Archive for January, 2010


Davos, World Economic Forum

January 31, 2010

You may have heard about the goings-on at Davos. If you’re like me you are probably wondering what all the fuss is about. The Davos World Economic Forum is a rather oversold talking shop, where – truth be told – nothing very substantial happens. But Davos is important because it is a place where the world’s movers and shakers set their jib for the coming year. And, considering these players represent major forces in the economy and capital markets, their general perceptions are important to businesses, large and small, in the real economy.

The themes that are getting all the attention this year are the recovery (so called) which seems to be faring much better than most pundits expected this time last year. These positive sentiments are, however, contrasted by a dark prevailing gloom; nobody seems to expect the global economy to return to robust growth anytime soon.

The reasons lie in the now obvious structural flaws in the international system. First of all, there is the big problem of global imbalances, which have been growing for decades. The problem is most countries around the world are planning export-lead growth strategies and secretly (quietly) taking steps to limit imports. The obvious flaw in this logic is with everyone exporting ‘who will be importing’? The answer… not the United States which for sixty years has played that role and today is simply not capable of carrying the world on its shoulders.  So this structural flaw will very likely lead to a downward spiral of currency manipulations, increasing protectionism and mud-slinging – not a happy prospect for growth.

The elephant in the Davos room is, of course, regulation of the banking industry. While bankers are reluctantly admitting (at least publically) that greater regulation is coming, they prudently point out that such regulation must be globally coordinated. This is true, but as the bankers know only too well, is practically impossibility in the time frame. So the bankers are cranking things back up and trying (without much success) to avoid saying anything foolish.

The fact of the matter is it’s not the 1930’s or even the 1980’s anymore, the world of credit and banking have changed, morphed into a self perpetuating, multi-headed hydra that nobody really understands. It’s NOT about banking anymore, for the banks themselves are only one part of a much larger global credit market ‘system’ that is beyond the scope of national regulation. Such contentious issues as bank proprietary trading, securitization and credit derivatives are not going away; fact is, they simply defy national borders. So the genie cannot be put back in the bottle. And, given the damage they’ve caused in recent years and the hopelessness of trying to bring them under any kind of supervisory system, more trouble undoubtedly awaits.

Finally the sovereign debt crisis has been reduced to farce. Unfortunately it is the most likely trigger for systemic crisis this coming year. Last week with the price of Greek gilts (government bonds) falling like a stone and yields rising, the EU intervened with a ‘kind of’ guarantee, which was greeted with a huge sigh of relief in markets.  But the underlying sentiment is not good. The latest, not very funny joke going around is that the “Pigs” won’t fly: the Pigs are Portugal, Ireland, Greece and Spain, who all have chronic debt problems and who now find themselves consigned to the financial out-house, with Greece at the head of the line.

Things to Think About:

  1. Most of us were hoping that this recession would be like previous recessions. We’d have a bit of belt tightening and then things would return to normal. That doesn’t look likely, at least in the near term, so a new normal of (at best) stagnant growth, increasing trade friction coupled with growing government fiscal crises will put the squeeze on business.
  2. The status quo, easy returns of the past are going to be much more difficult to maintain in the coming years. But every crisis presents both danger and opportunities, there will be growth areas in the economy, which need to be identified and focused on. Areas of growth seem to be emerging in Energy, Health Care and the Green/Environmental market spaces.  However, even in these areas new thinking, innovation and flexibility will be required to find and capitalize on opportunities.

What’s Ahead for the New Decade: China Trouble

January 12, 2010

One of the great virtues of China’s hybrid capitalism is that in a crisis the communist party can reach into the economy and pull levers not available to governments in Western economies. For instance in the past 18 months while the rest of the world has been literally pleading with banks to lend more aggressively and restart the economy, the Government of China has been hard at work behind the scenes priming the pump through its political control of the banking sector.  

The problems with this kind of political interference in banking are pretty obvious, according to Michael Pettis: “Every time that (Chinese) banks have engineered a policy-induced surge in lending, they have followed up with a surge in NPLs,(non performing loans) and it would be pretty extraordinary if this time were any different.”

And as dangerous as NPL’s are for the Chinese banking sector, they are not the only problem. The banking surge has contributed to a massive misallocation of capital in the Chinese economy that is creating some of the world’s biggest bubbles. Take Chinese stocks for instance, according to London’s Financial Times they’re trading (on an adjusted basis) at 50 times earnings, and Chinese real estate is even worse, in major cities real estate is trading at values of 15 -20 times average household income, an eye popping multiple.

The reality is this, the Chinese economy is on a debt driven investment boom, with fixed asset investment approaching 50 per cent of GDP, creating a massive over capacity largely in export manufacturing and real estate. It is worth noting that just before it collapsed in the 1990’s, Japan’s fixed investment numbers were 30 to 35% of GDP.

All of this creates a China bubble waiting to burst. When it does it will not be the end of the Chinese miracle – that will likely continue for decades. But a China crisis could have dramatic short to medium term effect on the global economy depending on when it takes place. At the moment, and for the foreseeable future, Chinese growth and demand is about the only good news on the economic scene. Certainly it is critical to underlying assumptions behind longer term economic recovery, and therefore market confidence.

Should China come unstuck before the Western economies are fully recovered, it could create another crisis equal or greater than the one we’re just climbing out of.  Not a happy thought, but one which we all need to consider and prepare for.  

Things to think about:

  1. It is important to realize that markets are not perfect, market signals are not objective representations of value. It is imperative that you know the true underlying values and plan accordingly. In other words, have a counter cyclic strategy ready to go at a moment’s notice; otherwise you may be caught like everyone else.
  2. Take your own council and watch the signals. There is a great desire these days among the Powers-that-be to paint a positive picture of the economy. Don’t believe everything you hear, even (especially) from central bank chairmen, politicians or those Lords of the Universe in investment banking. In other words, keep your head up and your stick on the ice.

What’s ahead for the New Decade: The Good News

January 4, 2010

Although there is much gloom and doom around these days, and some very real structural problems in the global financial system there is some good news as well. One of the most significant sources of good news is the fact that the Western economies are growing much more strongly than reported.

At present GDP calculations ignore or seriously undervalue the growth contributions of newer non-traditional (intangible) assets.  According to a recent University of Maryland study, (Corrado, Hulten and Sichel), when intangibles are added to the statistical mix, our economies looks measurably stronger than reported. Consider capital deepening, the economist’s measure of capital efficiency. In the period 1973 – 1995 the efficiency of capital as a measure of capital stock per labor hour was .43, the equivalent figure for the period 1995 – 2003 (the period of most rapid growth in non-traditional assets) is .84. In other words, the rise of the knowledge economy has translated into (approximately) a doubling in the efficiency of capital. The impact of the knowledge revolution on Labor productivity is equally impressive. The average productivity per worker in the United States as a measure of output per hour has jumped from 1.36 (1973 – 1995) to 2.78 (1995 -2003), put another way productivity per worker has more than doubled.

“The key finding of this research is that intangible investment by U.S. businesses averaged $1.2 trillion per year during the 1998-2000 period (it has now risen to $3 trillion per year, 2010). This amount is equal to the total amount spent by businesses for their tangible plant and equipment. This is also the amount by which U.S. GDP is increased by the capitalization of this broad list of intangibles. In other words… intangibles matter.” (Corrado, Hulten and Sichel, 2009) 

So what’s the Problem?

The message is clear, “when intangibles are included in the analysis, they explain more than a quarter of the total growth rate of output per worker and become the most important systematic source of growth in our economies.” So why don’t we acknowledge this growth? What’s the problem?

The problems are widespread, and deep-seated. To begin with conventional economics is struggling, focused almost exclusively on exchange processes and markets, ignoring asset development. As a result important changes in the nature of production in an emerging knowledge economy in combination with the profound impact of globalization continue to challenge traditional economic modeling which in large measure continues to be based on “factory-type industrial production taking place in isolated national economies”.

But economics is not the only profession wandering around lost, the accounting profession is in a worse state. Although there have been many advances in new asset recognition at the official level (accounting standard boards), the practice of accounting continues – almost universally – to ignore new assets, which do not appear on corporate balance sheets or other financial statements.

What Should Management Do?

Management needs to get up to speed on the real value drivers in their organizations, and fast.

An asset is anything you own or control from which you can expect future benefit. In other words assets are ultimately THE sources of your corporate earnings. However, if you asked most managers today to directly link their earnings to defined assets, they’d tell you it’s impossible, or that the earnings are associated with ‘services’ not real assets. The fact of the matter is that very few managers today have a firm grasp on the productive assets in their organizations, and as a result are making critical errors in judgment.

According to Corrado, Hulten and Sichel (CHS, 2005), there is no clear-cut distinction between tangibles and intangibles that would justify a distinction between the former being capitalized and the latter being expensed. In fact “any outlay than is intended to increase future rather than current consumption is treated as a capital investment” (CHS, 2005, p. 13).

Why does this matter? For one thing NOT capitalizing your broad asset potential increases the cost of capital to knowledge-rich companies. When you walk into the bank, or a room full of investors with an ‘empty’ balance sheet it’s an uphill struggle to convince anyone that you’re a good investment or that you even know what you’re doing. More importantly, particularly for larger more established companies, the treatment of assets is vastly different from services. And it is the behavioral differences that are critical in both developing the stream of earnings in the first place and sustaining the capital value from that effort for the company longer term.

Things to Think About

  1.  During the next few years, most of the developed world will adopt International Accounting Standards. The International Accounting Standards Board (IASB) is in the process of defining and legitimizing over 30 new classes of (non-traditional) assets including the formal kinds, patents, copyrighted software etc, but also many contractual based assets and other ‘relationship’ based assets including brands, trademarks and other customer equity related assets. How familiar are you with these developments? What are you doing about them?
  2. Don’t mistake cause and effect. Corporate earnings are the ‘effect’, the ‘cause’ of which is solid well-managed assets. In other words, management’s focus on earnings, share price and other financial variables needs to be balanced by greater knowledge and measurement of all the assets (sources of earnings) in their organizations.

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