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Bloomberg News anchor Tom Keene hosts a discussion with Chief Economist John Greenwood and Chief Investment Officer Ron Sloan about how investors can prepare their portfolios for a new economic era.
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Invesco
CONFERENCE CALL PARTICIPANTS
Tom Keene
Bloomberg News – Editor-at-Large
John Greenwood
Invesco – Chief Economist
Ron Sloan
Invesco – CIO of Invesco's Domestic Core Investment Management Unit
PRESENTATION
Tom Keene
Hello and welcome to Invesco Interactive, I'm Tom Keene of Bloomberg Television and Radio. With me today are Invesco’s Chief Economist, John Greenwood, and Ron Sloan, Chief Investment Officer of US Core Equities. Our topic is “Preparing for the Great Unwind.” We will discuss what to expect as the Unites States attempts to transition from a stimulus-driven market to an earnings-driven market, and how investors can prepare their portfolios for a new economic era.
I will get our conversation rolling, but it’s important that we hear from you. You can submit questions for our panel online and we will add them into our conversation as time allows, and we also have a few questions for you as well – and we will be able to answer those – through your video player; do that later in the conversation.
Let’s get started and this is just a great topic, completely subsumed by the moment. Now, we’re here and over the next couple of weeks, you will be able to rehear this video, but within it, we have shutdown. That seems to be the phrase of the moment. John, with your experience at Edinburgh, in England, and in Hong Kong, I am going to ignore you at first and go to Ron. Is this any way to run a country?
Ron Sloan
Of course, but that hasn’t stopped us from doing silly things before, of course, and so we will get past this. This is noise; we will get past this. I mean now the grand bargain today is the new term again and we’re going to incorporate this shutdown in discussions about the debt ceiling limit that actually starts to occur in a couple of weeks actually, so I think that we've kind of jumped the gun.
There is no doubt Republicans are painting themselves into a corner, how are they going to get out; maybe be incorporating this into the debt limit, but yes, it’s a heck of a mess.
Tom Keene
If we guess 3 days, 13 days, 23 days, and out and it’s just a guess that we have to frame, when does this begin to affect the equity markets? I would suggest we haven't seen that yet. We have seen Dollar movement, but I've been surprised how things have held up well. How is that?
Ron Sloan
Because it’s not, you know…there are a defense contractors that may actually be impacted, but in terms of Dollars and cents, revenues and earnings and per share, these big public companies are really not the dependent on Government spending, and so now there is a ripple effect impact on all this, of course, and so as it goes from 3 to 13 to a month or two months, if that were to be the case, yes, you'd see impact and it’s because of that cumulative effect, but it has to hit bottom lines in corporate America, and we’re not there yet.
Tom Keene
John Greenwood, you have an esteemed career, particular with service to Hong Kong on the tumult decades ago. Why doesn’t this happen in Hong Kong? Why doesn’t this shutdown happen in England or in other nations? What is unique about our foolishness?
John Greenwood
Well, your system is different. Elsewhere, when we approve a budget, we simultaneously approve payment for the expenditures incurred under that budget, so the legislator doesn’t have an opportunity to come back and question the validity of spending the money, so what you’ve done here is to split the process into authorizing the budget and then saying, ‘but you can't pay for it.’
Tom Keene
You can't – and we will get through this and who knows where it will be in a couple of weeks, but within this, is this a confidence decrease of the Unites States by the rest of the world? I mean there are inflammatory covenants right now, but within the scope of economic history, the system gets through this, doesn’t it?
John Greenwood
Yes, it does and as we saw in 2011, the effect of the downgrade was pretty minimal. In fact, US Treasuries rallied in the wake of that downgrade, because the equity market was hit and there was a big move from equities into bonds, so actually net-net bonds ended up doing quite well out of the downgrade. The perception among investors was it was going to slow growth or produce slower growth, and I think it would be the same sort of thing this time; it would produce perhaps a rally at some point in Treasuries, a temporary period of weakness in perceived growth, and in the equity market if it was sustained for long enough, as Ron was saying, but it won't go further than that. For example, there is no question of the Dollar losing its status as an international reserve currency. First of all, there is nothing to replace it, nothing on the horizon; nobody would turn to the Euro or the Pound or the Swiss Franc, or the Japanese Yen, and the Chinese Renminbi is years, if not decades, from acquiring international reserve status, so it doesn’t impinge to that extent at all.
Tom Keene
Okay, let’s begin on the unwind right now. Of course, folks, we've been living with this for six years, this idea of quantitative easing front and center right now. It is an unwind, but it was delayed. I'm going to assume that most of our audience is up to speed on the taper or the non-taper. Ron Sloan fell off his char at Invesco when he saw that news conference. I thought the Chairman was a bit surprised as well. Do we wait for October or do we go into 2014 not only with a shutdown, but with the type of GDP that we have right now?
Ron Sloan
Taper and stimulus, they're kind of two different things in my view, Tom. The taper is just stimulus on steroids; zero interest rate policy is stimulus and so is ZIRP (zero interest rate policy) in danger of being changed? No. Could the excessive buying of securities be in jeopardy? I think so. I think everyone agrees from Bernanke on down that it’s probably unnecessary, and it’s accomplished what it was. I mean I think there is real fear in the Fed about the potential asset bubble in equities that we are creating, because there is no doubt this market has moved on valuation and not earnings, and therein lies a little bit of this rub.
Tom Keene
And then within the tension here, and within the economic textbooks, John Greenwood, this isn't in the books, we are working with our equity investments, our bond investments, within an economic theory that’s unfound. This is new-new, isn't it?
John Greenwood
Yes, it’s based on the idea that a wealth effect will somehow solve the problem, but as I see it, the underlying problem was the excessive accumulation of debt in both the household sector and amongst financials, and the US has seen progressive pay-down or reduction in the indebtedness…
Tom Keene
The deleveraging that we’re seeing.
John Greenwood
The deleveraging and that deleveraging has acted as a headwind to growth, but you don’t suddenly change that overnight. It takes a long time for households to repair their balance sheets, for the financials to clean up their balance sheet, and that’s really what's behind this sort sub-par disappointing growth rate that we've continued to see.
Tom Keene
Well, as we've had the wind-up, Ron, and I need to congratulate you on your persistent call for a sub-par GDP, there was a 4% camp out there, a 3.5% camp, of real GDP and we haven't seen that. You have been right on GDP, but then with it we have had a double-digit world on equities. Have you been surprised by that?
Ron Sloan
I have, yes. I mean, you know, to pick up a little bit of what John was just talking about and incorporate it in this answer, the deleveraging of the household and financial institutions, it would be fine if the other side of that deleveraging was the same kind of quick rebound that we have seen in prior crises, but we’re not going to get that this time. This was a real plunge in the heart of the Dracula of too much leverage, so this is not going to come back and this is why this headwind is so significant, and so therefore the animal spirits to create spending, the animal spirits to create risk taking, boy, it’s just not there. It’s just not there.
John Greenwood
There is some risk of it in the financial sector, but in the household sector, no, and nor in the corporate sector.
Tom Keene
What do you mean by that? Expand on that, please.
John Greenwood
Yes. Households are still preoccupied with improving balance sheets. If you look at surveys both in this country and in the UK and in Europe, if people are given $1,000 to spend, one of the first things they want to do with it is pay down debt, so households are still…
Tom Keene
We’re still in that framework right now.
John Greenwood
They're still in that frame of mind. Financials, too, are still writing down the bad debts and the mistakes are still bubbling to the surface from the past, so they're not in a position to expand their lending. Lending growth in the US is only about 2-2.5% at the moment – very modest – so the only sector that could conceivably leverage up is financials or non-bank and non-shadow bank financials, so that would be things like hedge funds, private equity and so on.
Tom Keene
We've noticed that in New York to say the least.
John Greenwood
But the scale of that in terms of the GDP would be relatively small, so I'm not concerned about that and I think that regulators this time would keep a better watch on it.
Tom Keene
This is a really special Invesco Interactive today, because we’re going to talk about the idea of real versus nominal. Ron, you’ve said a lot about this. You’ve said real is irrelevant. I'm going to get quizzed here by Dr Greenwood, who is going to give me quality-C if I'm lucky. Here is real GDP, which is economic growth, and on it is inflation and those two together are nominal or top line, or as the British say, current GDP, so you’ve got real GDP and nominal GDP, and as you know, Ron, the media particularly is real, real, real, real. You say forget about that, we've got to look at the entire span of our economic growth with inflation.
Ron Sloan
Well, I just think that the wizard behind the curtain at the Fed is the Vice-Chairman, Janet Yellen. She basically is the keeper of these great econometric models and what we call this optimal interest rate path going forward, and her studies and her papers all indicate that we have such a large output gap and the inflation gap is still low, and so we have to overshoot in both cases. It’s going to take 6 or 7% nominal GDP growth to get on target. She is not afraid to do whatever it takes to get there and in that process, if the price we have to pay is 3% inflation, 3.5% inflation, we will take it in a heartbeat.
Tom Keene
Let’s carry this over from the equity markets to the world of economics. You know, John Greenwood, that Olivier Blanchard at the IMF and others have really pushed this idea of a new regime of desired higher inflation. Can we overshoot that? A phrase from Rudi Dornbusch, the late Rudi Dornbusch at MIT, do we overshoot that and go right through the inflation of Walter Heller of the early 1960s?
John Greenwood
No, very unlikely. Many, many people made this mistake. They thought that the solution to this crisis was going to be high inflation, but what has turned out to be the case is that when households and banks are repairing balance sheets, borrowing of credit does not go, and if you don’t have rapid growth of credit or money, you do not get high inflation. The best example of this is Japan. After Japan’s bubble burst, there was an extended period of admittedly slow deleveraging and very slow balance sheet repair, but look what happened there. They went into deflation, so the big surprise I think has been how long the inflation rate has been. At the moment, the PCE (personal consumption expenditure) deflates and the core one that the Fed monitors is only 1.2%, well below their desired target of 2%, so in that nominal/real split that you were just talking about, I think we’re going to have fairly low real and very little nominal.
