If you’re looking for a fun yet simultaneously depressing way to start your Thursday, SocGen’s incorrigible but exceedingly affable bear Albert Edwards is here to help.
Edwards – who occasionally takes time away from vacations to update investors on the new date for the apocalypse – is back from a 10-day trip to Barbados where he “warmed his weary bones on the beach” and read some local newspapers.
Somehow, that experience ended up finding expression in a lengthy Thursday diatribe about group-think at the Fed supplemented with some shit Jeremy Grantham said about how it’s good to argue with each other.
As usual, it’s best to just let Edwards tell you what’s on his mind rather than try and parse his thoughts upfront, but you’ll note that the conclusion is the same as it ever was: “[I] expect [the Fed] to blow the US corporate sector and economy sky high.”
Barbados’s central bank governor is sacked for refusing to print money. Who’s next?
Ive just returned from a reinvigorated ten-day break on my favourite Barbados beach. Whenever I am there, I always like to take a quick look at the local economic news. I was shocked to see that since my last visit, the Central Bank Governor, Delisle Worrell had been fired by the finance minister. It has been widely reported that Worrell was protesting at the Governments insistence he finance the intractable and burdensome public-sector deficit by printing money. Now why shouldnt Barbados follow the lead of the US and other developed economies by printing money? The main reason has to be that Barbados has a fixed exchange rate with the US. Economics 101 tells you that you cant print money with 6% twin deficits and expect the fixed exchange rate to hold. But despite the warnings of the IMF that the situation is unsustainable, especially as the US raises rates, apparently the Barbados Finance Minister has found a totally new way of doing economics. Fed Governor Yellen should take note that elected politicians dont take kindly to dissent.
Janet Yellen should know a thing or two about the stifling of dissent from her tenure at the Fed. While warming my weary bones on the beach I managed to venture beyond my normal diet of chick-lit (Marian Keyes being my favourite). But for some serious Fed/Yellen bashing I recommend Danielle DiMartino Booths, Fed Up. Nowhere is there more groupthink than in the Feds research staffs of elite PhD economists – the MIT mafia – who are married to their mathematical models. Danielle exposes at first hand the institutional groupthink and total disdain and ridicule for dissenting views. Danielle reserves her most strident criticism for those at the very top of the Fed who have continued along the same ruinous path of smug self-satisfaction they also trod in the run-up to the 2007 crisis.
The stifling of dissent and subsequent comfortable groupthink are some of the biggest dangers an organisation faces. By way of contrast is Jeremy Granthams GMO based in Boston where my former colleague, James Montier works. Jeremy encourages dissent and there is currently a very healthy disagreement taking place on the GMO website.
The problem with healthy debate is that so many people back themselves into a corner and take any contrary opinion as a personal attack on their very identity as a human being. Not so at GMO where there is a very lively public debate taking place. My former colleague in his latest posting entitled “Six Impossible things before Breakfast” begins
“One of the great joys of working at GMO is the freedom to disagree. Indeed, many moons ago when Ben Inker first approached me about joining GMO, he told me that, having read my work, he believed we were very much philosophically aligned. Ben noted, however, that occasionally I would reach a remarkably different conclusion than he, and that was interesting because we obviously approached problems using a very similar framework.
“Over the years, Ben’s observation has consistently revealed that at times the most valuable information can be found in our differences, and not in the areas in which we all agree. As the late Richard Russell opined, “If everyone is thinking the same, then no-one is thinking.” Or, as Alfred P. Sloan put it, “If we are all in agreement on the decision – then I propose we postpone further discussion of this matter until our next meeting to give ourselves time to develop disagreement and perhaps gain some understanding of what the decision is all about.” Indeed, one of my jobs internally is to ask difficult questions and take the other side of debates when I feel so inclined: a contrarian amongst contrarians. It turns out that I’ve pretty much been in training to be a stubborn, difficult pain in the arse my whole life!”
Hey, after working with James for many years, who am I to disagree with that last statement!
One piece of work I always recommend to people in the business is Jamess seminal 2005 collection of behavioural articles, written when we were at Dresdner Kleinworts, entitled The Seven Sins of Fund Management. In it he has a special chapter dedicated to the behavioural pitfalls of collective decision-making and groupthink. Here are some of his key conclusions, which after reading Danielles book, seem particularly relevant for the Fed!
