Divining the Roadmap To the "Unexpected" Contraction

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Any economic weakness in the context of a recovery is conditioned in the economics profession as "unexpected". Wednesday's news of a slight contraction in the US GDP accounting was universally noted to be exactly that. The reason economists cannot seem to grasp declining economic fortune is all the "stimulus" present. With so much monetary measures in effect all over the world, it does not seem possible to them that weakness would be apparent and persistent.

What was supposed to be better than 4% real growth by now has been at least halved in reality. In Europe, the shortfall to predictions has been far worse. Economic projections from really the start of the recovery period have seen one after another prediction for robust recovery pushed further and further into the future. If not 4% growth this year, there is always next - monetary stimulus will hit its mark eventually, as in the recovery is always just out of reach or sight.

The reason for the failure of economic fortunes to match monetary-driven optimism is a relatively simple concept. Monetary policy and money-driven measures to combat "cyclical" weakness are not neutral.

Mainstream economists will protest vociferously that neutrality does exist, and that over the long run monetary policy has absolutely no lingering impacts on the economic system. They have conducted statistical studies that confirm and prove, to their interpretations, monetary policy leaves no lasting fingerprints on economic dysfunction. If an economic system perpetually misfires, the conventional wisdom only posits that it is short of monetarism. Thus the cure is always more central banking.

Last week, IBM released its Q4 2012 earnings report. It was a tough but still successful year for Big Blue. The company started 2012 projecting full year earnings per share of $14.85. That estimate proved to be, like most relying on mainstream economics, a bit too optimistic. Instead, full year earnings per share grew only to $14.37 (fully diluted). The shortfall to initial estimates was due, in full, to the tough global economic environment. Top line revenues actually fell 2% for 2012.

In that context, that total net income grew to $16.6 billion, an increase of 4.4% over 2011, is testament to corporate resiliency. Despite apparent macro weakness, IBM was able to increase margins (+1.2 bps) and thus income. While that was good, EPS of $14.37 meant that IBM managed exactly 10% EPS growth, its 10th consecutive year of double digits. Of course, optically, there is a bit of divergence in those two growth rates since net income is supposed to be largely consistent with earnings per share (with net income as the numerator in that calculation). It was the denominator that kept IBM's streak alive.

The company saw free cash flow in 2012 of an impressive $18.2 billion, a 9.6% increase over 2011, and saw fit, with that EPS winning streak certainly a priority, to return $15.8 billion of that cash flow to shareholders. Dividends accounted for $3.8 billion, while the other $12 billion took the form of share repurchases. That was just enough to turn a 4.4% gain in net income into a just enough 10% increase in EPS.

On the expense side of the business, obviously costs were controlled rather vehemently in a macro environment that saw shrinking revenues. To that end, capital expenditures (for fixed assets) were increased only slightly in 2012 to $4.3 billion. Research & Development expenses grew 5.2% to $6.3 billion.

For full year 2012, IBM spent a little over $10.5 billion on capex and R&D combined, and $15.8 billion returning money to shareholders with its EPS, and therefore stock price, in mind.

Over in Italy, Reuters reported in early January that Italian banks were experiencing a return of depositor funds after a dismal first half of 2012. Flush with returning cash, those Italian banks promptly cut lending to non-financial firms. In fact, according to Reuters, lending to corporations and individuals fell 3.4% in November (the largest decline on record, going back to 2001) despite those deposit gains. The Italian banks did manage to increase their holdings of Italian sovereign debt, by about €4.3 billion.

The allocation to Italian sovereign debt is a reversal from the stated preferences of the previous year (2011). It was Italian government debt that got Italian banks into so much liquidity trouble in the worst of the European banking freeze of late 2011, so returning to that asset class could be construed as a far too short memory. That is particularly the case since Italian economic fortunes continue to recede, with the country, like Spain, mired in continued (and unexpected, of course) economic contraction.

However, the ECB has publicly stated that it will purchase a potentially unlimited amount of troubled sovereign debt to ensure that monetary policy is "transmitted" to these economically troubled nations. With such a backing, the ECB has essentially created the conditions where financial purchases of PIIGS sovereign debt will always and everywhere be profitable. It almost does not matter what price the purchaser pays, it is almost assured that the ECB will act in putting a floor under those prices. That gives sovereign debt as an asset class for investment an implicit profit subsidy at the expense, as we have seen, of businesses and individuals.

That is more than a little contrary to the stated purpose of monetary measures. If their aim is to get credit and debt flowing in those countries, the recent activity of Italian banks should be troubling. The real economy in Italy, and elsewhere in Europe, is undermined by an unintentional monetary means of intrusion that essentially is misallocating "capital" in those systems.

The IBM story in the US is a similar misallocation. The Federal Reserve has made it a policy goal to see US stock prices rise as far and as fast as financially possible. The November 2010 op-ed by Chairman Bernanke in which explained his goals and expectations for QE 2 noted that:

"Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending."

The focus on stocks, in particular, is an intangible distortion on the economic functioning of investment assets' relation to the real economy. That is the narrative of IBM in 2012, and its results were unfortunately not atypical across the broad spectrum of corporate America. Rather than invest current success in future productive capacity, the company felt it imperative to keep EPS growth in line in order to manage stock prices. The only reason corporate management would do so is the current state of investor expectations.