Tom Keene
And even down further.
John Greenwood
Yes, so I don’t think that we’re going to threaten any kind of a surge. We’re not going to see a surge of inflation, because the money in credit to drive it is simply not there.
Tom Keene
And that sets up the economic construct of the Great Unwind, and of course Ron Sloan’s idea of a nominal world. This is really front and center in all the interviews do.
What's front and center right now is we need a poll and a question to you, what are investors most concerned about, what are you most concerned about? Here we go. I'm most concerned about the Boston Red Sox right now, but that’s a separate story. What are you most concerned about; rising interest rates and inflation, obviously with the shutdown; are you most concerned about the nation’s fiscal policy or is it, as Ron was talking about, with lower GDP and macroeconomic advisors under 2% for the quarter just ended, how about slow US economic growth is item C, or how about slowing emerging market growth, the challenges we see with Brazil front and center? Think of that Economist Magazine article this week, that special 14 pages on Brazil, and then you’ve got just simply geopolitical instability as that other major worry that’s out there. I would say that’s been secondary recently, but it’s always ever-present, so rising interest rates, fiscal policy, slow US economic growth, slowing emerging market growth, and then geopolitical instability. That’s a whole set of walls of worry to worry about right now.
I've never seen so little chat, Ron, about equity markets, given so many walls of worry. I mean there is literally a wall of worry de jour, isn't there? It’s amazing. I think we should delay until – we shouldn’t invest until 2014. Let’s stay in cash for four years. I mean every day it’s a battle like that, isn't it?
Ron Sloan
To some degree, you're right. I think that…I think that businesses have approached this inflection area that we’re in now; I don’t think they can cut any more manufacturing, as the margin is being initiated back in this country. We’re not going to steal jobs from China, but greenfield facilities are being built here for all kinds of reasons that everyone is very well aware of; this manufacturing renaissance is occurring, cheap labor, cheap energy, and so that’s going to pull industrial America, and what creates these animal spirits? What creates this willingness to take risk by CEOs and companies? Well, they're in the business of growing their business and…
Tom Keene
I thought they were in the business of distributing cash – I took econ 101 in school. I thought they were in the business of distributing cash.
Ron Sloan
I…
[All talking]
John Greenwood
…and investment spending is still well below par.
Tom Keene
What will be the catalyst to boost investment spending?
Ron Sloan
Demand. I mean they have…if im a businessman, I don’t care what I spend on anything if I can move product. If I can generate higher revenue, almost regardless – and higher earnings – of what I give up in the middle, I want that. That’s what im in the business to do. Yes, Wall Street is rewarding people for hiding under their covers and either buying back stock or increasing dividends, but that’s yesterday’s story in my view. The real story I think going forward from here is business investment, so we need an IPO calendar, we need a big M&A calendar, and we started off this year with a big M&A calendar.
Tom Keene
Are we seeing that?
Ron Sloan
Not so much. We started off this year with a big M&A calendar and then it began to fall out.
John Greenwood
Im much more cautious than you are, because I think it all comes back to the consumer. If the consumers’ balance sheets are not fixed or if consumers don’t feel comfortable about their job prospects and so on, they're not going to be going to the shopping mall, which in turn means that the businessmen are not going to be doing the investments, so investment is a derivative of confidence and jobs in the consumer sector, and I don’t think we’re there yet. I think that this balance sheet repair process is going to take still two, three, four years more, and during that period, I would fully expect to see investment spending be also below par. I mean they may invest abroad or they may make acquisitions, but the scale of domestic investment I think…
Tom Keene
Okay, well, this opens up a nice tension between John Greenwood and Ron Sloan here over this investment timeline. You mentioned animal spirits before. John, I want you to define this for our audience. I think of George Akerlof and Robert Shiller’s book, “Animal Spirits,” from a few years ago, but we've got to go back to 1936, don’t we?
John Greenwood
Yes, Keynes first used the expression or first popularized the expression, and what he was trying to say was that for some reason that he couldn’t quite put his finger on in the 1930s, demand had dropped, and nobody wanted to invest. Well, today what we would say is that they had a balance sheet recession. They had too much debt accumulated in the 20s and when the crash came in 29/30/31/32/33, the will to invest again – those animal spirits – didn't perk up.
Tom Keene
But the distinction – this is critical – to me, Ron, is that this time around we’re up to our eyeballs in cash; witnessed the Verizon deal, the Apple transaction, and names that we don’t normally associate with Apple-like cash build if we take an economic definition of animal spirit and we bring it over to your demand for a nominal, more inflation world, what clicks in that animal spirit for businesses when they’ve got more money than God they don’t know what to do with?
Ron Sloan
Well, they’ve got cash, no doubt, primarily in technology and healthcare companies, and guess what? Most of that actually is overseas, so we do an Apple stunt, like they did earlier this year, we borrow money, it’s a return of capital, not a return on capital; that was just a stunt in my view, because they didn’t want to repatriate those Dollars back to the US, so whether it’s Cisco or other people like this, that’s their box. The absolute debt levels – forget the coverage aspects of it, which are quite high, the absolute levels of debt in corporate America are high. They're actually high, so it’s a little bit like the Government. We will be in a very – one of the great ideas probably is someone like Moody’s, because they're going to be in the business of rolling over bad debt pretty quickly, if we start to see interest rates go up, because they can't…they need to…into longer maturities, because they don’t want to have to pay 5/6/7% interest rates on the level of debt.
