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This Time It's DifferentJohn Mauldin
"For over ten years now,
a wide majority of market strategists and economists from respected
investment banks (Morgan Stanley, Dresdner...), a large number
of upscale financial publications (The Economist, The Financial
Times...), highly respected consulting firms (Lombard
Street Research, Grant's Interest Rate Observer, Gloom Boom Doom...)
have drawn on historical parallels to warn us that the expansion
of the past decade in US consumption was both unsustainable and
likely to end in tears. Real estate all over the Christian civilized
world was bound to collapse, along with global equity markets.
The world would then enter into an 'ice age'. So far, despite
the strength of the above thought process, and the numerous historical
parallels, the dreaded meltdown has completely failed to materialize.
So what is the next step?" A few weeks ago I mentioned a small dinner party in London hosted by Charles and Louis-Vincent Gave, the Gave's of GaveKal Research. They are quite bullish about the longer term prospects for the world, and as we will see below, argue that something new is happening that may not rhyme with our past economic history. Long time readers know I like History. It is an old friend. It is a very uncomfortable proposition to hear things may be different, as they argue it well. Feeling like having a little fun, I invited Bill Bonner to dine with us, knowing that he takes the very opposite view. With wives and friends there were ten of us. I made certain that Bill sat next to Louis and Charles, knowing his natural inclination to sit next to the ladies which would have been more fun for him, but would have produced no fireworks. (It was somewhat intimidating sitting at a table where everyone spoke 3-4 languages. In London, there are those who suggest I need to brush up on my English.) This week we are going to start a multi-week series centering on the debate at that table. It is one of the most important debates of this era, as not only does the outcome of the debate touch every part of our investment lives, but it also affects the very social and political worlds we live in. But first, let me thank those of you who bought my new and latest book last weekend. We rose to #2 on Amazon. Couldn't get past some book mentioned by someone called Oprah. For those of you who missed the announcement, I have gotten 11 of my friends to write a chapter on the one investment topic they are most passionate about, and of course, contributed my own chapter. The book is called "Just One Thing." To find out more about it you can click here and buy it. It is in most major bookstores, unless it has sold out. I believe you will enjoy it. For those of you who want to buy larger quantities to give to clients, you can call 1-800-CEO-READ and get a 40% discount if you buy a case or more (32 per case). And with that commercial break over, let's return to this week's letter. Our Brave New World In the late 1700s, the world was changing. The Industrial Revolution was just in its infancy. Steam engines were starting to power all sorts of enterprises. New manufacturing techniques drove down prices of production. A new source of wealth was being created. European economics was invented by a group of French Enlightenment philosophers who called themselves the Physiocrats (which means "rule by Nature"). The Physiocrats took Isaac Newton's idea that the universe was mechanistic and applied this mechanistic world view to the social production and distribution of goods and services. They examined the phenomenon of mercantile economics--mercantilism is the distribution of goods with the calculated goal of achieving profit--and argued that the distribution of goods operated under the same mechanistic and natural laws that the rest of the universe operated under. Enlightenment thinkers had been busy applying mechanistic thought to other areas of social organization, so it seemed quite natural to apply these principles to the economy. Yet, early on, many of them (Quesnay, Dupont de Nemours) suggested that the real way to create true wealth was from agriculture. This is somewhat natural, as that was how wealth had indeed been created. They simply looked around and noted what they observed. They missed entirely the new era that was emerging. For centuries it had been the same way. But that time, it was different. Things changed. The discussion at dinner began as Charles and Louis suggested that trade deficits no longer matter. Bill's eyebrows shot up and he rose to the occasion, coming back with his own arguments. It went back and forth for a few minutes, with your humble analyst egging all of them on. (It was good fun, and Louis was picking up the check. All in all, a most delightful meal at a very great restaurant.) "You've got to be kidding," he announced. "You are saying that this time it's different. "That is precisely what we are saying," shot back Louis. Bill looked at them like he was seeing someone from outer space. "But it's never different," he proffered. Then Louis gave us a copy of his new book, called "Our Brave New World" where they outline their reasoning. I knew Bill's new book, "Empire of Debt" sub-titled "the Rise of an Epic Financial Crisis" would be out in a few weeks. Bill and co-author Addison Wiggin make the exact opposite argument. History will indeed rhyme and lead to a serious financial situation, destabilizing the global economy. Today we start by looking at some of the arguments in Our Brave New World (also co-authored by Anatole Kaletsky, the Kal in GaveKal). It will take two weeks cover their thoughts. The we will turn to Empire of Debt, looking at Bill and Addison's arguments. Then I will weigh in with my own. I find there is merit on both views, but think there may yet be a third way to look at our