What Did We Learn This Week? (07/08)—Tim Pierotti, Chief Investment Strategist

Tim Pierotti, Chief Investment Strategist

Let’s start with what we already knew coming into this week.  We knew that financial conditions have gone from historically easy to historically tight in an incredibly short period of time. We knew the Fed isn’t letting off the gas until clear signs emerge that inflation is under control.  Don’t forget, that includes wage inflation.  While commodities might be breaking down and that helps, the Fed is a long way from seeing the kind of labor market softening they are going to need to start jawboning to the market that they might be pulling up on rate hikes.  As evidenced by the yield curve inversion, fear of an imminent recession has trumped fear of runaway inflation.  The Fed is getting the results it needs, but it will need to see significantly more.  So, coming into the week, we already knew the economic data would be softening and that is what we are getting.  The question isn’t will housing and labor weaken, but how fast will it weaken and how bad will it get?  The die has been cast.  As we have said repeatedly, equity markets will bottom before the economic data does, but in our view, we are still in the early days of the economic slowdown and there are no signs that Team Powell has any intention of riding to the rescue anytime soon.  The best thing that can be said about equities is that bearishness is virtually unanimous and that tends to beget countertrend rallies.  Don’t chase.  The process has only just begun. 

To us, the more interesting question is: what will growth and inflation look like as we come out of the impending recession?  On that front, our variant view is that we have a productivity problem.  GDP is driven by workforce growth and productivity growth.  It is entirely non-controversial to argue that the workforce growth piece is a problem for the US.  The demographic issues and declining immigration are well understood and self-evident.  The productivity side is the piece where we believe complacency remains and we believe one of the reasons why productivity will disappoint over the next decade is that investors in public equities have become more successfully insistent on forcing corporate management teams to return cash to shareholders versus spending on capital expenditures. 

David Giroux is a CIO and Portfolio Manager at T. Rowe Price.  He recently published a book titled “Capital Allocation”.  In the book, he concludes, “Academic research and the historical record indicate that the average company deploys capital suboptimally…Firms tend to increase capital spending in the mid-to-late part of economic expansions—right before demand for their goods declines.” His conclusion is one that is increasingly prevalent among investors.  Large hedge funds and mutual funds like T. Rowe spend millions of dollars via banks and broker dealers annually to get corporate access.  Much of that money is spent to hear directly from CEO’s about how their respective businesses are faring.  But there is another reason.  PM’s want to look across the table at a CEO and ask one simple question: what are you going to do with the cash?  Invariably, the answer they want is clear: we are going to give cash back to you Mr. Shareholder. 

While that may be the right decision for individual companies, economists like Thomas Philippon and German Gutierrez assert that there is a long-term cost to the economy in the form of declining long-term productivity growth.  “Firms spend a disproportionate amount of free cash flows buying back their shares.” Gutiérrez and Philippon cite increased shareholder oversight, particularly in guarding against managers’ desire to expand capital investments beyond an amount that would be in shareholders’ best interests, as well as short-termism, in which “stock-based compensation incentivizes managers to focus on short-term capital gains” via share buybacks rather than making long-term capital investments in their firm."

I'm not saying buybacks are bad.  I'm simply pointing out an underappreciated fact that a powerful trend has emerged where CEO's know the easy/safe decision is to favor immediate shareholder returns over investing back in the business.  Unfortunately, that trend has negative implications for the long-term growth rate of the US economy. 

Tim Pierotti is WealthVest’s Chief Investment Strategist. 

Tim has over 25 years of experience in various aspects of the equities business.  Prior to joining WealthVest, Mr. Pierotti spent seven years in Equity Research management roles at Deutsche Bank and most recently at BMO where he was a Managing Director and Head of US Product Management.  Tim has 11 years of investment experience most notably as Head of Consumer Research and Portfolio Manager at The Galleon Group, a former NY based $8Bln Long/Short hedge fund.  Tim is a graduate of Boston College and lives in Summit NJ.

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