared with $67,000 in purchasing by other industries. This spending sustains and creates more jobs. In fact, 2.2 jobs are created domestically for every new advanced industry job—0.8 locally and 1.4 outside of the region. This means that in addition to the 12.3 million workers employed by advanced industries, another 27.1 million U.S. workers owe their jobs to economic activity supported by advanced industries. Directly and indirectly, then, the sector supports almost 39 million jobs—nearly one-fourth of all U.S. employment.

…From 1980 to 2013 advanced industries expanded at a rate of 5.4 percent annually—30 percent faster than the economy as a whole. 

…Workers in advanced industries are extraordinarily productive and generate some $210,000 in annual value added per worker compared with $101,000, on average, outside advanced industries. Because of this, advanced industries compensate their workers handsomely and, in contrast to the rest of the economy, wages are rising sharply. In 2013, the average advanced industries worker earned $90,000 in total compensation, nearly twice as much as the average worker outside of the sector. Over time, absolute earnings in advanced industries grew by 63 percent from 1975 to 2013, after adjusting for inflation. This compares with 17 percent gains outside the sector. Even workers with lower levels of education can earn salaries in advanced industries that far exceed their peers in other industries. In this regard, the sector is in fact accessible: More than half of the sector’s workers possess less than a bachelor’s degree.

The report is not an unalloyed paean of praise, however, they go on to emphasise the need for better education and training in order to maintain momentum.

The last great technology stock collapse was seen in the aftermath of the “Dotcom” bubble which burst in 2001:-

dot-com-bubble

Source: Kampas Research

During the early part of the last decade the growth in valuation of the technology sector returned to its long-term trend. Since 2008, however, central bank policies have changed the valuation paradigm for all stocks by reducing interest rates towards the zero-bound. Their quantitative easing policies (QE) have flattening government bond yield curves to unprecedented levels, especially given the absolute level of rates. Nonetheless, many of the signs of a bubble have begun to emerge as this December 2014 article from the Economist – Frothy.com – explains:-

In December 15 years ago the dotcom crash was a few weeks away. Veterans of that fiasco may notice some familiar warning signs this festive season. Bankers and lawyers are being priced out of office space in downtown San Francisco; all of the space in eight tower blocks being built has been taken by technology firms. In 2013 around a fifth of graduates from America’s leading MBA schools joined tech firms, almost double the share that struck Faustian pacts with investment banks. Janet Yellen, the head of the Federal Reserve, has warned that social-media firms are overvalued—and has been largely ignored, just as her predecessor Alan Greenspan was when he urged caution in 1999.

Good corporate governance is, once again, for wimps. Shares in Alibaba, a Chinese internet giant that listed in New York in September using a Byzantine legal structure, have risen by 58%. Executives at startups, such as Uber, a taxi-hailing service, exhibit a mighty hubris.

…Instead, today’s financial excess is hidden partly out of sight in two areas: inside big tech firms such as Amazon and Google, which are spending epic sums on warehouses, offices, people, machinery and buying other firms; and on the booming private markets where venture capital (VC) outfits and others trade stakes in young technology firms.

Take the spending boom by the big, listed tech firms first. It is exemplified by Facebook, which said in October that its operating costs would rise in 2015 by 55-75%, far ahead of its expected sales growth. Forget lean outfits run by skinny entrepreneurs: Silicon Valley’s icons are now among the world’s biggest, flabbiest investors. Together, Apple, Amazon, Facebook, Google and Twitter invested $66 billion in the past 12 months. This figure includes capital spending, research and development, fixed assets acquired with leases and cash used for acquisitions (see chart 1).

Tech spend - Economist

Source: The Economist, Bloomberg

That is eight times what they invested in 2009. It is double the amount invested by the VC industry. If you exclude Apple, investments ate up most of the cashflow the firms generated. Together these five tech firms now invest more than any single company in the world: more than such energy Leviathans as Gazprom, PetroChina and Exxon, which each invest about $40 billion-50 billion a year. The five firms together own $60 billion of property and equipment, almost as much as General Electric. They employ just over 300,000 people. Google says it is determined to keep “investing ahead of the curve”.

…The second area of technology froth is in private markets. Their exuberance was demonstrated on December 4th when Uber closed a $1.2 billion private funding round that valued the five-year old firm at $40 billion. Baidu, China’s biggest search engine, is set to buy a stake, too (see page 101). There are 48 American VC-backed firms worth $1 billion or more, compared with ten at the height of the dotcom bubble, according to VentureSource, a research outfit. In October a software firm called Slack was valued at $1.1 billion, a year after being founded. 2014 looks set to be the biggest year for VC investments since 2000 (see chart 2).

VC in US - Economist

Source: The Economist

Whilst this investment boom has centred around the giants of the technology industry and venture capitalists in the private sector, few large scale scientific research facilities have been developed without government grants or subsidies as this December 2014 FRBSF Economic Letter – Innovation and Incentives: Evidence from Biotech – makes abundantly clear:-

The adoption of biotech subsidies raises the number of star scientists in a state by 15% relative to that state’s pre-adoption number of stars. We find a similar effect from the adoption of R&D credits. These findings are important because of the role star scientists play on the local development and survival of U.S. biotech clusters. In addition, we find that most of the increase in the number of stars is due to their relocation to states that adopt incentives. Meanwhile, subsidies have only a limited effect on the productivity, measured by patenting, of incumbent scientists already in the state. We also find that the increase in star scientists happening after a state adopts a biotech incentive is entirely due to an increase in private/for-profit sector scientists, with no detectable increase in academic scientists.

