The Investor's Guide to the National Accounts

Much of the economic data produced and released by national statistical agencies around the world represent a labyrinth for investors to navigate through and interpret for the purposes of making informed decisions about the trajectory of asset prices.  Many market economists whose job is to decipher and communicate the key themes of macroeconomic data releases to investors and the broader community do themselves a disservice by assuming too much prior knowledge and confusing their audience with jargon laden observations.  In this post, Skeptikoi hopes to demystify some of the jargon surrounding the most complex of all data releases, the National Accounts.

What does it actually mean to say that Australia's gross domestic product (GDP) expanded by 0.8% in real or inflation adjusted terms in the December quarter to be 2.8% than a year earlier.  GDP is a measure of the flow of production that occurs in a particular period.  The ABS avoids double counting by deducting from the value of output the value of intermediate goods and services used up in the production process.  The term gross refers to the fact that the flow of production does not adjust for deprecation or wear and tear of fixed capital such as buildings and capital equipment that occurs in production processes.

GDP is measured three ways: production, income and expenditure.  Most of the higher frequency data produced by the Australian Bureau of Statistics (and other statistical agencies around the world) - including retail trade and building approvals releases - relates to the expenditure measure of GDP.  The production measure is based on surveys of business, while the income measure is based on the income earned by the household sector (employee compensation), business sector (profits) and governments (tax revenue).

The income measure clearly illustrates why profitability and stock market performance more generally are not necessarily related to a country's GDP growth.  The GDP or gross value add of the retail sector for instance, represents the sum of labour earnings earned, after tax profit generated and tax paid to governments.  A rise in wage rates for retail sector workers - without an offsetting reduction in the number of hours worked in the industry - could boost labour earnings in the sector but depress profitability. 

For investors, the distinction between nominal and real GDP is important but still poorly understood.  Nominal GDP is simply the dollar value of production, while the real estimate adjusts for inflation.  Statistical agencies that produce National Accounts and economists tend to focus on the headline GDP measure in real or inflation adjusted terms.  This is reasonable when comparing measures of production across time periods that have materially different rates of inflation.  But inflationary pressures have remained low in Australia and other developed economies for over two decades now.  Further, companies generate nominal revenues and earn nominal profits or cash flows.  Consequently, nominal GDP is more relevant than real GDP for understanding trends in aggregate sales revenues. 

Skeptikoi has been critical of the Reserve Bank of Australia (RBA) in the past because excessively tight monetary policy has contributed to a nominal 'recession'; average annual growth in nominal GDP of less than 4%.  The 1.6% quarterly growth in nominal GDP was a welcome development.  Nonetheless, by Skeptikoi's measure, the Australian economy remained in a nominal recession for the second consecutive calendar year; nominal GDP expanded by 3.5% in 2013 following 3.4% growth in 2012.  This represents the weakest two successive years of nominal GDP growth in over two decades and growth in 2013 remained well below the twenty year median of over 6%.  In an era where nominal GDP growth targeting is gaining some currency around the world, the persistent weakness in the nominal economy constitutes a fail for the RBA.

The weak environment for nominal GDP has undermined the ability of companies to achieve strong revenue expansion and instead they have resorted to margin expansion to boost profitability.  The profits of non-financial corporations in particular jumped by 4.7% in the December quarter to be 20% higher than the pre-financial crisis peak of 2008.  Profits of financial corporations posted modest quarterly growth of 0.5%, but are also around 20% higher than the pre-financial crisis peak.

Australian companies in aggregate have achieved strong margin expansion by aggressively managing operating expenses, reducing capital investment where feasible and boosting productivity.  The National Accounts confirm the cost discipline that has been evident at the company level in recent reporting seasons.  Nominal unit labour costs - which are productivity adjusted wages growth  - increased by a modest 0.3% in the December quarter and have been stagnant since March 2012, which has helped to support business sector profit margins.  Excluding the financial crisis, one has to go back to the late 1990s for the last extended period of stagnant unit labour costs.

The weakness in unit labour costs and margin expansion owes much to Australia's productivity renaissance in the past three years.  Gross value added per hour worked in the market sector expanded by a nominal 1.1% in the December quarter, the strongest quarterly outcome since March 2012.  Since March 2011, productivity has expanded at a compound annual rate of over 3%, well above compound annual growth of less than 1% in the five years to March 2011.  The last time it grew at or above 3% for a sustained period was over a decade ago.

Of course, the flipside of the productivity renaissance and corporate Australia's aggressive focus on cost containment, is continued weakness in labour market conditions.  Aggregate hours worked actually declined marginally in the December quarter and have remained little changed in the past two years, despite unusually strong population growth.  Consequently, the unemployment rate has increased to 6% from 5.2% in December 2011.