world. And make no mistake, how you come down on this argument is critical. Because the investment strategies one would adopt if you hold these views are quite different. But wait until the series is finished before you tell me I am nuts. You can get Empire of Debt by going to Amazon. For some reason, Amazon wants $25 for the GaveKal book. You can order directly from GaveKal and get it for $20 including shipping. Our Brave New World is only 130 pages and can be read in a few hours. It is explosive and will certainly upset some readers. However, I think not reading it is a mistake if you are serious about trying to understand the world economy. My review clearly cannot do justice to the book. And you can order Bill's book and mine as well (hint) from Amazon. Now, let's start with this quote from the introduction of Our Brave New World. It sets the table nicely. Drinking the Kool-Aid "History never repeats itself; but it often rhymes. "This simple fact explains why so many financial analysts, market strategists and portfolio managers like to study past economic cycles and market reactions before taking investment decisions. By studying financial and economic history, market participants are able to anchor beliefs on solid facts. "When a thought process fails, i.e., when history fails to rhyme, money managers and analysts can typically respond in one of four ways:
"The reason so many analysts drag their feet in admitting that history has failed to rhyme this time around is that it would lead one to the dreaded conclusion that 'things are different this time'. But why is this a dreaded conclusion? Because anyone who has spent ten minutes on a trading floor knows that saying 'things are different this time' is:
"And yet, this is exactly what we aim to argue in the following pages. "Arguing that 'things are different this time', we freely admit that we might end up drawing the wrong conclusions, say silly things and establish relationships where there are none. We also realize that some of our more cynical clients (say those sitting in Boston or London), might read the coming chapters and conclude that we have really been drinking the Kool-Aid. These are the risks when one ventures into uncharted territory. We accept these risks gladly, for we are convinced that the first step to successful investing is an understanding of the current world. "Unfortunately, History is of little help to this understanding. We have to draw solely on logic, and the help of our friends and clients. With this in mind, we kindly ask that you contact us if you see a flaw in any of the arguments that we present. Again, this is a work in progress, the final aim of which is to help us understand the world we live in so that we can deploy our capital more efficiently." So, what makes it different this time? GaveKal suggests a number of things. First, there is a new business model. Just as industrialists were new in the late 1700s, there is now a new model developing. GaveKal calls this new model "platform companies." The old model was to design or find something, manufacture it, market it and sell it. (Think Ford, Caterpillar, 3M, oil, mining.) The new model keeps just the high value added parts and ditches the rest. The new model focuses on research and development, treasury, marketing, and the business process and out sources as much of the low margin work as possible. Think Dell, Wal-Mart, IKEA, Li and Fung. Most hotel chains now do not own their properties. The new model is to "produce nowhere but to sell everywhere....Platform companies know where the clients are and what they want and where the producers are. Platform companies then simply organize the ordering by the clients and the delivery by the producers (and the placing of their logo on the product just before delivery)." Production is the least profitable of all the processes. It ties up capital, means a lot of volatile (and costly) inventory, it is labor intensive (and subject to all sorts of problems when there is a slowdown (unproductive labor costs) or a quick need for more product and overtime costs). The market does not give manufacturing companies the same investment multiple as they do the platform companies. Platform companies have more stable incomes and profits. Who would you rather be? The Chinese and other Asian companies that make the Ipod at a 2-3% margin or Apple who sells it at a 40% margin? But this process means manufacturing jobs leave the developed world (The US, Canada, Old Europe, Australia, New Zealand and Japan) and move to the developing world, primarily Asia and Eastern Europe. This is not seen be many observers as a good thing. Take for instance good friend Marc Faber's recent writing: "I am fully aware that some observers will argue that it doesn't matter that US companies are increasingly moving their own plants overseas, or outsourcing altogether, because the improved profits that result from the outsourcing accrue to the parent company... However, what about the long term? How beneficial is it going to be for Western industrialized companies if IBM were to lay off 13,000 people over the next twelve months in the US and hire 14,000 in India...I suppose even a non-economist could see that the movement offshore of sophisticated manufacturing and well-paid service jobs has to have some negative macro-economic consequences..." And indeed jobs have been lost. But more have been found. Some would argue that we are seeing lower paying jobs, but the reality is that tax receipts, at least in the US, are always and everywhere up, even as the Federal government cut taxes! No one pays more taxes than they absolutely have to. Higher tax receipts means people are making more money. Not everyone, of course. Is the platform company model something that will pass or is it the new wave? GaveKal asserts that the model depends upon four things.