The authors’ conclusions, however, are qualified:-

We found that, after states adopted incentives, they experienced significant increases in the number of star scientists, the total number of biotech workers, and the number of establishments, but limited effects on salaries and patents. We also uncovered significant spillover effects from biotech incentives to employment in other sectors that provide services in the local economy such as retail and construction.

In terms of policy implications, it is important to keep in mind that our finding that biotech subsidies are successful at attracting star scientists and at raising local biotech employment do not necessarily imply that the subsidies are economically justified. The economic benefits to a state of providing these incentives must be weighed against their fiscal costs—for instance, the loss of tax revenues and resulting loss of public services. Our research suggests that state incentives are successful at increasing the number of jobs inside the state. Nevertheless, our results do not suggest that the social benefit—either for that state or for the nation as a whole—is larger than the cost to taxpayers, nor that incentives for innovation are the most effective way to increase jobs in a state.

Government incentives may appear benign, but, as Michael Dell put it, in a November 2014 Op Ed for the Wall Street Journal – Going Private Is Paying Off for Dell:-

Yet we find ourselves in a world increasingly afflicted with myopia-governments that can’t see beyond the next election, an education system that can’t see beyond the next round of standardized tests, and public financial markets that can’t see beyond the next trade. This was what Dell faced as a public company. Shareholders increasingly demanded short-term results to drive returns; innovation and investment too often suffered as a result. Shareholder and customer interests decoupled.

My personal preference is for a free-market approach, despite the risk of underinvestment in the most capital intensive areas of research.

Valuation?

The valuation of growth stocks has always been fraught with uncertainty, especially when future cashflows are often deferred by several years and earnings forecasts, subject to significant variance. An even greater difficulty, as the chart above makes clear, is to assess, and hopefully anticipate, the herd behaviour of technology investors.

The chart below shows the differential performance of the STOXX Europe 600 Technology Index (FX8.Z) the global IXN Technology ETF and the Nasdaq Composite:-

Stox Tech Euro 600 Nasdaq IXN Global Tech ETF

Source: Yahoo Finance

The European dalliance with technology investment was shorter lived than in the US. So was the violence of the subsequent bust. The market had still not cleared by 2008 and achieved new lows for the decade. The subsequent recovery has been muted. The IXN appears to be roughly halfway between the two extremes. US investor perception of technology seems to be substantially rosier than that of the European investor.

The six month chart reveals a rather different picture. Since the equity market correction last November, European technology has out-performed both the US and other technology stocks globally:-

Tech stocks 6 months

Source: Yahoo Finance

Looks can be deceptive. This move has been broader based than simply the European technology sector. Led by Germany, most Eurozone stock markets have traded higher. This has largely coincided with the QE actions of the ECB and the steady weakening in the value of the Euro that this policy has abetted. The Euro Effective Exchange Rate has fallen from 100 to 90 over the same period.

Research carried out by LinkedIn sheds a unique perspective on global trends in technology industries. Their analysis focussed on migrating workers, identifying which countries and cities were net beneficiaries. This July 2014 article from Bruegal – Fact of the week: Not one European city in the top 10 for tech talenttakes up the story:-

In terms of skills uniquely identified in movers, Math, Science, Technology and Engineering seem to play a particularly important role. In terms of industries, movers are found to work mostly in media and entertainment; professional services; oil and energy; government, education and non-profit but most importantly, technology-software.

…Five out of ten cities attracting people with tech skills (especially IT infrastructure and system managements; Java development and web programming) are located in India, including the first four of the list. San Francisco only comes fifth, followed by two other US cities and two Australian.

No European city at all makes it to the list. For the 52 cities looked at in the study, the median percentage of new residents with tech skills was 16%, or just under 1 in 6; in many of the Indian cities, its more than double that figure. European cities are the real laggards: the percentage of new residents with tech skills was 18% in Berlin, 15% in Paris, 13% in Madrid and 11% in Paris.

The trend obviously mirror the Indian ongoing technology boom, in a still rather “virgin” environment. Kunal Bahl – founder of Snapdeal, a wannabe Indian Amazon – told USA Today in 2011 that India offers huge opportunity “because there are no mature companies, like Google and Microsoft, over there. The feeling is like in the U.S. in 1999.”

But there may be more to that.. Research by Vivek Wadhwa (Stanford) revealed that half of Silicon Valley start-ups were launched by immigrants, many of them educated in US top universities. But he also noticed that “for the first time, immigrants have better opportunities outside the U.S.” because, among other things, of rather strict immigration laws and California’s steep cost of living. Bahl himself, who studied in the US and spent some time working at Microsoft, reportedly wanted to initiate his company in the US but eventually went back to India because of visa problems.

And this is also why the tech industry – at the (by now almost) desperate search for engineers – is supporting the introduction of specific “start-up visa” for high-skilled workers in the US. The insights provided by this data is particularly important in the context of the recent discussions on the US immigration reform, but it is not without implications for Europe, which is at the bottom of the ranking as far as attracting tech talent is concerned.

This research suggests that the recent outperformance of the European technology sector may be short lived, yet, another article from November of last year by Bruegal – Brain drain, gain, or circulation? – indicates a somewhat more optimistic outcome for parts of Europe, specifically the UK and Spain:-

Quality of Scientists - OECD

Source: Bruegal, OECD

This chart benchmarks the median quality of scientists leaving or moving (for the first time) to a country between 1996-2011. The size of the bubble corresponds to total flows (inflows plus outflows). Countries in red are net contributors to the international market for scientists, those in blue net recipients.

