Thursday, January 8, 2009

Now vs. the 1930s

Almost everyone I listen to on CNBC and Bloomberg are so convinced the current economic crisis won't be nearly as bad as the Great Depression. It is clearly different, but in some ways I see reasons why it could be even worse...

Mainly, few industries or sectors offer clear prospects for growth.

1- In the 1930s, most Americans didn't own a car and a large minority didn't have electricity. Merely by improving these conditions with things like road building and the Tennesee Valley Authority, government programs made a positive contribution.

2- In the 1930s, the economic system often called "Fordist-Keynsianism" was emerging as the new economic paradigm. Based Henry Ford's $5 day, this model focused on rising the living standards of workers and transforming them into a consuming middle class. It emphasized rising incomes and consumption. This model started coming apart with the inflation of the 1970s. Since then, corporate America has waged full-scale war on the Fordist-Keynsian model by shipping jobs overseas and scaling back benefits such as pensions.

3- In the 1930s, the modern integrated industrial corporation was still relatively new as a way to organize production. Modern integrated corporations include companies like IBM, GM, GE, AT&T, Procter & Gamble, etc. In the 19th century, technological progress was the name of the game -- things like electricity, railroads, higher crop yields, steel, etc.

This movement reached its peak during WWI, when the USA was expanded production to supply the allies with guns and butter. After the war, the country wound up with too much capacity, causing nasty deflation. By the mid-1920s, the agricultural sector was already in a depression and other primary industries like steel struggled. This was great for companies like GE and GM because it reduced their raw-material costs, making them massively profitable.

The key strength of integrated industrial corporations was much less their mastery of technology and much more their mastery of markets. They created brand identities and carefully managed sales and distribution, unlike textile and steel companies in the 19th century that relied on middle men to sell their products. (There were no brands back then.)

These integrated companies were centers of knowledge and information: It's where all the data about sales, production and finance intersected. This gave rise to a new class of white-collar middle-class workers, which would dominate American life for the next 70-80 years.

The problem now is that information is getting commoditized like never before. That means the same industries that benefited in the 1920s because they could monopolize knowledge are now facing a major threat.

Media is a perfect example. It grew in the 1920s and did pretty well even during the great depression. Today, it is being decimated by its own lack of creativity and the Internet. It started with the record companies in the late 1990s, spread to the newspaper companies starting in about 2005 and now is decimating television ... One mid-level executive at a major network recently told me "we're not planning to open any new television stations again."

(I think that even without the Internet or this recession, the established media companies were at the end of the road... That's why they resorted to growth via leverage and consolidation in the late 1990s.)

I covered the credit market as a reporter for several years. During that period, it was commonly stated that U.S. companies were "in great shape" financially. They were making tons of money and their debt levels were relatively low.

Since then I have become more skeptical and uncovered some data that casts major doubts on these assertions:

Unlike the chart in my previous posting, this chart looks at the debt of all businesses -- big corporations and small businesses. One of the reasons why companies appeared to be in better shape in the last few years was that companies enjoyed a massive profit bubble, with pre-tax earnings rising from 2% of GDP to 9% between the end of 2001 and late 2006. I believe at least three factors caused this bubble:

1-Companies benefited from significant capex in the late 1990s, which allowed them to produce more for less. It also allowed them to get by spending less on plant and equipment.

2-Globalization allowed companies to outsource many activities. As they purchased more from China, they experienced a situation like the 1920s -- only this time instead of benefiting from falling prices for food and steel, they enjoyed cheaper merchandise from China etc.

3-Cheap credit allowed companies to refinance debt to lower levels. It also let the U.S. consumer borrow excessively, making demand grow faster than it should have.

Now that the economy is going into retraction, profits are getting crushed. We've seen this across the entire retail space, and it will become increasingly common for industrial companies. So far, we've heard from Alcoa and Lenovo (not American, but still a good indicator of things to come in the USA).

That means debt burdens will actually go up, even if companies don't borrow money. Imagine you earn $5000 a month and have a $1500 mortgage payment. It takes up 30% of your "free cash flow." Now, imagine your pay drops to $4000 a month because your company loses a customer, or something like that. Now your debt payments absorb 37.5% of your money. The entirety of corporate America is facing this on a massive scale.

Another obligation that's going to get even bigger are corporate pensions.

On Dec. 23, S&P says companies in the S&P 500 index are now at least $257 billion underfunded.

On Jan. 7, BNY Mellon Asset Management said the liabilities of the average pension plan rose 31.5% last year. This was partially because of falling stock prices, which reduced assets and will require bigger contributions from sponsors. But most of the decline came from the Fed muscling bond yields lower, which reduces the ability of pension plans to earn income. Another unintended consequence of the Fed's heavy hand in free markets.

On Jan. 8, Mercer said pension funds were $409 billion short.

Based on all this information, it's clear the established corporation as we know it faces big problems. Their liabilities are going to get bigger over the coming year, putting even more pressure on employment.

Another looming issue is problems in the loan market. UBS is predicting that about $54bln of loans could get put up for sale this year as collateralized loan obligations (CLOs) and hedge funds dump assets. Amazingly, these two categories of investors control more than $240bln of the $370bln market for leveraged loans. (This demonstrates the huge decline of banks in the economy that I highlighted in this posting.) Do you think the average American knew that largely unregulated lenders account for such a large portion of the US loan market? CLOs are like mortgage-backed securities that hold big corporate loans instead of home mortgages. Both CLOs and hedge funds owe huge amounts of money at any one moment in time, so vulnerage to quick liquidations when things go against them.

This just demonstrates how hard it's going to be for debt-laden companies this year.

One final observation, which UBS took from the Bank of International Settlements. This table shows bonds outstanding as a percentage of GDP in several countries:

USA 219%
Japan 207%
Italy 199%
Germany 155%
UK 142%
Brazil 77%
China 51%

Debt is clearly a first world, developed country problem. This is going to hang like a ball and chain around the neck of our country for years to come, especially after politicians throw money at the economy in hope it will rebound. It's like throwing a cow's ear to your dog. When he's a puppy, he loves it.. over time, he's less and less excited about it. Now the dog is blind and arthiritic. He's lucky if he can walk 20 feet across the room. The trick won't work anymore.

At this point, the best thing we could do would be to find a way to replicate the economic experience of WWII, when people were essentially forced to build a nest egg of savings. This is what unleased the consumer boom that is finally ending now. It should be complemented with a rational dismantling and re-engineering of shopping centers and suburban subdivisions. The only problem is that that Wall Street can't make any money under that scenario, so I doubt it will happen!

No comments: