Happy Days Are Here Again? Redux or Fools’ Folly?
It’s appropriate and timely to speculate on the sustainability of all the wonderful U.S. economic news coming out at the end of the second quarter with 4.3 percent GDP growth, including relatively equivalent jumps in the retail sector. In fact, retail stocks have been among 2018’s best performers. Despite the positive numbers, from an ironic timing perspective, the mainstream media has been posting retrospectives on the Great Recession and the collapse of Lehman Brothers 10 years ago. There was an echo in my mind when Jamie Dimon, CEO of JP Morgan Chase, reportedly answered one of his children’s questions during the last recession: “What’s a recession?” His reply was something like, “Oh, it’s something that happens about every 10 years.” So, if the 10-year rule is true as explained by arguably the most powerful and smartest financial executive in the country, we must perk up and put on our thinking caps. If we look at the most recent numbers heading into the third quarter, along with the economic similarities leading up to the 2008 crash, we shouldn’t blithely tap to the tune of “Happy Days are Here Again.”
The hyperbole coming out of the current administration that we’re roaring back to a 4-plus percent growth economy is just that. Hyperbole. Most economists believe that this positive blip is a result of the new tax breaks and a minimal increase in wages, which could quickly be offset by inflation (including a little help from tariffs). They believe the blip will settle back into a 2 to 2.5 percent economy. And since 70 percent of our GDP is consumption, the retail sector will surely be on a parallel growth trajectory. I would like to remind readers that following the 2008 crash, famed economist Lawrence Summers predicted the 2 percent economy would stick for years to come, if not forever. He called it secular stagnation.
Will this 2 to 2.5 percent settling wait until 2019 so our retailers can experience another two quarters of ebullience? Many experts believe the second-quarter “happy days” are sustainable for at least through the end of 2018. Most of the experienced legacy retailers are taking a more cautionary view, having been surprised by the sector’s volatility too many times, particularly during this technology revolution.
The August Reality
For starters, retail growth in August 2018 might be described as a “nothing burger.” The Commerce Department reported a 0.1 percent rise in sales vs. 0.7 percent in July, and it was the smallest gain since January’s sales decline. Department store sales declined 1 percent in August, after a gain of 1.4 percent in July. Furniture and home furnishing retailers’ sales dropped 0.3 percent following a flat July. Apparel and accessory store sales fell 1.7 percent after a 2.2 percent gain in July. Online sales, while continuing to grow, still vastly favor Amazon (comprising almost 50 percent of all online sales), which grew 19.1 percent, following July’s 19 percent. Total online sales dropped from a July gain of 1.5 percent to a 0.7 percent increase in August.
And finally, the pricing “race to the bottom will never go away, even in the face of inflation. In August, apparel prices plunged 1.6 percent from July. While this is only one product category, it provides some context for the rest of this article.
The Rest of the Year?
This slip in apparel prices is an indicator of pricing issues across all categories. Regardless of all the happy days conversation, or any other macro-economic factors, price promoting will last forever across all consumer categories. The reason? All retailers will acknowledge (but avoid talking about it) that they simply can’t control this chronic dynamic.
It’s called the supply-demand imbalance. Again, I’m hammering on this fundamental economic issue as I have for several years, because if you are part of any consumer-facing business and don’t understand it, you’ve been living on another planet. Supply started piling up right after the golden, explosive economic growth in the U.S. between 1950 and 1980. Then as population and demand growth began to slow, supply did not. The imbalance was offset somewhat during the 80s when women entered the work force, lifting household incomes and consumption. But that was a one-off. Then during the 90s and into the early 2000s, demand and consumption was boosted by easy credit. But that too, was a one-off. Through both of these one-off bumps in demand, supply kept racing ahead. And oh … let’s not forget the onward explosion of retail websites adding to overcapacity.
This puts what I’m about to say clearly into context. This continually increasing overcapacity perpetuates the pressure on price promoting as the path of least resistance to growth. And at the end of the day, with no real organic increase in demand, any growth that one entity may achieve has really come out of the hide of other entities. It’s a borrow from Peter to pay Paul scenario., which we all know is not sustainable in the long run.
An Inescapable Rock and a Hard Place
Folks, here’s the real nightmare. Just as you have been forced into the race to the bottom pricing horror, you are also being forced into investing billions of dollars to perfect the so-called omnichannel process with its never-ending stream of technology advancements. How do your margins in this “between a rock and hard place” work for you?