Ideally, a country should want to be below or on the 45-degree line, indicating that the quality of the newcomers is just as high (or higher) as that of the leavers. Conditional on this, a country should also prefer a larger rather than smaller bubble, representing a sizeable flow of scientists and indicating a full exploitation of synergies gained from international cooperation. Finally, countries should aim to land in the top-right quadrant, indicating higher quality of both incoming and outgoing researchers. 

Over the long-term (pre-crisis) period analysed, Spain and the UK seemed the best placed at attracting high-quality scientists. France and Germany were broadly breaking even in terms of quality, although we note that they were facing significant net outflows of scientists, as was the UK.

All in all, in the sample here presented, while the US (unsurprisingly) comes out as the top performer in terms of net inflow of quality researchers, Italy ranks quite poorly. Not only the country is a net contributor of scientists, it also trades high quality researchers for lower quality ones. Time for a reform of the university system?

The EU Commission is seeking to address the deficiencies of innovation policy within its borders. At a Bruegal event last January in a speech entitled – The New European Research Agenda – Commissioner Moedas – outlined plans to improve the environment for innovation:-

First, create the framework conditions for a more productive exchange of research results, fundamental science and innovation. Things like:

Screen the regulatory framework in key sectors in order to remove bottlenecks

Accelerate the implementation of standardisation

Promote the public procurement of innovation and innovation in the public sector

Promote a venture capital culture

Reduce bureaucracy in science and innovation systems

Second, is to consolidate fundamental research as the flagship for Europe. As the essential foundation for a knowledge-based society. Working towards a single, open market for knowledge though open science.

Third: implement Horizon 2020 and the new Investment Plan to leverage the Europe economy towards a higher plane as a research and innovation-based area. Working towards a single, open market for knowledge though open science. It is better to focus on our potential than to dwell on illusions. We will always be different from other parts of the world. But that difference has many benefits!

These are stirring words, but in the EU turning words into deeds takes time. In unfettered, free-markets, resources are allocated more efficiently. Nonetheless, hope remains.

In terms of absolute valuation, US technology bulls point to the relatively undemanding PE ratio of the Nasdaq – around 24 times, vs 175 times during the zenith of the Dotcom frenzy. On the other hand, commentators such as Dent Research point to a flat-lining phase of the 45 year innovation cycle – this phase commenced around 2010 and will last until around 2032:-

It shows how clusters of powerful technologies increase productivity and move mainstream for about 22.5 years, like what we saw from 1988 into 2010.

Now we’re in the doldrums of this cycle and won’t move into the next upward swing again until after 2032. In short, the productivity revolution is over for the next two decades or so. That means less earnings and wage gains, regardless of demographic trends.

Interestingly, Dent then go on to wax lyrical about the potential for Bio-tech. In technology even the bears tend to be bullish about something.

We need to read Robert Gordon – Is US economic growth over? Faltering innovation confronts the six headwinds, to find a real bear. His CEPR paper was published in 2012 but these are ideas he has been developing for more than a decade. The premise is that the economic growth of the last 250 years is the exception rather than the rule:-

The ideas developed here are unorthodox yet worth pondering. They are applied only in the context of the US, because the worldwide frontier of productivity and the standard of living have been carved out by the US since the late 19th century. If growth of the US productivity frontier slows down, other nations may move ahead, or the slowing frontier could reduce the opportunities for future growth by all nations as the pace of productivity growth in the US fades out…

… The paper suggests that it is useful to think of the innovative process as a series of discrete inventions followed by incremental improvements which ultimately tap the full potential of the initial invention. For the first two industrial revolutions, the incremental follow-up process lasted at least 100 years. For the more recent IR3, the follow-up process was much faster. Taking the inventions and their follow up improvements together, many of these processes could happen only once. Notable examples are speed of travel, temperature of interior space, and urbanisation itself.

The benefits of ongoing innovation on the standard of living will not stop and will continue, albeit at a slower pace than in the past. But future growth will be held back from the potential fruits of innovation by six “headwinds” buffeting the US economy, some of which are shared in common with other countries and others are uniquely American. Future growth in real GDP per capita will be slower than in any extended period since the late 19th century, and growth in real consumption per capita for the bottom 99% of the income distribution will be even slower than that.

Gordon goes on to identify six headwinds buffeting the US economy – slowing the pace of GDP growth:-

  1. The disappearance of the demographic dividend
  2. Educational attainment
  3. Rising income inequality
  4. Outsourcing (especially due to technological development)
  5. Environmental constraints on energy pollution
  6. Combined household and government debt

These are important impediments to growth but I believe not all of them are as clear cut as Gordon suggests.

Firstly, the demographic dividend may be in decline but technology has made it easier for people to work until much later in life. Added to which, a more flexible labour market encourages greater participation. I wonder whether the decline in labour force participation is to some extent due to the improvement in welfare provision and not just a deficit of permanent “quality” jobs?

Despite the concerns of Gordon and Bruegal, education is in the process of being revolutionised by new technologies. Mass Open Online Courses (MOOCs) are but one aspect of this sea-change. The cost of providing education – which has risen inexorably over the last 50 years – could be reversed. Of course Gordon has cause for concern about educational achievement. Whilst technology will allow “the horse to be led to water” it is another matter “making it drink”. The Economist – Wealth without workers, workers without wealth – from October 2014, discusses this issue in the broader context of new technologies disruption of labour markets globally:-

The modern digital revolution—with its hallmarks of computer power, connectivity and data ubiquity—has brought iPhones and the internet, not crowded tenements and cholera. But, as our special report explains, it is disrupting and dividing the world of work on a scale not seen for more than a century. Vast wealth is being created without many workers; and for all but an elite few, work no longer guarantees a rising income.