In summary, the National Accounts reveal a business sector that is prospering despite subdued environment for nominal GDP and revenue expansion in recent years.  The strong quarterly increase in nominal GDP is a welcome development but is unlikely to herald the start of a strong recovery if the interim reporting season is anything to go by.  Skeptikoi expects cost discipline to continue, as firms increasingly cater to the market's insatiable appetite for income by boosting free cash flows and lifting or maintaining already high dividend payout ratios.  Great news for investors; less so for workers and job-seekers.

The Bankers Who Cry Wolf

‘In recent years…a tension has emerged between reform and growth.  Regulators want to complete the reform in part by having banks hold substantially more capital, a goal which the financial industry supports.  Nonetheless, this vies with the broader aim of lifting growth by increasing available credit and bank lending.’

Axel Weber, Chairman of Swiss bank, UBS

Most people are familiar with Aesop’s tale of the boy who cried wolf.  A bored shepherd boy amuses himself by crying wolf when there is no wolf.  He does so twice and villagers come rushing to help each time, only to find that that there is no wolf.  When he cries wolf a third time, the villagers believing that he is lying to them once again, ignore him; only this time, a wolf has set upon and scattered the shepherd boy’s flock.

The chorus of bankers complaining about onerous capital requirements reminds Skeptikoi of Aesop’s tale.  Two banking and finance academics, Anat Admati and Martin Hellwing have recently published a book (The Bankers’ New Clothes) that exposes the myths surrounding bankers’ cries of wolf.  Given that excessive leverage amongst financial institutions propagated the financial crisis, Skeptikoi strongly recommends the book to anyone interested in the safety of the global financial system.

The bankers’ common cry is that they are forced to set aside regulatory capital, which sits idle on their balance sheet and could otherwise by lent to businesses and households.  The Chairman of Swiss investment bank UBS suggests that there is a trade-off between regulatory capital requirements and economic growth.  As seductive as this might sound, it is utter nonsense.

To understand why, it is important to consider the basic function of a bank as ‘maturity transformation’.  On the right side of a bank’s balance sheet are its liabilities: wholesale debt funding, customer deposits and common equity that it raises from shareholders.  A bank uses these funds to lend to businesses, households and governments.  The loans are a bank’s assets that obviously sit on the left side of its balance sheet.  There is a mismatch in maturity between the bank’s assets and liabilities; its assets are typically long term and illiquid.  There is no transparent price mechanism that reflects and conveys the market value of loans.  In contrast, a bank’s liabilities are short shorter term and liquid; for instance, customer deposits are either at call or have a term of up to three years, while funds borrowed from wholesale debt markets have a similar short maturity.

The key function of a bank is to manage the mismatch in maturity between its assets and liabilities.  It does so primarily by carefully evaluating prospective borrowers’ ability to make their loan repayments.  To this end, a bank might demand some form of collateral from the borrower.  A mortgagee has to pay a minimum deposit or down-payment, while banks typically impose debt covenants on business borrowers that allow the bank to re-negotiate the terms of the loan if those covenants are breached.

Capital regulation is concerned with a bank’s mix of liabilities.  In banking, capital refers to the amount of equity raised from shareholders and used to fund a bank’s lending activities.  Why would a prudential regulator wish to impose constraints on a bank’s funding or liability mix?  It gets back to a bank’s delicate task of managing the maturity mismatch between its long dated illiquid assets (ie. loans) and short-term liquid liabilities.  A bank that is heavily reliant on short-term funds borrowed from wholesale debt markets can easily become vulnerable to a crisis of confidence if a large enough number of business and housing loans it has written have defaulted.

Capital regulation simply forces banks to have a minimum amount of common equity (relative to total assets or risk weighted assets) in their liability mix.  A crisis of confidence is less likely if a bank has secured a larger share of its funding from equity or shareholder capital, which Admati and Hellwig describe as ‘un-borrowed money’.  As residual claimants to a bank’s cash flows, a bank can cease dividend payments to shareholders in the event that it gets into trouble.  Common equity acts as a buffer or shock absorber in the same way that a large deposit or down-payment better shields a mortgagee in the event that the value of her house declines.

Bankers continue to propagate the myth that that capital regulation constrains a bank’s ability to lend and inhibit credit growth.  Capital requirements do not require banks to set aside capital to sit idly in their vaults; the need to have a minimum amount of common equity in their funding mix does not affect the asset side of a bank’s balance sheet, notably its loans.  A bank retains complete discretion as to whom it lends to, and how much.

Even though five years have passed since the collapse of US investment bank, Lehman Brothers, banks’ capital ratios remain woefully inadequate.  Basel III has imposed more onerous capital requirements than its predecessors. Some national prudential regulators – including the Australian Prudential Regulatory Authority - have imposed  even higher capital ratios than recommended by Basel III.  Nonetheless, the leverage ratio (common equity to assets) for Australia’s major banks is typically no higher than 7%.  That is, for every $100 worth of loans written by a typical Australian bank, it holds only $7 of equity.  In contrast, the median leverage ratio for non-financial companies listed on the ASX200 is 50%!  The pattern of over-leveraged banks is similar for US and European banks, whose leverage ratios of around 10% are well below non-financials of 40%.