The above items are all part and parcel of a capitalist economy. "So in a sense, 'platform companies' are the children of the capitalist system." And where does growth in a capitalistic society come from? It either comes from what is called Ricardian growth (from economist David Ricardo), or the growth that comes from a rational organization of talent, where each person contributes at his best level of skill. Countries which do not allow for free movement and advancement of its workers are less profitable than those which do. How much talent is wasted in countries that do not allow women to work, or do not educate their poor universally? Growth is clearly better when those with the best skills and services are allowed to thrive, free of protectionism. This is true whether it is on a personal level or on a country level. If China can manufacture something cheaper than is the case in the US, then why should consumers be required to pay more? And if something costs less, then more of it will be bought. Thus Ricardian growth. Yes, that does result in some workers losing jobs, but in a fluid and free economy, they find others. While some find jobs with less income, as noted above, incomes on average are up. And yes, we have fewer manufacturing jobs, but we are manufacturing more "stuff" than ever. We have become more efficient, as technology has made our manufacturing processes in the developed world more productive. Then second type of growth is what Schumpeter calls creative destruction. It is the growth that comes from new ideas and inventions driven by entrepreneurs. New ideas mean new products which create whole new levels of demand. It can also mean that some products become obsolete. There was a time when my fax machine hummed all day. Now, we get 2-3 faxes a day, at most. I no longer have a home phone, as we all use cell phones. Things change. They go the way of the buggy whip. For Ricardian growth you need low trade barriers. For Schumpeterian type growth, you need low regulations, low taxes, access to capital and the ability and right to fail. To the degree which countries encourage such things, they prosper or grow more slowly. The real danger to the platform model? Governments and protectionism. As they point out, a Dell computer says "Made in China" but it is really more accurate to say assembled in China. It is made from parts and software from a score of countries. Of course, the "trade deficit" is counted as China's. Yet, Senator Schumer regularly bashes China, appealing to his union supporters, but fails to notice things like this. Should we also get upset with Korea and Taiwan and Russia and Sweden and the rest of the countries who contributed? We live in a world where our ability to measure economic reality is becoming more and more limited. In a world where the US government counts Microsoft physical exports as "plastic" because the disks are plastic and only worth a few dollars at most (Dennis Gartman swears he was told this by a government official who was physically counting export shipping at a port), how can we trust the numbers? The Dollar Asset Standard But let's let the GaveKal guys make their own conclusions. I quote this passage at length, because it sets up the argument and some key points: "As mentioned [in the book], one of the first implications of the 'platform company' model is that industrial jobs (those close to the hearts of our bearish friends and left wing politicians) in the 'creative world' disappear, only to reappear in Mexico, China etc... Over time, the job market in the developed economies moves to a minority of very creative individuals who work for themselves, and a majority of fellows who work in the service industry for the creative minds and/or the tourists coming in from the industrial world.... "If we assume that a new part of the world is getting richer (China, India, Russia, Brazil, etc.), then we should probably assume that some entrepreneurs in those countries are making it big. This assumption is not a stretch; there is enough anecdotal evidence to support (if you doubt that some new entrepreneurs are making it big, go to the Louis Vuitton store in Shanghai on a weekend). If we further assume that, in the countries getting richer, we will start to witness the emergence of institutional savings (pension funds, mutual funds, family offices, etc.), then we should expect big 'savings flows' from the rapidly growing developing world into the Western world. "In simple words, the emerging markets' newly rich will feel like investing a part of their newly created wealth in regions of the world where property rights are well protected and where there is a rule of law. The excess trade balances earned by the 'industrial world' have, in fact, little choice but to be reinvested in the assets of the 'creative world'. The pension funds of the 'industrial world' will buy the companies which give their countries work. The successful individuals in the 'industrial world' will also buy real estate in the 'creative world' (because it also happens to be the 'fun world'). This implies that the assets in the 'creative world' and especially the prestige assets will always border on the overvalued. Similarly, given the ability to change a producer if he becomes a little bit too demanding, asset prices in the industrial world will remain a little bit undervalued at all times... "Which brings us to the following point: balance of payments consists of two parts:
"Taking this a step further, we can assume that, as a result of the constant capital flows, the countries with a well developed capital market will have an overvalued currency and a very low level of long rates. Which in turn leads to robust real estate markets and higher asset prices. "We call this 'the dollar asset standard'. Basically, diversified and safe assets in the Western world replace gold as the standard of value in the eyes of new savers in Asia, Latin America, or Eastern Europe. "The first implication of this new 'dollar asset standard' is that overvalued currencies, combined with a low cost of money (i.e. low barriers to entry), will prevent anybody in the 'developed financial market world' from making any money in industrial goods. In turn, this development will ultimately force companies in the developed financial market world to move to the 'platform company' business model, specializing in design and in marketing, and letting someone else produce the goods. "But this is where it get interesting: once they make the switch to the 'platform company' model, a number of companies will likely realize that they should domicile their research and marketing activities in countries with low marginal tax rates, both for their shareholders and their employees." This latter point is already happening, of course. Just this week, the Wall Street Journal ran a front page story on how Microsoft saves billions in US taxes each year by having an Irish subsidiary. Ireland has seen significant economic growth because of its low tax status, especially compared to the continental Old Europe. More and more companies are moving their operations and subsidiaries to low tax countries. That is enough for this week. Next week we look at why the US does not really have a cash deficit, as assets are rising faster than our trade deficit. This, according to GaveKal, can make the current deficit last a long time. Why does this happen? Also, rising incomes throughout the world will change trade and manufacturing. 300 million Chinese with cell phones? How should we then invest? Tune in next week. And for those who think this all sounds crazy, we will then spend some with Bill and Addison, as they tell us it is never different. That there are consequences to poor economic policy and central banks playing with the money supply and interest rates, and that bubbles do not end happily. You can get either or both books at Amazon or GaveKal. or I highly recommend them both. As I said, this debate is central to our investment, political and social worlds. And don't forget to order Just One Thing if you haven't done so. New York and London Tomorrow I am off to New York and will take a few days for some R&R, exercise and read some science fiction books with no economics in them at all before really kicking back into work on Monday afternoon. I get to have dinner with Art Cashin and Dennis Gartman on Monday night, and see a lot of good friends and clients and colleagues on Tuesday and Wednesday. I will be speaking on Wednesday afternoon at the Value Investing Conference. It looks like a great line-up of speakers. I am still working on my speech. That night I fly with my partners at Altegris to London to look at a few hedge funds, do some press interviews and meet with my London partners (Absolute Return Partners) and then back to Texas to get ready for Thanksgiving. This year all the kids (all seven) will be coming in, as well as other family members. I am really looking forward to it. Tonight is dinner with good friends and new friends I have yet to meet. It is getting close to time to hit the send button. I hope you have a great week. Your 'really looking forward to seeing friends all next week' analyst,
John Mauldin
321gold Inc |