Income inequality is a popular economic theme and Gordon pays tribute to Emmanuel Saez – though not Thomas Piketty who has become its popular champion. From my interpretation of Piketty’s book, I believe that income inequality is a natural outcome of the long term benefits of peace. Reducing government intervention in the functioning of free markets is a better solution to this structural problem. Smaller government will not remove inequality but it will increase economic mobility, and, in the process, create faster economic prosperity – thereby more rapidly improving the standard of living for the greatest number of people. In freer markets, the technology entrepreneur, and creative risk takers in general, have a greater incentive to embrace opportunities.

Outsourcing is not new, David Riccardo observed its effects long ago. As rich countries adapt to concentrate on their comparative advantages – hopefully undistorted by government subsidy and protective tariff – the short-term headwind of lost domestic labour will be offset by the lower cost to the consumer of outsourced services. A greater proportion of a consumer’s income will then become available for investment. Once the investment has been allocated, the increased pool of available labour can then be retrained for employment in more productive enterprises. Frederic Bastiat – That Which is Seen and That Which is Not Seen makes this point much more eloquently than I could hope to do.

At the global level, man’s capacity to pollute his environment has not diminished but developing countries are less able to afford the luxury of conscience. Our best hope is technology. Yet technological discovery occurs by evolutionary leaps rather than steady increment. The lag between discovery and commercial application can also be long and variable. The collapse in the price of photovoltaic cells, making solar power dramatically more viable as an alternative to fossil fuel, is but one example. The tantalising potential of the development of tidal energy generation is another – especially given man’s predilection to inhabit the margins of the sea. Carbon sequestration technology – at present uneconomic – might be the next technological “leap”. I remain an optimist about man’s ingenuity. Since the Economist first published its Commodity Index in 1864 the price of commodities has been falling by roughly 1% per annum in inflation adjusted terms – punctuated by sharp price increases normally associated with war. Peace leads to investment and, as new technologies are adopted, prices begin to march lower once more.

This leaves Gordon’s concern about debt. Now, debt is a problem. It can be overcome, but the solution to excessive debt is not more debt. Deleveraging can be achieved by steady reduction or sudden default. Sadly, history favours the latter approach – I wonder whether Polonius’s advice to Laertes today would have been:-

Always a borrower never a lender be,

For loan oft loses both itself and bank,

And borrowing sure as hell beats husbandry.

Last September – Deleveraging, What Deleveraging? The 16th Geneva Report on the World Economy – discussed this global issue in detail:-

Contrary to widely held beliefs, the world has not yet begun to delever. Global debt-to-GDP is still growing, breaking new highs. Figure 1 shows the evolution of total debt (excluding the financial sector) for our global sample (advanced economies plus major emerging market economies). While there was a pause during 2008-09, the rise of the global debt-GDP ratio recommenced in 2010-2011.  Data in the report also show that debt-type external financing (leverage) continues to dominate equity-type financing (stock market capitalisation)

Global Debt to GDP

Source: CEPR

Perhaps surprisingly, the authors advise central banks to be cautious about interest rate increases in this environment:-

In such a context, and with still very high leverage, allowing the real rate to rise above its natural level would risk killing the recovery. Beyond pushing the economy into a prolonged period of stagnation, this would also put at risk the deleveraging process which is already very challenging.

Although there is a lot of uncertainty about such predictions, our call is for caution on interest rate rises. The case for caution in pre-emptively raising interest rates is reinforced by the weakness of inflationary pressures.

…The policy requirements for successful exit from a leverage trap are much broader than the appropriate conduct of monetary policy. The report addresses the fiscal challenges, the scope for macro-prudential policies and the restructuring of private-sector (bank, household, corporate) debt and sovereign debt.

The report also argues that – given the risks and costs associated with excessive leverage – more needs to be done to improve the resilience of macro-financial frameworks to debt shocks and to discourage excessive debt accumulation. Finally, we advocate enhanced international policy cooperation in addressing excessive global leverage.

I keep hearing the immortal words of Stan Laurel:-

Well, here’s another nice mess you’ve gotten me into.

Signs of fatigue

With all markets, I begin my analysis with technical patterns. This is a form of self-preservation; to paraphrase Keynes, I may be right in my fundamental analysis but the market is never wrong. On this basis I see no compelling reason to exit the technology sector, although there is a case to be made for rotation out of the Nasdaq and into technology stocks in Europe. I make the caveat, however, that European stocks have inherently less liquidity than US stocks and are therefore likely to exhibit greater volatility, especially on the downside.

The second stage of my analysis is to look at the change in the makeup of tech indexes. The constituents of the Nasdaq are a case in point. The table below shows the top 10 stocks by market capitalisation in 2000 and 2015:-

2000 2015
Microsoft MSFT Apple AAPL
Cisco CSCO Google GOOG
Intel INTC Microsoft MSFT
Oracle ORCL Facebook FB
Sun Microsystems JAVA Amazon.com AMZN
Dell Computer DELL Intel INTC
MCI WorldCom MCWEQ Gilead Sciences GILD
Chartered Semiconductor CHRT Cisco CSCO
Qualcomm QCOM Comcast CMCSA
Yahoo! YHOO Amgen AMGN

Source: Nasdaq

Several of the names have changed, added to which, many of today’s valuations, as measured by P/E ratios, are far less demanding – although Amazon (AMZN) at more than 700 times earnings, remains a notable exception. Looked at from another perspective, the technology promise of 2000 has delivered – today’s top tech companies are delivering real earnings. To understand whether the undemanding multiples are a harbinger of a period of “ex-growth” to come or represent an undervalued opportunity, we need to examine each individual stock in detail. This is beyond the macroeconomic analysis of this report, but one “macro” factor worth considering is the question of debt versus equity finance.