So, what about inflation? Won’t it justify price increases? The logical answer would be, yes. As costs rise, businesses need to pass along those increases along to the consumer. Ha ha! The consumer will say no, because in a way over-supplied economy, they will always find lower prices. Why do we see most of the growth in retail in the off-price sector, including legacy brands like Macy’s and Nordstrom who are expanding their off-price brands? And there are many other off-price brands which are rapidly expanding. And how about the thousands of new dollar stores and robust growth in the outlet store sector? Customers recognize that Costco continues to be a bulwark of value. And then there’s always Amazon undercutting everyone.
The big wild card in this downward pricing vortex is the trade war, which our President keeps ratcheting up. He and his advisors don’t seem to understand the supply-demand imbalance and the reality that consumers will not pay the higher prices that tariffs will drive. Simply said, consumer-facing businesses will not be able to pass along higher prices to the consumer.
There’s that margin headache again.
Wait a Second!
What about the 2017 tax break for consumers and corporations? The average consumer will have (a little) more money, which they will presumably spend. But the lion’s share of the tax break went to business and the wealthiest top sliver of individuals in the country.
So, the way this is supposed to work is that demand will rise because consumers will have more in their pockets to spend. And corporations will take their huge tax breaks and invest in building more factories, hiring more workers and increasing wages — all to create higher-paying jobs, and more of them, to build more and more supply to meet the incredibly increasing demand and consumption. It’s a flywheel whirling into infinity. Yet according to our President, this formula will get us back to the 4+ percent GDP growth rate, back when “America was great.”
Well, the titans of industry are not stupid. They realize there is not enough demand to keep pumping out more and more supply. So, they are taking the enormous tax cut and investing it in their own companies by buying back shares, which enriches the stockholders.
Another grand idea that will only exacerbate this imbalance is the one-time huge tax break of around 10 percent (vs. the former 35 percent tax) for those corporations that bring corporate profits back to the U.S. that have been parked in foreign countries to avoid the higher tax rate. Again, it is counterintuitive logic that those profits would come back to the states and be reinvested in building more supply, plants, more jobs, etc., essentially to drive more growth. Trust me, most of those profits are staying parked outside of the U.S.
President Trump said at the time, “We expect to have in excess of $4 trillion brought back very, very soon. Over $4 trillion, but close to $5 trillion, will be brought back into our country. This is money that would never, ever be seen again by the workers and the people of our country.” Once again, he’s spewing forth alternative facts and does not understand what the titans of industry are actually doing.
The Wall Street Journal reviewed securities filings from 108 publicly traded companies accounting for the vast majority of the estimated $2.7 trillion in profits parked abroad, and asked each company what it was doing with the funds. In their filings and responses, companies said they have repatriated about $143B so far, this year. And about two-thirds of the money came from two corporations – Cisco and Gilead Sciences. And that’s a “B” for billion, not a “T” for trillion.
According to a Morgan Stanley accounting and tax-policy analyst, only about half of the $2.7 trillion is in cash or other liquid assets, further damping the President’s exaggerations. Furthermore, a study by Federal Reserve economists of 15 companies with the most foreign cash revealed increases in stock buybacks and little evidence of an investment surge.
The Macro Nuke
Parallel to the continually increasing imbalance of supply and demand, there’s a continually increasing amount of capital sloshing around the globe, frantically seeking for opportunities to invest in — and lately, the riskier the better. That tonnage of money finds one of two (or both) receptacles to invest in: paper (public equities) and investments (private equity) to prop up the “losers.” In terms of the second, private equity essentially perpetuates the oversupply – Sears and many others come to mind. Both objectives are to ultimately drive higher growth – equities indirectly and private equity, more directly. The illusion that pushing more and more supply into an already over-supplied economy (including services) can be justified intellectually by referring to famed 18th Century French economist Jean Baptiste Say’s doctrine (Say’s Law). He said, “Supply will always find its own demand.” I say, “oh Say can’t you see” your law doesn’t work today. Nor does another famed economist Joseph Schumpeter’s theory of “creative destruction,” positing that the creation of the new, destroying and replacing the old, would essentially maintain a balance of supply and demand.