Banks that fund a greater share of their loans with common equity are safer and should be able to better withstand a run or a financial crisis.  Why then don’t banks hold more equity capital?  The answer is simple; taxpayer funded guarantees on deposits and systemically important banks encourage banks to take on excessive risk.  And government guarantees allow banks to borrow funds from wholesale debt markets at cheaper rates.  The lure of cheap debt funding is far too tempting for most bankers and trumps any systemic concerns that high leverage could undermine the stability of the financial system.

As long as governments and prudential regulators continue to heed bankers' cries of wolf on capital regulation, capital ratios will remain dangerously low.  Against ths backdrop, Skeptikoi believes that a crisis of confidence could once again expose the fragility of the global financial system.

The Restless Investor, Trust and the Global Cycle

On face value, Woodside Petroleum and Macquarie Bank have little in common.  One is an oil and gas company, the other an investment bank.  For a long time, investors have considered both to be growth stocks; their revenue growth is projected to exceed growth in the broader economy.  Woodside is exposed to strongly growing demand for liquefied natural gas (LNG) from Asia while Macquarie has transformed itself into a global asset manager, exposed to the growing demand for private pensions among ageing developed country populations.

Both companies raised their dividend payout ratios in 2013 and announced they would maintain a higher than normal payout ratio going forward.  Investors normally interpret higher dividends from growth stocks as a signal of lower future growth prospects and mark them down accordingly.  But these announcements were favourably received by the market and each stock delivered higher returns than the ASX200 over the course of 2013.

In recent years, companies globally have deferred or abandoned growth options and increasingly returned cash or capital to shareholders via higher dividend payments and stock repurchases.  Skeptikoi believes this phenomenon stems largely from the financial crisis and the rise of the restless investor, with an assist from the disappointingly slow global recovery which has dulled investors’ appetite for risk.

The defining feature of the restless investor is a loss of trust arising from the financial trauma of 2008.  Research studies have shown that low levels of trust discourage stock market participation.  Trust might have an important bearing on the finding that macroeconomic experiences can have life-long effects on attitudes towards risk; investors who experience low market-wide returns in their formative years tend have more conservative financial portfolios through their lifetimes, reflected in smaller stock allocations.

The restless investor has lost trust in the ability of companies to undertake value accretive acquisitions or large capital expenditures that have distant payoffs.  Against the backdrop of still weak revenue growth, higher discount rates and shorter expected payback periods, companies have eschewed grandiose growth options and turned to a new cost discipline to boost profitability.  While a subdued nominal GDP growth environment has undermined the ability for companies to achieve meaningful top line growth, they are aggressively attacking their operating expenses and deferring capital expenditures where feasible to boost margins and free cash flow.  And strong free cash flow helps to support a sustainable lift in payout ratios.

Is there a risk that the restless investor’s loss of trust and preference for capital now over future capital growth could undermine the ability for firms to deliver sustainably strong growth in earnings per share?  Skeptikoi doesn’t think so.  The new cost discipline is a welcome development following decades where CEOs remained focused on growing revenues – at times, at the expense of profitability and shareholder value.  The renewed cost discipline will continue to focus the minds of CEOs on what they can control rather than chasing the pipedream of double digit revenue growth and market share gains that destroy shareholder wealth.

Stocks with sustainably high payout ratios will under-perform when the supply of income from the corporate sector eventually outstrips demand.  At that point, expect companies to re-engage their growth options more aggressively, which will put a smile back on the faces of the shrinking army of downtrodden investment bankers.

But if market gyrations are any guide, the journey to equilibrium is rarely seamless or linear.  Do not discount the role that the disappointing global cycle in recent years has played in fostering the rise of the restless investor.  The IMF and other forecasters have consistently downgraded world growth prospects since 2010.  The IMF’s preliminary estimate shows that world nominal GDP expanded by around 6.5% in 2013, down from 9% in 2011 and the lowest annual growth in over a decade excluding 2009.

Skeptikoi is wary that material upgrades to world growth prospects would raise the appetite for risk and be associated with under-performance of stocks offering strong and sustainable yield.  But the signposts suggest that we are not at one of those junctures just yet.  The IMF is projecting global nominal GDP growth to pick up over the next two years to around 7.5%, still weak by historical standards.  And the IMF has a long history of producing excessively optimistic world growth forecasts.  The persistence of large output gaps in many developed economies remains a headwind and should keep central bank policy rates close to zero for at least another year.  Moreover, any snap-back in risk appetite typically occurs when stock markets are very cheap, which isn’t the case at present.