Equity versus Debt

At the risk of making a sweeping generalisation, technology companies are more likely to finance their projects via equity than debt – although established, large cap, technology companies make ample use of the capital markets. Technology projects often require long-lead times to deliver positive cashflows and the value created is invariably intellectual rather than physical. An Oil company with proven reserves may have to wrestle with the volatility in the price of crude oil, but it can mortgage those “reserves” – they have a fairly predictable future demand. Technology companies must endure the vicissitudes of disruptive innovation. Todays “must have” products can rapidly become tomorrow’s museum “curiosities”. To this extent, technology firms are better placed to weather a cycle of increasing interest rates because they carry less debt.

Here lies a dilemma. In the absence of the interest rate on debt to signal the riskiness of an investment, the availability of equity finance becomes critical. As the IPO market has become more active, venture capitalists have been pouring money into earlier and earlier investment opportunities to avoid having to pay too high a price for private equity – I’ve heard the phase “pre,pre-seed” which smacks of a lack of discrimination. Access to equity investment should be a signal about the validity of a project – in the current “overinvestment” environment, the informational value of this “signal” is dramatically diminishing.

Conclusions and Investment Opportunities

The current technology boom is very different from the dotcom bubble of 2000. The top companies in the sector have real earnings and trade at less demanding PE multiples. There are still early stage companies which have no cashflows but these are the much less prevalent today. At the risk of stating the obvious, look for companies with low debt to equity ratios, since these will weather the storm of rising interest rates more comfortably. Look for companies with growing earnings and, where possible, growing dividends. Keep a close watch on the price trend of the stock and have a stop-loss level in mind at which you will exit to preserve capital, regardless of your own opinions. Set a price target if you wish but remember that markets are prone to irrationality – I tend to let the “trend be my friend”.

For the present, technology stocks look set to continue rising, but it is important to remember that the correlation between equity indices tend to be high – The Nasdaq and the S&P500 have a one month correlation of more than 90%. Interest Rates may stay low for a protracted period, but the risk is asymmetric – not far to fall, a long way to rise – and conventional wisdom, which advocates investment in stocks because they are negatively correlated to bonds, may be severely tested as central bank interest rates normalise globally. For more on this topic the November 2013 paper from Pimco – The Stock-Bond Correlation is well worth investigation.

A final caveat concerning technology stocks. Most of the constituents of tech indices are growth stocks and therefore tend to have higher betas than the underlying index. This is a simple measure of their volatility – replete with Gaussian assumptions of “normality”. When constructing your investment strategy, keep the absolute level of volatility in mind, albeit is a measure of variance rather than risk. If this is a technology bubble, make allowance for it and you will weather its tempests, underestimate it and you will be forced to capitulate; the bull market isn’t over yet and the broader market will determine the timing of its demise.

German resurgence – Which asset? Stocks, Bunds or Real Estate

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Macro Letter – No 32 – 20-03-2015

German resurgence – Which asset? Stocks, Bunds or Real Estate

  • German domestic consumption is driving GDP growth as wages rise
  • The effect of a weaker Euro has yet to be seen in exports
  • Lower energy prices are beginning to boost corporate margins
  • Bund yields are now negative out to seven years

Last month Eurostat released German GDP data for Q 2014 at +0.7%, this was well above consensus forecasts of +0.3% and heralded a surge in the DAX stock index. For the year German growth was +1.6% this compares favourably to France which managed an anaemic +0.4% for the same period. German growth forecasts are being, feverishly, revised higher. Here is the latest data as polled by the BDA – revisions are highlighted in bold:-

Institution Survey Date 2015 Previous 2015 2016
ifo ifo Institute (Munich) Dec-14 N/A 1.5  
IfW Kiel Institute Mar-15 1.7 1.8 2
HWWI Hamburg Institute Mar-15 1.3 1.9 1.7
RWI Rheinisch-Westf. Institute (Essen) Dec-14 N/A 1.5  
IWH Institute (Halle) Dec-14 N/A 1.3 1.6
DIW German Institute (Berlin) Dec-14 N/A 1.4 1.7
IMK Macroeconomic Policy Institute (Düsseldorf) Dec-14 N/A 1.6  
Research Institutes Joint Economic Forecast Autumn 2014 Oct-14 N/A 1.2  
Council of experts Annual Report 2014/2015 Nov-14 N/A 1  
Federal Government Annual Economic Report 2015 Jan-15 1.3 1.5  
Bundesbank Forecast (Frankfurt) Dec-14 N/A 1 1.6
IW Köln IW Forecast Sep-14 N/A 1.5  
DIHK German Chambers of Industry and Commerce (Berlin) Feb-15 N/A 0.8 1.3
OECD Nov-14 N/A 1.1 1.8
EU Commission Feb-15 1.1 1.5 2
IMF Oct-14 N/A 1.5 1.8

 

Source: Confederation of German Employers’ Associations (BDA), Survey Date: March 13, 2015

The improvement in German growth has been principally due to increases in construction spending, machinery orders and, more significantly, domestic consumption, which rose 0.8% for the second successive quarter. This, rather than a resurgence in export growth, due to the decline in the Euro, appears to be the essence of the recovery. That the Euro has continued to fall, thanks to ECB QE and political uncertainty surrounding Greece, has yet to show up in the export data:-

germany-exports 2008-2015

Source: Trading Economics

German imports have also remained stable:-

germany-imports 2008-2015

Source: Trading Economics

This may seem surprising given the extent of the fall in the price of crude oil – it made new lows this week. German Natural Gas prices, which had been moderately elevated to around $10.4/btu during the autumn have fallen to $9.29/btu, a level last seen in early 2011. That the improved energy input has not shown up in the terms of trade data may be explained by the fact that crude oil and natural gas imports account for only 10% of total German imports. Nonetheless, I suspect the benevolent impact of lower energy prices is being delayed by the effects of long-term energy contracts running off. Watch for the February PPI data due out this morning (forecast -1.9% y/y).