Right now, investors want cash flow returned to them because they want fast rising shares (born by fast rising EPS) and a constant flow of dividends. The latter is fully due directly to ZIRP - investors have so very few alternatives to acquire fixed income streams that dividends have become a preferred means to that end. For IBM's corporate managers, who are largely paid by share price, that means harnessing the company's efforts into returning cash to shareholders rather than investing for future production (which is not currently as valued by investor expectations). This is short-term thinking that, in the context of the macro-economy, misplaces and distorts investor expectations in favor of short-term prices and at the expense of the economy.

In point of fact, however, what these micro examples show is that there is no separation between macro and micro. Central banks aim to affect macro indications, such as Chairman Bernanke alluded to in interest rates and stock prices, to achieve ostensibly macro targets, but the micro means to get from A to B can only be through misallocations. The more the economic system gets interrupted by monetary intrusions, the more dysfunctional it becomes on the whole.

In corrupting the "normal" course of economic and monetary flow, these policy measures distort the expectations of investors and economic agents. Financial firms in Italy change their preference away from successful "intermediation" in favor of government bonds, but at the expense of other debt opportunities. That is not intermediation at all; that is pure speculation driven by artificial intrusions of central bank money, altering what is supposed to be the flow of "capital" to successful enterprises and systems. It is the success of enterprises and businesses in the micro that directly leads to the success of macro, meaning that there is no real separation of one from the other. Distorting one (micro) necessarily leads to dysfunction in the other (macro).

The very character of heavy intervention into the financial system misallocates financial resources away from the real economy as banks disintermediate in favor of speculation and companies shed capital rather than retain it (a form of speculation). The prime problem of the US economic system has been weak personal income. Real per capita disposable income has been at best flat, and contracting far too often, since the middle of 2011, yet corporate profits have been simultaneously robust. The link between those two, in an economic system that "values" future production over asset inflation, is capital expenditures and internal investment. Successful capital is the lifeblood of future expansion and the real transmission of capital (not money) formation into sustainable economic expansion.

This distortion becomes a positive feedback loop under the heavy hand of monetary and central bank influence. As companies assign more "value" to returning capital to shareholders, weakening the link between current success and future growth, that means the circulation between successful business and labor's share of it is diminished. That leads to a more challenging business (macro) environment since labor is hard pressed to keep up spending patterns, leading to shrinking revenue growth. At that point, since monetary distortions push companies to value current share prices above all else, marginal capital flows even more in the direction of misallocation (dividends, share repurchases and M&A) rather than investment (R&D and capital expenditures). Job growth and labor participation shrinks still further, and so on.

The character change of investor expectations is not some exogenous, unrelated event of human irrationality. In fact, it is a very rational response to the distortions of monetarism. Asset bubbles are not even random formations - they are the very rational response to monetarism's propensity for "liquidity". If there is "easy" money to be made, it will attract human interest in an exponentially growing manner. That is not irrational exuberance, it is bending the character and expectations of human agents through monetary distortions proffered under the cover of macro engineering.

Monetary policy is decidedly not neutral. It is a powerful mechanism for changing the intangible parameters of micro functioning. Central banks, for all their posturing and statistical proof, influence the flow of money in the economic system at terms beyond the immediate. Economists remain unaware of this because it cannot be directly measured or captured via mathematical formulation. I highly doubt the Federal Reserve's ferbus mathematic model of the economy incorporates IBM's choice to return almost all of its free cash flow to shareholders - and it certainly doesn't capture that IBM borrowed a few billion dollars to help do it. When the monetary world is believed to end at the edge of macro, what goes on beyond in the micro world will always be a surprise.

As much as the Federal Reserve would like the weather to be the decisive factor in the fourth quarter's contraction, the economy has been through weather events before without so much commentary and worry. The fact that October's disruption in the US and the snow in the UK are even discussed as major economic factors are evidence to just how unbelievably brittle these economic systems are. The US and the UK, as well as Europe, have seen some of the heaviest doses of monetary applications in human history. And still, despite all of it, snow and storms are blamed for derailing what should be a robust growth trajectory. Obtuse excuses and success are mutually exclusive.

We were promised and projected sound economic function over and over, yet these conventional practitioners find themselves confounded at the wrong end of perpetually "unexpected" weakness. Rather than point the finger at Mother Nature, it might be better to look at the intangible distortions of vital micro functions and calculations. The constant misallocation of capital, in fact the corruption and disintegration of good capital into mere money in the churn of asset speculation, is far more relevant to any building contraction than "transitory" weather factors.

As long as banks are favored to be handed subsidized central bank-led profits, the process of disintermediation will continue in exactly the arena that central banks mean to "stimulate". At the same time, delinking corporate profitability from growing labor income through actual, physical investment is indubitably the very agent of economic instability and brittleness that the perpetually confused comically mistake for normal weather. Together, these are the very roadmap to "unexpected" recession, a destination made increasingly inescapable by the decidedly non-neutrality of monetarisms.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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