Age of Wisdom, Age of Foolishness (27)
“Let’s go round again”
Warren Buffett joined the new game of Monopoly (aka economic rent seeking), which was first observed being played by CEO’s in Age of Wisdom, Age of Foolishness (25) “Pride and Extreme Prejudice”, his most recent annual shareholder meeting earlier this month. He said:
“What really we want to do at our present size and scope, and with the objectives we’ve got for our shareholders, is we want to buy big businesses with good managements at reasonable prices and then try to build them over time……
………… It’s a different sort of build-up of value……..
……….We’ve moved into phase two.”(our emphasis)
For all of the recovery, since 2009 and during the Fed’s QE programme, Berkshire Hathaway’s book value has consistently lagged the S&P 500. Buffet’s portfolio companies have been unable to grow sales or expand margins successfully enough to beat the S&P. Berkshire does not pay a dividend. It must therefore rely on internal growth of retained earnings, reinvested in the businesses, or buy large companies that are cheaply valued. QE has inflated company values, way beyond their ability to grow at the anaemic levels of GDP growth. Therefore, the only way for Buffett to perform is by acquiring companies that have strong pricing power.
Weak sales growth combined with rising pricing power, are symptoms of Stagflation. In times of Stagflation, the only way to grow “big businesses”, of the kind that Buffett is interested in, is through acquisitions and margin expansion. Buffett has therefore signalled that he is a believer in Stagflation as his “Phase Two” baseline scenario. Berkshire Hathaway is now in the business of buying pricing power, rather than sales growth. Berkshire is becoming even more of an asset management company than an operating company.
Age of Wisdom, Age of Foolishness (26) “Milking It For All It’s Worth” opined that :
“Asset managers are also becoming economic rent seekers; seeking to live off the management fee rather than the performance fee”.
UK asset managers may have to adopt the corporate structure of Berkshire Hathaway soon, if they are to continue to “milk it”. The UK Financial Conduct Authority is looking very closely at what they pass on to clients hidden in their arcane fee structures[i]. The economic rent for UK asset managers is under threat, so maybe they will be forced back to making money the honest way through performance again.
How the bubble associated with “Phase Two” will end is suggested in the behaviour of cash strapped consumers, faced with static salaries and rising prices. Those who have not been forced into rental accommodation may once again use their homes as collateral, assuming that they have sufficient positive equity. The chances are however that this positive equity cushion is not substantial enough; and that they may be loath to risk the roof over their heads again after experiences in 2008.
The lowest branch on the tree now seems to be the 401 (k) Plan. Consumers, especially the young, are raiding their 401 k’s to meet rising current expenses[ii]. The higher asset prices rise, the more raiding of the 401 (k) occurs. Consumers are sucked into believing that they can withdraw from their 401 (k) plan, because the remainder which is invested is increasing in value as asset prices inflate. When 401 k’s have been run down and consumers have no current savings or retirement savings left, the bubble will burst.
If r>g where’s i?
It will be interesting to see how the theory of Capital of the latest new kid on the economic block will stand up, over the coming period of Stagflation. Thomas Piketty has made a fortune by staking his reputation on an economic theory which seeks to explain why extreme wealth inequality causes Capitalism to fail. In his theory, when the rate of return on capital (r) becomes greater than the rate of economic growth (g) the system becomes unstable and fails.
Piketty does not make the distinction between capital employed in the capital markets and capital employed in a business. This important distinction was made in Age of Wisdom, Age of Foolishness (26) “Milking It for All It’s Worth”. When there is an abundance of liquidity, thanks to central bankers when economic growth is weak, CEO’s have a tendency to invest in capital markets rather than in the real economy. Consequently they invest in their own shares or those of competitors; and exploit enhanced pricing power to create shareholder value.
The r from the capital markets is greater than the r from the company’s operations; and both are larger than the g of the economy. The r from the capital markets is increased by raising prices in the real economy, otherwise known as inflation (i), which then pushes the r in Piketty’s Theorem above the sustainable limit of g in the real economy.
This Stagflation condition is what we see occurring now. Central bank liquidity and fiscal support can sustain the consumer and hence the level of inflation, for as long as both Government and Central Bank continue to follow this loose policy. It will be interesting to watch the application of Piketty’s Theorem to fit the data going forward.
Looking at Berkshire Hathaway through Pinketty’s prism, one may conclude that Buffett buys when the r>g dynamic collapses during bear markets. This does not explain how Berkshire has done so well buying companies that were not at troughs of the market or during recessions. Buffett’s success with purchases during these periods must therefore have something to do with pricing power known as i. Going forward, Buffett has signalled that his “Phase Two” is all about i.
Another valedictory speech by Jeremy Stein, warned of the volatility to come in the Fed’s “Phase Two” as it exits QE[iii]. This warning was enough to prevent American risk assets from participating in the general relief rally that came when President Putin appeared to step back from the brink the following day. American investors remain economic rent rather than growth seekers. Emerging Market investors are in exit mode.
“Buy in May and go away ‘til June”
European investors are still being strung along by Mario Zelig’s patter. The latest ECB rate announcement and press conference had something for everyone in the audience[iv]. There was no change in interest rates, however there was the strongest hint yet that some form of easing is coming in June. Recent German economic data has started to soften[v] and the strong Euro is now something that they would like to see mitigated going forward.