More supply is being created faster than the destruction of existing supply. Regarding the premise “supply will always find its own demand,” well a lot of it is finding demand in landfills and in grey or black markets. And regarding the oversupply of money, private equity propels shadow banking, looking for riskier investments and seeking larger returns.
Daniel Rasmussen, the founder and portfolio manager of Verdad Advisers, wrote a chilling article in American Affairs titled: “Private Equity: Overvalued and Overrated?” https://americanaffairsjournal.org/2018/02/private-equity-overvalued-overrated/
He cites Cambridge Associates: “Private equity returns have lagged the Russell 2000 index by 1 percent and the S&P 500 by 1.5 percent per year over the past five years. Yet, institutional investors are flooding private markets with capital, about $200 billion per year of new commitments. The result is soaring prices for private companies of all shapes and sizes. Just before the financial crisis in 2007, the average purchase price for a PE deal was 8.9x EBITA (earnings before interest, taxes, depreciation and amortization). a commonly used measure of cash profitability). Deal prices reached 8.9x again in 2013 and are now up to nearly 11x EBITA.
“But asset prices are going up everywhere. What makes private equity dangerous is the use of debt—and the use of phony accounting to conceal the riskiness of these leveraged bets. The average PE deal is 65 percent debt financed, and whereas the valuations of public equities are determined by transparent, liquid public markets, PE firms determine the valuations of their own portfolio companies. Unsurprisingly, they report far lower volatility than public markets.
“Private equity assets today exceed $2 trillion, and PE firms have $700 billion of dry powder capital just sitting there, waiting to be invested. The market is so flooded with investors and valuations are so high that even the truest believers have not found a way to invest it. There is a huge amount of money betting that this consensus is right, and the voices arguing that the consensus is wrong are marginal relative to the chorus of those who agree.”
Rasmussen goes on to make the case that the winning premise of leveraged buyouts that takes an ailing company private, out of the scrutiny of Wall Street, and that the “superior” minds of the PE firms will turn these businesses around in five or so years. They would then cash out, taking the company public (again), selling it to another entity or simply taking it into bankruptcy (and maybe starting the debt engine all over again). Rasmussen said the opposite is happening today, citing more failures than turnarounds, leaving heavily debt-laden businesses to die or just limp along. However, the PE firms have pocketed their winnings during the turnaround period, as the sick business pays down the debt with interest (of course). Mervyns was owned by Cerberus back in the day; they bled the entity to death by jacking up the store leases.
So, a bubble here and a bubble there, and more and more money everywhere. The bubbles are getting bigger and bigger with valuations that are just out of sight. And by the way, let’s hear it one more time: there is no underpinning demand growth in the real world of stuff and stores and services to sop it up.
Finally, The New York Times was kind enough to support my dark observation by looking back to the Great Crash and speculating forward: What Could Trigger the Next One?
Just follow the bouncing ball:
- Debt issued by non-financial companies is near its highest levels at roughly 45 percent, which was the same ratio in 2008.
- Even in the market for the safest corporate bonds, funds have been flowing to borrowers that have some of the lowest credit ratings — the category known as BBB. Roughly $1.4 trillion of that debt is currently outstanding, making it the largest single piece of the investment-grade corporate bond market.
- Lending is growing outside of the traditional banking system, led by entities like PE firms, hedge funds and mortgage companies, the so-called shadow banking system. The share of mortgages originated by non-banks is close to 50 percent vs. just above 20 percent in 2008, leveraged loans are close to $1.2 trillion vs. around $500 billion in 2008
- Student debt is roughly $1.5 trillion, more than double than in 2008, and the second largest category of outstanding consumer debt; the delinquency rates are above 10 percent.
- Emerging markets’ debt in the aggregate is greater than the size of their actual economies, and most of it is denominated in American dollars, thus making the loans very expensive. The tariff wars are going to exacerbate this situation.
Have I Left Anything Out?
Oh yes, I forgot to mention that this time around, according to economists and financial experts, we will be less equipped to stall the vortex down into a depression than we were in halting the 2008 Great Recession. And accordingly, the recovery will be weaker and longer.
Oh my, I’ve overstayed my welcome visit into your mind. So, let me finish with a little good news. Christmas and the Holiday Season will come soon for the retail industry, perhaps to end the year with happy days.
But, winter is coming for the overall economy.