Looking through the vicissitudes of the global economic cycle, the restless investor’s loss of trust will continue to constrain the parameters of corporate financial policies for some time yet.  Skeptikoi believes that the process of healing from the financial crisis is far from over; we have only just passed the fifth anniversary of the collapse of US investment bank Lehman Brothers.  In the wake of the financial trauma of 2008, the corporate sector is learning an expensive lesson about the asymmetric nature of trust; it can be lost very quickly, but takes a very long time to re-establish.

The Conglomerate's Fall From Grace: Two Tales of Diversification

By the time he had stepped down from the roles of Chairman and CEO of one of America's largest and oldest industrial companies in 2001, Jack Welch was arguably one of the country's most successful business men, a CEO superstar.  During the two decades he ran General Electric (GE), the stock rose 4000%.  Following his retirement from GE, Mr Welch was in hot demand on the public speaking circuit; many were prepared to pay handsome sums to get insights on how he had successfully managed a global, sprawling conglomerate.

GE represents an anomaly to text book theory and the trend in recent decades towards corporate focus. Long gone are the days where it was common practice for firms to undertake mergers and acquisitions in unrelated industries to boost flagging growth prospects. 

The development of Modern Portfolio Theory (MPT) through the 1950s and 1960s espoused the benefits of financial diversification; the value of corporate diversification is limited to the extent that investors can achieve diversification for themselves.  But at the time, the reality of high transaction costs was far different from the assumptions underpinning MPT; it was expensive for investors for investors to achieve home made or DIY diversification.  Corporates were all too willing through the 1960s and 1970s to help investors diversify by buying up target assets in unrelated industries.

By the 1980s, two developments had changed the conventional wisdom towards corporate diversification.  It had become apparent to investors that the conglomeration of corporate America has failed dismally.  Growth prospects for many diversified enterprises had not met expectations.  The failure stemmed from a lack of focus and the inability of internal capital markets to allocate resources efficiently across often disparate and unrelated divisions.

Second, the growing institutionalisation of the stock market had made it easier and cheaper for investors to achieve financial diversification themselves.  In particular, the launch of the world's first index funds in the 1970s by Wells Fargo and Vanguard was a game changer not only for the asset management industry but also for corporate diversification.  The ability to access low cost funds that tracked the S&P500 index meant that investors no longer had to rely on companies to undertake diversification themselves.

By the early 1990s, corporate America had undone most of the legacy of the conglomeration experiment.  Many diversified firms restructured voluntarily, selling off underperforming assets that were not central to their key competitive advantage.  And where management refused to see the writing on the wall, capital markets obliged, in the form of highly geared and aggressive private equity firms.  Some of these firms would spectacularly fail burdened by excessive levels of debt.  But investors had already delivered their verdict; corporate focus had won over corporate diversification.

The Schumpeter column in the Economist magazine suggested recently that the conglomerate might be staging a return ('From Dodo To Phoenix').  After all, the prospect of still subdued growth in nominal GDP around the world continues to undermine the corporate sector's ability to achieve meaningful revenue expansion.  Corporate diversification could help to boost flagging growth prospects and larger firms might be able to offer higher salaries than their focussed counterparts thus attracting and retaining the best minds the labour market has to offer.  The internal capital markets of conglomerates can also reduce reliance on at times fickle capital markets.

But Skeptikoi believes that a sequel to the first conglomerate wave is unlikely for three key reasons.  The costs of financial diversification have continued to decline sharply.  The advent of exchange traded funds (ETF) has revolutionised the asset management industry by increasing liquidity and transparency, as well as further reducing the costs of tracking a wider range of country and sector indices.  An S&P500 ETF typically attracts a management expense ratio of less than 10 basis points and can be traded on the market just as easily as a stock can. 

Second, a loss of investor trust since the financial crisis has meant that shareholders have little faith in CEOs to undertake value accretive acquisitions, particularly in industries unrelated to their core focus.  They are increasingly rewarding companies for returning cash or capital back to them in the form of share repurchases and higher dividend payments.  To this end, Skeptikoi expects the trend towards corporate focus to become even more entrenched; more companies are likely to break-up and sell off underperforming and unrelated assets to boost free cash flow and cater to investors' insatiable appetite for income.

Third, the financial crisis has failed to revive the fortunes of conglomerates.  If there was ever a time for conglomerates and their internal capital markets to shine, it was in the wake of the financial crisis, where external sources of funding either became prohibitively expensive or even dried up completely for smaller firms.  But if anything, their prospects have continued to deteriorate.  Emerging markets - where conglomerates are more common - have underperformed significantly in recent years.  And the great aura surrounding GE is no longer.  From the lofty heights of the credit boom where the stock typically traded at a 20% book premium to the broader market, it now trades closer to a 20% discount.  It remains to be seen what judgement history will deliver on the legacy of GE's superstar CEO.