When Growth Ain't Good

Most of the time, growth is good. It’s not hard to see why. Utilisation rates rise, economies of scale kick-in, and operational leverage pushes up profits.

But, from time to time, growth ain’t so good. And it most definitely ain’t good in a time of infrastructural bottlenecks and resource shortages. In fact, it’s so bad to have strong growth at a time of shortage, that markets tend to perform better when there’s a major global slowdown.

Right now, shortages are exactly what we’ve got. Unfortunately, I think that global growth still has legs. That puts us into a position not unlike 1967 – when we still had the prospect of six more years of decent global growth – but markets embarked on a 16 year bear market just the same. After staying bullish from mid-Jan to late April this year, I’ve been getting cautious equities for the last month or so. Last Tuesday I went short – and I now stand around 70% net short of equities.

So why can growth be bad? Well, it’s because various commodities display a distinctly asymmetric response to tightening markets. The chart below shows the relationship between price and inventory for copper. A small reduction in inventory between May 2005 and May 2006 led the price to more than double. We’ve just seen something similar with oil over the past year.

And the problem is that these extreme moves in resources crowd out returns on capital and labour in the rest of the economy. Consumers’ real incomes come under pressure, and corporate earnings growth falls back. And it gets worse - at the same time, these kinds of resource moves keep headline inflation elevated. And headline inflation has a little understood property – it drives stock ratings. The higher the headline inflation – the lower the PE rating. Falling earnings and a de-rating is a toxic cocktail indeed.

That’s led me to a pretty simple strategy; stay short equities until oil breaks down.

Now, my view on oil is pretty straightforward. I don’t think it’s speculation that’s got us here, I think it’s fundamentals. I think the bidding up of oil prices in a shortage is entirely rational. And up to now, pretty predictable. But now that the oil chart looks not unlike the chart of Gouda tulip prices in the Netherlands from 1634 to early 1636 – during which time tulip prices rose tenfold – the oil price outlook is far from predictable from here. An imperceptible change in fundamentals, or in market mood, could send us either crashing or soaring.

And just because someone tells you that everyone is bullish of oil, that there are stocks held in tankers off the coast of Iran, or that marginal cost is below price – none of it means that the price is going down. From 1980-1982 oil supply rose, and demand weakened. But the price kept going up. In the 12 months from February 1636 to February 1637, Gouda tulip bulbs rose six fold more –for a total 6,000% appreciation in three years (vs. 1400% for oil in the past decade). And the tulips, they weren’t even useful.

Of course, oil would struggle to do anything like the final six fold tulip blow off – because by that time, around half the returns on capital and labour globally would have been crowded out. We’d be in the mother of all recessions. There would be extreme demand destruction. All I’m saying that any sense of oil ‘fundamentals’ and ‘valuation’ should be taken with a pinch of salt. They may not have much bearing on price.

So why do I think global growth still has legs?

It starts with a contradiction.

The chart below rings a warning bell. It shows the change in the US trade deficit. When the deficit shrinks it means less imports from the rest of the world and less dollars for the rest of the world. That on its own is not a major problem. The problem comes when you consider credit. Because the dollar finds its way into an overseas bank – and it gets multiplied 5-10 times by the banking multiplier. That’s why a shrinking US deficit often precipitates financial crises. It worked again in 2007.

But it’s not good enough to look at the deficit alone – the equivalent to global base money growth – it’s also worth looking at the global equivalent of broad money – you need to take account of money velocity – how much the money base is multiplied.

Now global financial statistics are never perfect. But the best we have on global money is shown in the chart below. It shows US base money, plus global central bank reserves held with the fed, plus an adjustment I have made for Gulf surplus cash (which isn’t reported in global reserves).

What’s interesting is that it is reaccelerating. This is similar to what happened in the 70s, as petrodollars were distributed around the world. This should be bullish for growth. And as it is petrodollars that is causing the majority of the growth – it is the direction of that marginal dollar that will determine investment returns over the coming years. In my view, those petrodollars are moving increasingly towards infrastructure spending.

But there is another hurdle to jump. And that is returns. If the cash goes into money losing enterprises, it will soon dissipate. The next chart shows the difference between nominal growth (a proxy for economy wide returns) and the cost of credit (a proxy for the cost of capital) in Brazil, Russia, India and China. Back in the 90s the cost of capital was above the return. So investments lost money on average, and the environment was deflationary.

Now, they are making a lot. That generates a self reinforcing growth process. This is not an end of cycle and global recession story – it is a mid-cycle story.

But, the process is inflationary. Utilisation across the BRICs (Charts courtesy of James Carrick who substituted Taiwan for China, as the data isn’t good enough in China) is at multi-year highs across the board. That’s inflationary. And inflation is just what we’re seeing.

In an environment where the West is being crowded out, and when the banks are doing everything they can to survive (which means hoarding capital) – it is worth looking for trouble at the weakest credit. That weakest credit is Eastern Europe.

These economies are seeing demographic decline, large fiscal and current account deficits, with debt often denominated in foreign currency. They are an accident waiting to happen.

So my basic position is this – the crowding out thesis I’ve been trading is now coming to the fore. I own infrastructure and resources stocks (although a reduced position from this time last week), I am 70% net short – including shorts on Banks with Eastern European exposure. And I’ll cut my short when oil breaks down.