Tom Keene
Let’s get through that in a minute, this interest rate dynamic falls into equities and, of course, in this economic debate as well. We've got poll results from our question on your concerns and, well, I guess the shutdown answer, our top answer, fiscal policy within the Unites States, 39%, and the second one, which we saw certainly in the third quarter this year, I think editorialize before we see that first look at GDP, 30%, so 39% fiscal policy, 30% US economic growth, and we say that with a deficit to GDP, John Greenwood, going from 10% down to 4% and change from [far above 10]. I mean the President could take a victory lap and CDO could take a victory lap, looking at an improved fiscal landscape, why were we concerned about fiscal policy, because we've seen an improvement?
John Greenwood
I think because the timeframe is different. I think most of those answers are a short-term concern about the budget, the debt ceiling and so on, so it’s a very short-term concern. It may also be a longer-term concern, but I think that it’s less of a concern than maybe you and I would have temporarily. The other part of it is, well, the growth segment. That would have been my number one choice, because politicians and central bankers are getting impatient with the long growth. I tried to lay out an explanation for it, but it still means that politicians get frustrated and want…
Tom Keene
Well, they have a different mandate to the economists or equity guys in Invesco. Ron, we've been doing this for some time, and it’s been a great joy for me to do Invesco Interactive, and one of them is you drive around in the cars of New York City, which is the ultimate confidence litmus test, and the answer is nobody is talking about equity markets, and yet one year, two years, three years, four years of terrific equity return, and what I hear from every shop worldwide, without question, is this idea of a lack of enthusiasm for equities and this idea that I haven't been in the market, how do I get in now if I've already seen three or four years of double-digit return? How do you get in now?
Ron Sloan
That’s an excellent question. You know, I don’t know what's going to be the great divide that will create that. We have been talking about animal spirits and willing to take risks at the corporate level, and investors, they just need excitement. They need a Facebook to work; they need a Tesla to work. Now, those are wildly speculative stocks in my view, but it’s got people talking about it and I think that’s what has to happen, so we need not just good returns, because they are grinding returns, they are dividend reinvested returns, and that’s boring in a world where we’re trying to make up, especially my generation, the baby boom generation, and I'm the lead pack of that, we have such an investment downfall that we have to wake up in a relatively short period of time.
Tom Keene
Well, I heard about this; they were talking about it in Business Week last week. Alicia Munnell at Boston College and her Center for Retirement Research, the numbers are breath-taking. Short of just working forever, which is the option I've taken, short of that, the idea is how do you catch up? I mean do you just have to allocate more to equity?
Ron Sloan
Well, the people are afraid that I cannot absorb another crash. I've had two in the last decades. I can't; I'd love to be in equities. Yes, they’ve been a good return, but I can't go there again. I am just scared. Financial planning 101 is every year you get older, you're supposed to get less risky…
Tom Keene
Really?
Ron Sloan
…with your portfolio.
Tom Keene
I missed that memo.
Ron Sloan
Yes, you're supposed to be moving from equities to bonds…
Tom Keene
Yes, yes, yes.
Ron Sloan
…and so we've had that and now what do we do, right, and so I think that…I don’t know what's going to get them over the top. I think…my solution to everything is earnings, so it gets back to the question of the people we’re interested in; we’ve kind of talked around that issue here. Companies have to generate faster earnings growth.
Tom Keene
Okay, but within the Great Unwind, and John, I think this is critical, most of America and I think all of the developed world can suggest that we've seen this prosperity go all to corporations and it has gone to building cash, and a few years ago some substantial earnings growth. When does it – within the Great Unwind, when do the people…to your consumer confidence question, when does labor get their fair share to build that interior confidence to make the people invest, the corporations to invest?
John Greenwood
Well, the answer to that is typically in the second half of a business cycle expansion – in the first half almost all the rewards go to capital and that’s pretty much what's happened. In the second half, as employment picks up, unemployment declines, and wages increase, more and more rewards tend to go to labor. Now, the good news here is that in my view, because we’re growing at a sub-par rate and there's really no constraint on the future expansion, I think we will have a very extended business cycle expansion, something like 10 years, the sort of thing we saw in the 1990s, and that means that the entry points for equity can be reasonably spaced over the next two or three years, and you still will not miss out, because we will not be at full capacity utilization and inflation won't be a problem until sometime in the late teens or early 20s.
Tom Keene
The vector of the unemployment rate has come down wonderfully and persistently. We are miles from normal however you measure that. Are we just going to get there? Is it just a linear function and I think of the doves on the Fed, Rosengren, Yellen, and the others, we just get there?
John Greenwood
No, because included or excluded from that 7.3% figure is those who are no longer participating, those who dropped out through frustration, because they couldn’t get a job.
Tom Keene
And a raging debate within itself.