The ZEW Institute – Indicator of Economic Sentiment – released on Tuesday, showed a fifth consecutive increase, hitting the highest level since February 2014 at 54.8 – the forecast, however, was a somewhat higher 58.2. This is an extract from their press release:-

“Economic sentiment in Germany remains at a high level. In particular, the continuing positive development of the domestic economy confirms the expectations of the experts. At the same time, limited progress is being made with regard to solving the Ukraine conflict and the sovereign debt crisis in Greece. This has a dampening effect on sentiment,” says ZEW President Professor Clemens Fuest. The assessment of the current situation in Germany has improved notably. Increasing by 9.6 points, the index now stands at 55.1 points.

The good news is not entirely unalloyed (pardon the pun) IG Metall – the German metal workers union which sets the benchmark for other union negotiations – achieved a +3.4% wage increase for their 800,000 members in Baden Württemberg, starting next month. Meanwhile, German CPI came in at 0.09% in February after falling -0.4% in January. This real-wage increase is an indication of the tightness of the broader labour market. Nationally wages are rising at a more modest 1.3%, this is, however, the highest in 20 years. German unemployment fell to 4.8% in January, the lowest in 33years, despite the introduction of a minimum wage of Eur8.50/hour, for the first time, on 1st January.

One of my other concerns for Germany is the declining trend of productivity growth. Whilst employment has been growing, the pace of productivity growth has not. This 2013 paper from Allianz – Low Productivity Growth in Germany examines the issue in detail, here is the abstract:-

Since the labor market reforms implemented in the first half of the last decade, Germany’s labor market has been on a marked upward trend. In 2012, there were 2.6 million (+6.8%) more people in work than in 2005 and the volume of labor was up by 2.4 million hours (+4.3%) on 2005. But the focus on this economic success, which has also earned Germany a great deal of recognition on the international stage, makes it easy to overlook the fact that productivity growth in the German economy has continued to slacken. Whereas the increase in labor productivity per person in work was still averaging 1.0% a year between 1995 and 2005, the average annual increase in the period between 2005 and 2012 was only 0.5%. The slowdown in the pace of labor productivity growth, measured per hour worked, is even more pronounced. The average growth rate of 1.6% between 1995 and 2005 had slipped back to 0.9% between 2005 and 2012.

Allianz go on to make an important observation about the importance of capital investment:-

…the capital factor is now making much less of a contribution to economic growth in Germany than in the past, thus also putting a damper on labor productivity growth.

… Since the bulk of the labor market reforms came into force – in 2005 – the German economy has been growing at an average rate of 1.5% a year. Based on the growth accounting process, the capital stock delivered a growth contribution of 0.4 percentage points, with the volume of labor also contributing 0.4 percentage points. This means that total factor productivity contribute 0.7 percentage points to growth. So if the volume of labor and capital stock were to stagnate, Germany could only expect to achieve economic growth to the tune of 0.7% a year.

Although gross domestic product also grew by 1.5% on average during that period, labor productivity growth came in at 2.0%, more than twice as high as the growth rate for the 2005 – 2012 period. Between 1992 and 2001, the contribution to growth made by the capital stock, namely 0.9 percentage points, was much greater than that made in the period from 2005 to 2012; by contrast, the growth contribution delivered by the volume of labor was actually negative in the former period, at -0.4 percentage points, and 0.8 percentage points lower than between 2005 and 2012. This could allow us to draw the conclusion that the labor market reforms boosted economic growth by 0.8 percentage points a year. Although there is no doubt that this conclusion is something of a simplification, the sheer extent of the difference supports the theory that the labor market reforms had a marked positive impact on growth. In the period between 1992 and 2001, total factor productivity contributed 1.0 percentage points to growth, 0.3 percentage points more than between 2005 and 2012. This tends to suggest that the growth contribution delivered by technical progress is slightly on the wane.

The finding that the weaker productivity growth in Germany is due, to a considerable extent, to the insufficient expansion of the capital stock and, consequently, to excessive restraint in terms of investment activity, suggests that there is a widespread cause, and one that is not specific to Germany, that is putting a stranglehold on the German productivity trend.

The hope remains, however, that especially Germany – a country that has managed to get to grips with the crisis fairly well in an international comparison – will be able to return to more dynamic investment activity as soon as possible.  

The issue of under-investment is not unique to Germany and is, I believe, a by-product of quantitative easing. Interest rates are at negative real levels in a number of countries. This encourages equity investment but, simultaneously, discourages companies from investing for fear that demand for their products will decline once interest rates normalise. Instead, corporates increase dividends and buy back their own stock. European dividends grew 12.3% in 2014 although German dividend growth slowed – perhaps another sign of a return to capital investment.

German Bunds

Bunds made new highs again last week. The 10 year yield reached 19 bp. Currently, Bunds up to seven years to maturity are trading at negative yields. These were the prices on Wednesday after then 10 year Bund auction:-

Maturity Yield
1-Year -0.18
2-Year -0.225
3-Year -0.202
4-Year -0.173
5-Year -0.099
6-Year -0.065
7-Year -0.025
8-Year 0.053
9-Year 0.127
10Y 0.212
15-Year 0.38
20-Year 0.519
30-Year 0.626

 

Source: Investing.com

Wednesday’s 10 year auction came in at 0.25% with a cover ratio of 2.4 times, demand is still strong. The five year Bobl auction, held on 25th February, came with a negative 0.08% yield for the first time. Negative yields are becoming common-place but their implications are not clearly understood as this article from Bruegal – The below-zero lower bound explains – the emphasis is mine):-

The negative yields observed on some government and corporate bonds, as well as the recent move into further negative territory of monetary policy rates, are shaking our understanding of the ZLB constraint.

