Home' Trinidad and Tobago Guardian : October 30th 2014 Contents BG20 COMMENTARY
BUSINESS GUARDIAN www.guardian.co.tt OCTOBER 2014 • WEEK FIVE
Last Tuesday global blue chips
IBM, McDonald s and Coca Cola
produced earnings that did not
meet with analysts expectations.
The individual stocks as well as
the overall market tanked on the
news. The assertion was that global growth
was slowing and the US consumer was not
as resilient as first thought.
Later in the week came stellar results from
3M and Caterpillar that resulted in a boost
for those two stocks which lead a market rally
on the premise that global growth was not as
tepid as first thought. In fact, places like Europe
and Germany in particular may not be in as
dire a situation as was seen to be the case a
couple weeks ago.
A fundamental lesson here is that investors
who are fixated on the headlines as they ebb
and flow on a day-to-day basis, even when
those headlines relates to company earnings
performance are likely to find themselves
whipsawed and confused.
Whipsawed in the sense that they would
be reacting to stock market volatility on the
back of headlines and confused in that over
time, they would not have been able to generate
any consistent returns in the market, often
coming to the conclusion that this is not the
place for them to invest their money as the
game is rigged.
Investors are well advised to take note of
headlines as they occur, but to ensure that
either they or their investment advisers have
a proper understanding of the relevant issues
so that effective decisions can be taken regard-
ing their investments. Headlines have to be
assessed in an overall context.
For example, while all the companies iden-
tified above are global blue chip multinationals
and so would be affected by the global macro
environment, management actions, market
share changes and many other factors impact
In addition, no company is realistically able
to outperform expectations every earnings
quarter, quarter after quarter.
To explain the point, let us start with an
analysis of certain broad economic factors and
see how it flows right down into the granularity
of corporate performance.
There is a huge debate going on in the devel-
oped world as it relates to the forces of inflation
versus disinflation (or even outright deflation).
Many of the persons who were in the inflation
camp a few years ago (including yours truly)
have been asked to eat humble pie as the argu-
ment is that no inflation is present, or even
on the horizon, and that has been used as the
rational to explain why interest rates have been
held so low for so long, a trend that is likely
When engaging in any debate, it is essential
to define the terms that are being used. When
discussing inflation, there is asset price infla-
tion, producer price inflation and finally con-
sumer price inflation. Most of the discussion,
and, in fact, the basis for Central Bank policy
has been centred on the latter.
The reality is that we have had significant
asset price inflation as, for example, US stocks
have increased by roughly 300 per cent from
the 2009 lows.
The property market has also rebounded in
the US with many coastal areas benefiting
from significant purchases from non-US
investors. In particular, Miami has benefited
from Latin inflows, New York from Europe
and the West coast areas from China.
Overall, asset price inflation has come about
as a result of the loose monetary policies of
the US Federal Reserve and other major central
banks around the world. Yet these injections
have not found its way into the mainstream
and so the capital markets and banks have
been the primary beneficiaries.
Granted, there has been some trickle down
effect on consumption as a result of persons
being able to spend more as their stock port-
folio increases in value. However, such effects
are primarily for the wealthy so high-end pro-
ducers and retailers have benefited, but com-
panies whose primary business rests with the
middle and low-income household, such as
Coca Cola and McDonald s, have not.
Producer price inflation speaks to the price
that producers of goods pay for raw materials.
It includes the cost of mining or extracting
raw materials and the delivery costs associated
with those materials. Commodities represent
a good gauge for producer price inflation.
Going into the global financial crisis, demand
was overheating and this lead to a sharp rise
in commodity prices. Everything from oil and
natural gas to copper and aluminum all were
at record levels. Agricultural (soft) commodities
were also at record levels as there were even
demand shortages, leading to protests and
rationing in some emerging markets.
In the post-crisis era, commodity prices
remained buoyant as a falling US dollar pro-
vided some measure of support to these com-
modities. Appreciate that commodities are
priced in US dollars and a falling US dollar
will see the underlying commodity increase
in price, all other things being equal.
Overall, raw material prices have fallen
around 40 per cent since 2008, but the major-
ity of that decrease has occurred in the past
three years where prices have declined by 25
per cent. Currently, we have falling gasoline
prices in the developed world, especially in
Since 2008, only livestock and lumber prices
are higher than they were before the crisis.
Overall, it points to a deflationary trend in
producer prices. A big part of the equation is
that demand has softened, not only in the
developed world, but also in emerging markets.
The easy monetary policies of central banks
have not been supported by the right fiscal
measures, so recovery from the crisis has been
tepid and volatile.
For consumer prices, which are the most
publicised benchmark for inflation, pressure
has also been to the downside. Companies
have engaged in significant cost cuttings and
rationalisation so that overheads have
decreased. In addition, slack in the labour
economy has kept wages in check. In fact,
labour s share of corporate profits are at historic
Producer prices are down and in a weakened
economy demand pressures are such that there
is little impetus for consumer prices to increase
at a rapid rate. The combination of these two
factors has kept inflation in check.
So were the inflation hawks wrong?
Not really, when one considers that there
was significant asset price inflation over the
past six years. More than that, the lack of pro-
ducer and consumer price inflation was sig-
nificant contributory factors to the level of
asset price inflation and understanding this
dynamic was and still is key to generating
stock market returns.
As the inputs into the cost of delivering a
product or service to the consumer decreased,
any marginal increase in prices, however small,
went into corporate profits.
In the post-crisis era, companies, especially
global multinationals, have been able to
improve their margins with the result being
that in the US, corporate profitability as a per-
centage of US gross domestic product is at an
all time high (See Chart).
It is therefore no coincidence that the US
stock market is at all time highs and this dis-
cussion points to a fundamental rationale for
the stock markets being at these levels. Persons
who were fixated on who was right or wrong
regarding the inflation debate and lost sight
of the underlying purpose of the analysis (to
generate positive investment returns), would
have achieved little for their clients.
What happens next is also important. Is
the status quo sustainable? On the one hand,
as slack in the labour market is reduced, wage
pressures will have a knock-on impact on
consumer prices. As commodity prices fall,
the margins of producers will decline, unless
their cost of production declines in lock step.
Appreciate that there are limits to profits
from margin growth and once this cycle has
run its course, the ability to grow revenues
will be the key determinant of corporate prof-
If you understand the above dynamic, you
will then come to appreciate why Coca Cola
announced a change from using economic
value (EVA) added as their tool for measuring
company performance towards using revenue
growth. There was a time when "Coke" was
one of the standard bearers for the EVA model.
This model is actually in use by a number of
local listed companies. It may still be relevant
to most companies, but appreciate the need
to adapt and change to the circumstances of
Company management needs to adapt to
the changing environment and investors also
need to adapt rather than fixate on any one
position. Adapting allows you to profit from
the prevailing circumstances.
Either that or you fail.
Ian Narine is a registered broker with the
Securities and Exchange Commission.
Adapt or fail
SOURCE: ST LOUIS
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