John Greenwood
Yes and that amounts to as much as – depending on which measure you use – much as four percentage points. It’s similar to the U6 measure of unemployment, which is around 11/12%, so there is still a very large margin of people who would like to be working, so what that means is that not only do we have spare capacity on the capital side, but we also have plenty of spare capacity in the labor market.
Tom Keene
I want to link all this to interest rates, as sort of the litmus paper, the thermometer out there of where we’re going on that, but first, within this unwind, is the raging debate of, ‘Do we unwind on a stable basis or do we unwind with instability?’ Ron, do we get through this smoothly and in control, or do my ratings go up, because it seems…you know, we’re down 500 points today, interest rates are higher! Which is it? Tell me where it is going to be a wild ride.
Ron Sloan
We’re not on a 10-year path without a bear market to cleanse the spirit, so to speak, and to offset this kind of liquidity move that we have had. We’re not going to start at 17.50 with a bull market. We have had a bull market, so we’re going to start this next period at some lower number, so we’re going to have some real shovelling to do here, and this is going to be messy, because we’re going to move from…the markets will begin to anticipate that the Fed in spite of the lack of tapering in September, they are going to taper and the liquidity, punchbowl, sugar-high, whatever we want to call it is going to go away, so your interest rate policy isn’t, but that is really a corporate issue that the markets have been wildly fuelled by the Quantitative Easing (1s, 2s), Operation Twist, Quantitative Easing 3. I saw a statistic that suggested that from the time of the first Quantitative Easing Program the S&P was up like 130%, as long as you took out...it was up 130% just in those periods when quantitative easing was occurring. In those periods when quantitative easing wasn’t occurring, the S&P was down 25%.
Tom Keene
When I look at this, John Greenwood, and folks, don’t forget you can send us in questions, that is important, we need to hear from you about your thoughts on the Great Unwind, we’re preparing for it, I thought it was going to be here at 3pm, but it is not, but we will get it here at some point, some quarter, actually we may start tapering any month now, but within this, John, the idea of where we are before we go into interest rates, it is the idea again of confidence that you mentioned before. Will we have a confidence in the stability with this? Can Chairman Bernanke suggest that they can manage this unwind?
John Greenwood
Well, he can suggest it, and they have said quite explicitly that they have experimented with…
[All talking]
Yes, with various ways of unwinding the Fed’s balance sheet. My personal view is that they will continue to hold it and let it run off at maturity, so that it won’t put pressure on the markets, but even so, in a slow growth environment with low interest rates, we’re going to have periods, such as Ron has just been talking about, when the market runs ahead of the underlying reality. What is essentially going on there is that PEs are being driven up, unsupported by earnings, so, if you like, what we have had is a PE driven expansion, and we have yet to see the sort of earnings phase when PEs would be relatively stable and then the earnings would be a much more important driver of the market overall. Now, it is inconceivable that that would be a slow and steady improvement, but I think what you can say in relation to the business cycle is that if I am right about the business cycle continuing to expand, then when dips occur you will be bailed out by the subsequent growth, because earnings essentially follow GDP, and if the GDP goes on growing and returns to a more normal level in four, five, six years, then we will have a decent stock market.
Tom Keene
We’ll just be in a nominal space if we get a nominal GDP of 5 or 6%. Here is another question, Ron Sloan. I love this question because I get this constantly, now you get to answer the question. The idea of, okay, cheap labor, everybody is moving a job to Malaysia, wherever, you say a manufacturing renaissance, okay, I’ll buy it in Mexico, in Malaysia. Why are we going to have a manufacturing renaissance in the United States, granted, okay, energy I get? There is a manufacturing renaissance in the Dakotas, we all understand that, but how can you have a manufacturing renaissance in a predominantly service sector economy?
Ron Sloan
Well, it is going to become less service sector economy in my view.
Tom Keene
Do you think so, meaningfully?
Ron Sloan
I do, every automaker in the world is building a grassroots facility in the South East part of the United States, every single one of them, or they're expanding an existing facility. All you had to realize was that UAW Settlement, where the 30-hour fully loaded machinist is working right next to now the Plan-B or B-Scale $15 fully loaded machinist doing the same thing. That UAW Settlement is going to create a new kind of machinist and he is going to be at mid-teens cost, which is where Coastal China is now, basically.
Tom Keene
So the labor arbitrage goes away and we…
Ron Sloan
Labor arbitrage goes away, and these are sophisticated machinists. We’re not going to get into the assembly business, that is gone and it is gone forever, and to the degree that that created the middle-class, well, we may not have a middle-class.
Tom Keene
Well, this goes back to the Great Unwind, and I don’t mean the Great Unwind of QE, John Greenwood, I mean the Great Unwind…Daniel Yergin in the Commanding Heights, opens with Clement Atlee, England, and the great, great fear here of your request for nominal GDP and your statement of low inflation forever is the machinist moving from a big salary to a low salary, which is wage deflation, either real wage deflation or even top line wage deflation. When do our incomes go up?