Matthew Yglesias writes… Interest rates on a range of debt — mostly government bonds from countries like Denmark, Switzerland, and Germany but also corporate bonds from Nestlé and, briefly, Shell — have gone negative.

Evan Soltas writes… economists had believed that it was effectively impossible for nominal interest rates to fall below zero. Hence the idea of the “zero lower bound.” Well, so much for that theory. Interest rates are going negative all around the world. And not by small amounts, either. $1.9 trillion dollars of European debt now carries negative nominal yields,

Gavyn Davies writes… the Swiss and Danish central banks are testing where the effective lower bound on interest rates really lies. Denmark and Switzerland are clearly both special cases, because they have been subject to enormous upward pressure on their exchange rates. However, if they prove that central banks can force short term interest rates deep into negative territory, this would challenge the almost universal belief among economists that interest rates are subject to a ZLB.

JP Koning writes that there are a number of carrying costs on cash holdings, including storage fees, insurance, handling, and transportation costs. This means that a central bank can safely reduce interest rates a few dozen basis points below zero before flight into cash begins. The lower bound isn’t a zero bound, but a -0.5% bound (or thereabouts).

Evan Soltas writes that if people aren’t converting deposits to currency, one explanation is that it’s just expensive to carry or to store any significant amount of it… How much is that convenience worth? It seems like a hard question, but we have a decent proxy for that: credit card fees, counting both those to merchants and to cardholders… The data here suggest a conservative estimate is 2 percent annually.

Barclays writes… Coincidentally, the ECB has calculated that the social welfare value of transactions is 2.3%.

Brad Delong writes…In the late 19th century, the German economist Silvio Gesell argued for a tax on holding money. He was concerned that during times of financial stress, people hoard money rather than lend it.

Whilst none of these authors definitively tell us how negative is too negative, it is clear that negative rates may have substantially further to go. The only real deterrent is the negative cost of carry, which is likely to make price fluctuations more volatile.

German Stocks

Traditionally Germany was the preserve of the bond investor. Stocks have become increasingly popular with younger investors and those who need yield. Corporate bonds used to be an alternative but even these issues are heading towards a zero yield. I have argued for many years that a well-run company, whilst limited by liability, may be less likely to default or reschedule their debt than a profligate government. Even today, corporates offer a higher yield – the only major concern for an investor is the liquidity of the secondary market.

Nonetheless, with corporate yields fast converging on government bonds, stocks become the “least worst” liquid investment, since they should be supported at the zero-bound – I assume companies will not start charging investors to hold their shares. Putting it in finance terms; whereas we have been inclined to think of stocks as “growth” perpetuities, at the “less-than-zero-bound”, even a “non-growth” perpetuity looks good when compared to the negative yield on dated debt. We certainly live in interesting, or perhaps I should say “uninteresting” times.

A different case for investing in stocks is the potential restructuring risk inherent throughout the Eurozone (EZ). Michael Pettis – When do we decide that Europe must restructure much of its debt? Is illuminating on this issue:-

It is hard to watch the Greek drama unfold without a sense of foreboding. If it is possible for the Greek economy partially to revive in spite of its tremendous debt burden, with a lot of hard work and even more good luck we can posit scenarios that don’t involve a painful social and political breakdown, but I am pretty convinced that the Greek balance sheet itself makes growth all but impossible for many more years.

while German institutions and policymakers are as responsible as those in peripheral Europe for the debt crisis, in fact it was German and peripheral European workers who ultimately bear the cost of the distortions, and it will be German households who will pay to clean up German banks as, one after another, the debts of peripheral European countries are explicitly or implicitly written down.

In many countries in Europe there is tremendous uncertainty about how debt is going to be resolved. This uncertainty has an economic cost, and the cost only grows over time. But because most policymakers stubbornly refuse to consider what seems to have become obvious to most Europeans, there is a very good chance that Europe is going to repeat the history of most debt crises.

For now I would argue that the biggest constraint to the EU’s survival is debt. Economists are notoriously inept at understanding how balance sheets function in a dynamic system, and it is precisely for this reason that we haven’t put the resolution of the European debt crisis at the center of the debate. But Europe will not grow, the reforms will not “work”, and unemployment will not drop until the costs of the excessive debt burdens are addressed.

If Pettis is even half-right, the restructuring of non-performing EZ debt will be a dislocating process during which EZ government bond yields will vacillate wildly. If the German government ends up footing the bill for the lion’s share of Greek debt, rather than letting its banking system default, then stocks might become an accidental “safe-haven” but I think it more likely that rising Bund yields will precipitate a decline in German stocks.

Here is how the DAX Index has reacted to the heady cocktail of ECB QE, a falling Euro and a deferral of the Greek dilemma:-

DAX Jan 1998 - March 2015 Monthly

Source: Barchart.com

The DAX has more than doubled since the dark days of 2011 when the ECB saved the day with rhetoric rather than real accommodation. From a technical perspective we might have another 1,500 points to climb even from these ethereal heights – I am taking the double top of 2000 and 2007 together with the 2003 low and extrapolating a similar width of channel to the upside – around 13,500. The speed of the rally is cause for concern, however, since earnings have yet to catch up with expectations, but, as I pointed out earlier, there are non-standard reasons why the market may be inhaling ether. The current PE Ratio is 21.5 times and the recent rally has made the market look expensive relative to forward earning. At 13,500 the PE will be close to 24.5 times. This chart book from Dr Ed Yardeni makes an excellent case for caution. This is a subscriber service if you wish to sign up for a free trial.