- The eternal hope is that groups come together, exchange ideas, and reach sensible conclusions. The reality of group behaviour is frequently very different. Psychologists have documented that, on average, groups are more likely to amplify rather than alleviate decisionmaking biases.
- Groups tend to reduce the variance of opinions, and lead members to have more confidence in their decisions after group discussions (without improving accuracy). They also tend to be very bad at uncovering hidden information. Indeed, members of groups frequently enjoy enhanced competency and credibility in the eyes of their peers if they provide information that agrees with the group view!
- Groups also have a tendency to suffer cascades. Under cascades members abandon their individual information, choosing to agree with others, because they think they know more. Groups are also at risk of suffering polarization and possibly groupthink. Polarization occurs when members of a group end up in a more extreme position in line with their original beliefs after discussion with the group. Groupthink is an extreme version of polarization leading to all sorts of problems.
- Beating the biases of group behaviour is every bit as difficult as overcoming individual biases. However, secret ballots may help reduce social pressures to conform. The use of devils advocates may help (but they must believe the case they are arguing, and run the risk of being ostracized). Having respect for the other group members can help, but we all know how difficult that can be!
GMO is practicing what James preached from the sell-side many years before. The healthy internal public debate centres around whether this time is somewhat different and whether the US corporate sector might have indeed permanently improved profitability Jeremy Grantham in the latest GMO Quarterly Newsletter grapples with the question whether the US corporate sector has reached a new permanently higher level of profit margins. He posts two familiar charts showing a higher profit average for the last 20 years.
Taking the right-hand chart above showing BEA whole economy profit margins (post-tax), I reproduce the same line in red below, but also add in the pre-tax measure (dotted line). Interestingly, pre-tax margins do not seem to be so elevated relative to history.
My former colleague Leo Doyle always used to say that most profits/GDP measures were comparing a numerator net of depreciation with a denominator that was gross of depreciation and I should add depreciation back into profits. We do that below and you can see how lower tax and higher financial profits have played a key role in the last 20 years in elevating profit margins as the dotted line in the right-hand chart below does not appear unusual.
We think the explanations Jeremy Grantham gives for the higher level of US profitability, especially at the quoted level are spot on, particularly the monopoly power that a high level of regulation has engendered. Andrew Lapthorne looks at the profitability (ROE) of the five biggest US companies in each sector (by sales, with 32 sectors that makes 160 companies) and compares their ROE with the other 2,500 companies. He sees profitability of the vast bulk of US inc has declined on a secular basis and is now in line with the rest of the world.
Andrew calculates these high market margins are in part due to a shift in the market make-up from lower margin industrials towards higher margin consumer staple and tech companies that have managed to extract monopoly pricing power. If we look at the median measures of profitability to strip out this effect, we see that not a lot has changed in the US.
As both Andrew and Jeremy point out, higher US leverage is another key reason why US profitability is higher than elsewhere. Excluding financials in the right-hand charts above, Andrew shows no significant difference in profitability between the US and the eurozone when comparing ROA (return on assets, ie taking account of recent rapid rises in US leverage).
Below is our favourite chart that emphasizes everything that Danielle DiMartino Booths, Fed Up fears for the future, namely how the Yellen Fed has encouraged the US corporate sector to gorge themselves on debt. Even the IMF has recently warned, in its own understated coded way, that the Fed has created a time-bomb waiting to blow up.
Jeremy Granthams interesting conclusion is that despite the likelihood that US profits may have found a new higher plateau, perhaps the biggest structural threat to high profit margins comes from a bonfire of regulation, which will fill the moat by undermining the monopoly rent the US bulge-bracket companies are able to extract by reducing barriers to entry.
But in my view, a more immediate, cyclical threat to US profitability is steadily rising wage inflation (see left-hand chart below). This is probably the main reason why the charts at the start of this piece show whole economy profit margins rapidly declining back towards their mean level since 1970. At a time when unit labour costs are running way ahead of corporate output price inflation, US profit margins cannot help but carry on falling further. In our opinion there is no US profit miracle, especially at a pre-tax level outside of a few bulge-bracket tech and consumer staples companies. This cycle looks boringly normal to us. The last nail(s) in the coffin will be the Fed rate hikes which we, and now even the IMF, expect will blow the US corporate sector and economy sky high. You have been warned.