John Greenwood
The wage adjustment is more because of the growth of China and India and competitiveness abroad. That we should welcome because on the other side of it, the sales of whatever it is Boeing or MMM Triple M overseas are benefitting from their incomes, so we have 50% of the earnings in the US stock market generated overseas thanks to that very strong growth abroad. That is one part of it. I don’t think that we will have wage deflation in a nominal sense. We have seen kind of static…
Tom Keene
Will we be England we fear or the America of the ‘30s that we fear?
John Greenwood
No, no, QE has been about preventing that kind of deflation.
Tom Keene
Which is Bernanke’s PhD line.
John Greenwood
Yes, and that has been successful doing that, so we are going to continue to have nominal growth, albeit at a very low inflation rate. I didn’t say low inflation forever, but certainly, for several years, there is no possibility with the shape of bank balance sheets and the shape of consumer balance sheets of generating enough animal spirits to drive prices up.
Tom Keene
I don’t want to go to a poll of the equity markets, but I have got to get this in first, is we know it has been – and away from your expertise in equities – it has been a horrendous 90 days for bonds. Bond price is down, yields are up, and any form of flavor, some of have bounced bank nicely in munis and a few others were up. Have you seen this at Invesco, have you seen people in their bond portfolios go, ‘That Ron Sloan, his area looks pretty good right now.’ Is there an unwind from bonds into equities?
Ron Sloan
There is, we are seeing it, it is small, we’re not getting all those Dollars, and where is it going? It is going into some niche products, some of our global products, our international products are seeing some of that, primarily right now. Is it in the kind of, a big traditional, US oriented equity mutual funds, not so much, but we are seeing the beginnings of that Great Unwind, I believe, and we have seen some of it this summer.
Tom Keene
Maybe this is a point of distinction between the two of you. Where will the 10-year yield be in 12 months, Ron Sloan?
Ron Sloan
Oh boy! I am hoping…
Tom Keene
You can be an economist and give me like a range. I don’t need a single point.
Ron Sloan
It is 3-5.
Tom Keene
That is good. He has learned well.
Ron Sloan
I am hoping it is well above 3, Tom, I am hoping it is well above 3. This is…
[All talking]
…in my view.
Tom Keene
Okay and that is an ambiguity of good economic growth, a better economy bringing…
Ron Sloan
I think so, you know the old adage about ‘Don’t fight the Fed,’ but what does the Fed want. The Fed wants higher nominal growth. I don’t want to stand in the way of that, so I am hopeful they are going to be successful.
Tom Keene
You grew up – you rather, went to school in Edinburgh, up the hill from the Royal Loch at Adam Smith’s old house.
John Greenwood
The Royal Mile.
Tom Keene
The Royal Mile and Adam Smith’s house right there. I would bet you disagree with what Mr. Sloan just said. Where will rates be in a year?
John Greenwood
I think they will be a bit lower than that, I think they will be in the range of 2.75-3.25. I don’t think we will see a huge step up, because the growth isn’t going to kick in strongly enough, and certainly, the inflation is not. Inflation, if anything, is going to go the other way. There may a temporary sort of fear that drives yields up, but that would subside, so I would go for a lower range.
Tom Keene
That again frames here folks, with this unwind a distinction, and debate over interest rates, huge ramifications upon anybody’s 401(k). I am all in cash, so it really doesn’t matter. Let’s go to our next poll. It is true; I am just waiting for the right signal to get in the market. Here is the poll.
“Where do you see the biggest opportunities in the equity markets?”
This of course is a classic sector question.
A. Consumer Discretionary
B. Financials
C. Healthcare, and boy is that a move with the Affordable Care Act, those equities have really moved
D. Information Technology, or that dreaded
E. Sector - Other
How is ‘Other’ doing for you?
Ron Sloan
Well, you know, I think from here because I am I think pro-growth, I do think we see an inflection in earnings growth, probably beginning late fourth quarter. We are seeing some investment spending. If you look at the most number, monthly, that I look at, is the Durable Goods Report and the Factory Order Report. We have had mostly – for the last 15 months – we have had book-to-bills greater than one, so we are building production, the opportunity for production gains to continue, and in that environment, I like, if interest rates are going to be considerably above 3% a year from now, I want the price takers, I want industrials and I want energy, I want technology companies, because of the new product orientation, I want companies that can price aggressively their products and not get squeezed in that environment, and those aren’t the great – unfortunately – those aren’t the great yield plays that have driven this market over the last few years, which are staples and utilities.
Tom Keene
Well, in the other, Ron, in the question we had on consumer discretionary and financial and healthcare, and the oil, is this great divide this year, it is the vogue right now, of small-cap versus large-cap. 99% of my interviews are by big-cap companies with dividends grow, what is the fiveyear dividend growth rate, and the market has gone completely against that zeitgeist, hasn’t it?
Ron Sloan
It has. I think small companies are much better; they really are inflation hedges and so because of their real close proximity to real growth. Now, having said that, small-cap investing is a very streaky business, and so we have had a good run, could they take a breather for a while, yes, but if the Fed is successful, small companies will be the best hedges because they grow fast.