The domestic nature of the economic resurgence is exemplified most clearly by the chart below which shows the five year performance of the DAX Index versus the mid-cap MDAX Index, I believe it is time for the large cap stocks to benefit from the external windfalls of a weaker Euro and lower energy prices:-

DAX vs MDAX 2000-2015

Source: Finanzen.net

Real Estate

In Germany, Real Estate investment is different. Government policy has been to keep housing affordable and supply is therefore plentiful. This article from Inside Housing – German Lessons elaborates:-

Do you fancy a one-bed apartment in Berlin for £35,000 or a four- bed detached house in the Rhineland for £51,000?

In many parts of Germany house prices are a fraction of their UK equivalents – in fact, German house prices have decreased in real terms by 10 percent over the past thirty years, whereas UK house prices have increased by a staggering 233 percent in real terms over the same period. Yet German salaries are equal to or higher than ours. As a consequence Germans have more cash to spend on consumer goods and a higher standard of living, and they save twice as much as us, which means more capital for industry and commerce. Is it any surprise that the German economy is consistently out-performing ours?

There are a number of reasons for the disparity between the German and UK housing markets. Firstly, German home ownership is just over 40 percent compared to our 65 percent (there are stark regional variations – in Berlin 90 percent of all homes are privately rented) and the Germans do not worship ownership in the way we do. Not only is it more difficult to get mortgage finance (20 percent deposits are a typical requirement) but the private rented sector offers high quality, secure, affordable and plentiful accommodation so there are fewer incentives to buy. You can rent an 85 square metre property for less than £500 per month in Berlin or for around £360 per month in Leipzig. There is also tight rent control and unlimited contracts are common, so that tenants, if they give notice, can stay put for the long-term. Deposits must be repaid with interest on moving out.

In addition, Germany’s tax regime is not very favourable for property owners. There is a property transfer tax and an annual land tax. But the German housebuilding industry is also more diverse than ours with more prefabraction and more self-builders. The German constitution includes an explicit “right-to-build’’ clause, so that owners can build on their property or land without permission so long as it conforms with local codes.

But the biggest advantage of the German system is that they actively encourage new housing supply and release about twice as much land for housing as we do. German local authorities receive grants based on an accurate assessment of residents, so there is an incentive to develop new homes. The Cologne Institute for Economic Research calculated that in 2010 there were 50 hectares of new housing development land per 100,000 population in Germany but only 15 hectares in the UK. That means the Germans are building three times as many new homes as us pro-rata even though our population growth is greater than theirs. This means that German housing supply is elastic and can respond quickly to rising demand…

 

German rental protection laws – for the renter – are stronger than in other countries – this encourages renting rather than buying. From an investment perspective this makes owning German Real Estate a much more “bond like” proposition. With wages finally rising and economic prospects brightening, Real Estate is a viable alternative to fixed income. The table below was last updated in May 2014, at that time 10 yr Bunds were yielding around 1.5%:-

Apartment Location Cost Monthly Rent Yield
Berlin
45 sq. m. 108,225 500 5.55%
75 sq. m. 230,025 779 4.07%
120 sq. m. 489,360 1,362 3.34%
200 sq. m. 935,200 2,442 3.13%
Frankfurt
45 sq. m. 164,385 788 5.75%
75 sq. m. 308,025 1,182 4.60%
120 sq. m. 538,560 1,750 3.90%
200 sq. m. n.a. 3,066 n.a.
Munich
45 sq. m. 218,160 773 4.25%
75 sq. m. 463,275 1,172 3.00%
120 sq. m. 774,120 2,066 3.20%
200 sq. m. 1,850,000 3,562 2.31%

Source: Global Property Guide Definitions: Data FAQ

For comparison, commercial office space in these three locations also offers a viable yield: –

Office Location   Yield  
  2013 2012 2011
Berlin 4.7 4.8 4.95
Frankfurt 4.65 4.75 4.9
Munich 4.4 4.6 4.75

Source: BNP Paribas

I believe longer term investors are fairly compensated for the relative illiquidity of German Real Estate.

The Euro

For the international investor, buying Euro denominated assets exposes one to the risk of a continued decline in the value of the currency. The Euro Effective Exchange Rate is still near the middle of its long-term range, as the chart below illustrates, though since this chart ends in Q4 2014 the Euro has weakened to around 90:-

Euro_Effective_Excahnge_Rate_-_ECB_1993_-_2015

Source: ECB

Investors must expect further Euro weakness whilst markets obsess about the departure of Greece from the EZ, however, a “Grexit” or a resolution (aka restructuring/forgiveness) of Greek debt will allow the markets to clear.

Conclusion and Investment Opportunities

German Bunds continue to be the safe-haven asset of choice for the EZ, however, for the longer term investor they offer negligible or negative returns. German Real Estate, both residential and commercial, looks attractive from a yield perspective, but take care to factor in the useful life of buildings, since capital gains are unlikely.

This leaves German equities. A secular shift from bond to equity investment has been occurring due to the low level of interest rates, this has, to some extent, countered the demographic forces of an aging German population. Nonetheless, on a P/E ratio of 21.5 times, the DAX Index is becoming expensive – the S&P 500 Index is trading around 20 times.

At the current level I feel it is late to “arrive at the party” but on a correction to test the break-out around 10,000 the DAX looks attractive, I expect upward revisions to earnings forecasts to reflect the weakness of the Euro and the lower price of energy.