Tom Keene
I know we don’t talk about individual companies here, but within the large bond transaction with Verizon, John Greenwood, the question I got, “Is this low interest rate financial repression that we have seen, is it nothing more of a transfer by well-meaning Central Bankers, say Chairman Bernanke over to corporate America, because if a given company can come out with a substantial bond transaction at a low interest rate, that is a huge interest rate advantage to them on that transaction, isn’t it?”
John Greenwood
Yes, it is part of that process we were talking about earlier of the gains in the early part of the business cycle going to capital, and this is one manifestation of that, but this is only going to go on as long as the Fed is purchasing assets. As the taper kicks in, the impact of the Fed on those longerterm yields is going to diminish, and it is going to end up being driven by the inflation rate and the growth rate alone, not by Fed purchases.
Tom Keene
You have terrific Asian experience in all this, your thoughts on the strength of the economics of
emerging markets in this Great Unwind. They are directly linked to what is going on with our Central Bank in the United States, aren’t they?
John Greenwood
Absolutely.
Tom Keene
Brazil is shocking, I don’t mean to editorialize, but Brazil’s decline in economic growth is stunning.
John Greenwood
Essentially what happened is following the big recession here investors found that in the US, in the UK and Europe, the yields they could get on safe assets were very low, so a lot of money was directed overseas, firstly because the yields were much more attractive in emerging, and secondly, because the growth was in emerging, so both equity and bond money went to emerging. We had huge flows, in total, to all the emerging areas in excess of a trillion Dollars. As soon as that testimony occurred from Ben Bernanke on May 22nd that the asset purchases might be terminated or might be slowed, everything went into reverse and we have seen obviously a big sell-off. The economies that got hit worst are the ones that had been most lax with the discipline, so like India, Indonesia, Brazil, and the countries that had allowed domestic money and credit to expand most rapidly have seen a deterioration in the current account and a sharp decline in the currency as well, but countries like Taiwan and Korea have kept it together, they have maintained the discipline, and we haven’t seen anything like such a big sell-off.
Tom Keene
Can we maintain our discipline here? You're in charge of core US equities; do you do it with the Central Bank that you would suggest has maintained its discipline?
Ron Sloan
Boy, that is a tough one. Look, I am old school. Everything…when we started this conversation this afternoon, John mentioned, and you mentioned some…this is new, this is unchartered territory here that Bernanke is taking us on with this wild ride here. I would have to confess that I have been more skeptical than embracing of what he has done.
Tom Keene
Oh boy, you have absolutely nailed US GDP. I sat here with you while everybody was trotting out 3% real growth and if you go back four quarters or eight quarters, you hit the ball out of the park on GDP growth.
Ron Sloan
Well, because I believe that Yellen has the Governors in her hip pocket. When you play poker, right, you have got to find out…if you have to ask who the patsy is, it is you, and so she is the keeper of all the data, and guess what, that Federal Reserve Board, there are no businessmen on there now, they are all economists and she speaks their language, she talks their language, she has got them believing her data, and it is irrefutable as she presents it.
Tom Keene
We need a Canadian to run our Central Bank, that is the solution. John, you were going to say something.
John Greenwood
I was, the FOMC has been as guilty as anybody else. They have been persistently overoptimistic about the growth rate. They keep forecasting that next year or the year after will be 3/3.5%, in other words, their models do not capture the headwinds to balance sheets and growth that we have discussed in terms of the balance sheet problems that have emerged. The growth is much more likely to continue at a low growth rate. It is going back to that question of emerging. Those countries, although they have been sinners, if you like, they have kind of lost the discipline in the last two or three years. The adjustment, I think, will be a fairly brief one, nothing like as serious as it was after ‘97/’98 and that sort of period, but it does mean that for the world as a whole, not only are the bigger emerging countries adjusting, and some of the smaller ones too, but also the developed world is growing slowly, and that has significant implications for inflation and for commodities.
Tom Keene
Let me go to the poll results we have on the equity sector question. No surprise, top answer of equity opportunities, ‘Healthcare’ what a moon-shot. I won’t mention the names of the stocks, because I don’t own any of them, but they're like this and then straight up they go. In healthcare, Ron Sloan, let’s call it ‘The Affordable Care Act Total Return Fund,’ I mean maybe that is it. Let me cut to the chase. Does this sustain itself, and can you still market weight or overweight healthcare at this time?
Ron Sloan
I think you can, because let’s take kind of the biggest companies on down for a minute. Large pharmaceutical companies are still…the market is still not paying for their R&D pipelines. Merck just announced this week another very large personnel cut. Basically, they are going to…because they have to write-off some of their R&D efforts, so they are going to spend more money on fewer drugs now, and the market is…you can do a sum of the parts on whether it is Sanofi or Novartis or Pfizer or Merck, any of these companies, what you see is on the sum of the parts basis, the market has fairly priced them, the only thing that is…the real wildcard there is the R&D pipelines, and I just think that these people didn’t get dumb overnight, I can’t tell what they are going to be, but you're getting paid pretty well to sit there with some of these, even at today’s prices. Then beyond that, whether it is the drug chains, how about hospitals, talk about a huge beneficiary of this, because all of a sudden their bad debt portfolios go to zilch and that all falls right to the bottom line, and that could be anywhere between 10 and 20% of their revenue. This is a big, big number.
Tom Keene
I want to point out also in the poll, information technology coming in second place to healthcare. Let me do one final question. I want to really center back to this idea of the Great Unwind and where we will be. We’re all in search of animal spirits, which I think to the two of you means a different thing. John Greenwood, let me start with you when we go back to Keynes, and this idea of searching for that confidence that is out there. Will we get back to the normal confidence that we saw, say, in the middle of the 1990s, or is it a new confidence, which is a more subdued confidence?
John Greenwood
We will get back to it, but I think it will take several more years, maybe even five/six more years, and it will be…well, if we think about what happened in the 1930s, people who borrowed in the 1920s never borrowed again in their lifetimes. In other words, that event was so traumatic that they were cautious forever after. Nowadays, I think we have shorter memories and we have seen enough countries where the memories were very brief and there have been serial episodes of borrowing bubbles, so I think that within, certainly, five to six years, normal growth would be fully restored and the animal spirits would have returned.
Tom Keene
One of the distinctions that John mentioned earlier was the animal spirits of the consumer versus the animal spirits of investing. Where is the consumer?
Ron Sloan
I would agree with John, I think the consumer is significantly damaged in here, I don’t think there is any doubt about it. We have heard – as an example – the average Wal-Mart, for virtually this entire recovery, not the bad part, but the recovery, the average Wal-Mart customer, the company is saying has been unable to buy at Wal-Mart for the last week of every month, and I don’t see that changing very rapidly.
I think, if I am a CEO of a business right now, I am going to have to – and everyone is looking around waiting for someone else to take the first step, I think they are going to have to create their own demand, and they are going to have to sacrifice some margins to do that, and I think if they telegraph that well to the street, I think we will see it, and I think from small acorns do might oaks grow, and I think we’re seeing those acorns in some of the macro data, and so I think the industrial world is going to drag the consumer world. We’re going to change that consumer – industrial mix in the company.
Tom Keene
I want to squeeze in one more question from the audience, this on export and we can take this not only to US but to Germany and Europe as well, even to Asia, but I don’t think we have time for that. Let’s just stick with the US and Europe, and the idea of export volumes, unit volumes; we have this romance, Ron Sloan, of trying to be an export power within this giant $16 trillion economy. With your manufacturing renaissance, do we become an export power, and does a weak Dollar assist that?
Ron Sloan
We have to get better at exports and the weak Dollar is going to help, and so in spite of many pundits who want to cheer for a higher Dollar, I think that we don’t want a higher Dollar, quite honestly. Is it a risky and dangerous game? Yes, it is, because John talked about the International Reserve Status, we only have it because no one else can step up. We’re a residual reserve currency, not an omniscient reserve currency.
Tom Keene
And John, we see the German Election, we see Euro now 1.35/1.36, we’re not near 1.40, but this idea comes up here. Europe combined is a huge entity, do they stay as an export power or do they just demand that weaker Euro. Wait, we can’t have a weaker Euro and a weaker Dollar at the same time. How does Europe handle this?
John Greenwood
Well, the way we resolve that is, Germany has benefitted hugely from the Euro, because if Germany still had the Deutschmark, that Deutschmark would be much stronger than the Euro today, so that is to Germany’s advantage. That has enabled them to move their exports up from 30% of GDP to over 50% of GDP.
Tom Keene
Versus, we’re at, what, 16%?
John Greenwood
Yes, 16, 17.
Tom Keene
So their exports are more than double ours.
John Greenwood
Oh yes, almost three times. Similarly, but the other thing to say is that, ironically, the Euro is extremely strong, despite the depressed state of the economy. How can that be? Well, it is like Japan, after the Japanese bubble burst, there was zero growth, virtually of money and credit in Japan. Interest rates were very low, they had low rates, but tight money, and that is exactly what we’re seeing in Europe, very low rates, almost negligible growth…
Tom Keene
Balance sheet shrinkage of the ECB.
John Greenwood
Exactly, and therefore the Euro is staying too strong for the good of the European economy.
Tom Keene
Where does it need to be, is normal 1.16 when it was launched, up we go, I can’t remember now, 1.60/1.50, down we go, where should the Euro be?
John Greenwood
Right now, it should be in the low 20s I would say, the low 1.20s against the Dollar, and that is always going to be a moving target.
Tom Keene
I look at this Ron, and I want to make a joke about a strong Dollar, weak Dollar policy, but since we’re shutdown, there is no one to deliver the policy in Washington.
Ron Sloan
There you go, it is a tough situation, yes.
Tom Keene
Well, it has been interesting on the Great Unwind and where we are with it. I thought it was going to happen this summer, that didn’t happen and of course the shock of the non-taper of a few weeks ago.
That wraps up this edition of Invesco Interactive Webcast Series, but the conversation doesn’t stop here, visit Invesco’s website to read in-depth insight and timely blog posts from their Portfolio Managers, and sign up to follow Invesco on Twitter. You could also access Invesco from your iPad with the Invesco US App.
Thank you, John, and thank you, Ron for sharing your thoughts and thanks to all of you for your time and for your smart questions that you submitted this afternoon.
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