The Peripheral European markets were just starting to feel the headwind from Jeremy Stein’s “Phase Two”, so Zelig’s words breathed a stronger tailwind. Mario Zelig however does not morph into IMF or French people, in the same way that he morphs into other beings. He was very insistent upon the fact that he would not be pressured to act by what he termed as outsiders. The pressure from outsiders, who are a lot closer to Core Europe, may soon start to build even stronger after Finland effectively decided to U-Turn on austerity; and fired its finance minister to show the strength of its new conviction[vi].
Janet Yellen’s “Phase Two”, based on her latest testimony, remains as equivocal as ever. The economy allegedly “paused” in Q1 and there are blue skies ahead; however these blue skies are not smiling on the housing market which she now says “will bear watching”. There was no emphasis on the latent inflation that Jeremy Stein was trying to prevent by deflating the bubble in risk assets, before he was sent back to academia, so it’s a good bet that the risk asset sell-off is over (assuming that the Grown Ups play nice over Ukraine). Trying to understand this equivocation, it would seem that Yellen wants the “Taper” to soften housing even further so that the prolonged period of low interest rates, after the “Taper” ends, is extended into the next easing cycle[vii].
NATO lurched towards its “Phase Two”, as it was faced with a competing presidential elections in Ukraine, which it supports and a proposed secession referendum in Eastern Ukraine, which Russia supports[viii]. NATO strategy is changing, towards a more robust posture in the East and the presence of American forces on the ground is now under consideration[ix].
Having dislocated America’s “Pivot”, President Putin focused his opponents’ attention on his priorities in Ukraine. A military victory is judged to have been won, when an opponent is made to do one’s bidding. The dislocation of the “Pivot” is a Russian tactical victory, although a purist would say it is really a Chinese strategic victory.
President Putin then went on to rack up his next victory, when he magnanimously offered to withdraw his troops from the Ukrainian border and called upon the Ukrainian separatists to postpone the secession referendum. The political capital garnered from this action also forces the EU to now seriously consider the status of the Russian speakers in Eastern Ukraine. The EU and the Ukrainian government will now have to grant serious autonomous concessions to Russian speaking Eastern Ukraine; which will see it back in the Russian sphere of influence yet also still integral to the Ukraine in order to continue to promote Russian influence into the country.
If things are not going well, Putin only has to move his forces back to the border again, in order to coerce the EU into making further concessions. Evidence of this leverage was provided by American analysts, who said that there was no sign that the Russian forces had actually withdrawn[x]; which was then swiftly countered by Russia’s announcement that the forces would be participating in war games in the near future[xi].
Memory immediately drifts back to the pretense of war games that preceded the annexation of Crimea. To help jog this memory, President Putin put in a cameo appearance in Sevastopol to celebrate the defeat of Nazi Germany on the Russian anniversary of May 9th[xii].
In Eastern Ukraine, the putative separatists announced that they would ignore Putin’s request to postpone the referendum and proceed anyway[xiii]. Putin is therefore in the position of being able to claim that he has acted in good faith, in trying to avert the referendum; whilst then having his hand forced by the ethnic Russians in Eastern Ukraine, whom he is morally obliged to protect even if they have behaved like insubordinate children.
“One (nation) is the loneliest number”
The current geopolitical instability trigger point was observed, back in Age of Wisdom, Age of Foolishness (18) “Beyond the Pale”[xiv], when Prime Minister Netanyahu cast a shadow across Mrs. Merkel’s face and wiped a smile off the face of President Obama. In Age of Wisdom (24) “The Short Good Friday”[xv] it was opined that:
Israel on its present economic and political course is headed for a major conflict.
Prime Minister Netanyahu took another step further towards this “major conflict” last week, to coincide with the upcoming celebrations of nationhood, when he took the constitutional step to legally redefine Israel as a nation state of Jewish people only[xvi]. “Phase One” officially began in on May 14th 1948; “Phase Two” unofficially began when Netanyahu addressed AIPAC on March 2014[xvii] and officially begins on May 14th 2014. Those who listened would have heard him open his AIPAC speech with the words:
“I bring you greetings from Jerusalem, the eternal, undivided capital of Israel and the Jewish people.” (our emphasis)
Those who missed the AIPAC speech, and/or those who thought it was all bluster, should now think again in light of the proposed constitutional amendment on nationality; and also look up the words eternal and undivided in the dictionary. The latest suggested constitutional amendment enshrines these two words into law. There can be no “Two State Solution” in a country where there is only one State and one nationality.
Dr. ‘Thank You’ finds the Lost Citadel of Zion
Divine intervention also seems to have provided a religious precedent to underline the emerging legal precedent. The timing of this divine intervention, on the eve of the nationhood celebrations and the proposed constitutional amendment, is miraculous to say the least. The Citadel of Zion has apparently just been found by an archaeologist under East Jerusalem, a location where the soon to be disenfranchised Palestinians try and exist. The archaeologist, with a surname that means thank you in Arabic, is funded by a shadowy organization which acquires land from Palestinians[xviii]. Spielberg at his best could not do justice to this story’s plot.
The dig began in 1995, so the timing of the current announcement is all the more miraculous. Miracles and religious precedents have often preceded some of the most violent episodes in history. As historical miracles and precedents go, this latest one is known in the American vernacular as a “Slam Dunk”; we can now expect what the same vernacular calls “Shock and Awe” when it follows the “Slam Dunk”.
He’s got the Power
A hint at the “Shock and Awe” to come, was provided by Netanyahu’s speech to veterans of World War II on the commemoration of the defeat of Nazi Germany by Russia. The reader should note carefully the Russian context in which this speech was made. The Israeli connection of Iran to Ukraine was made in Age of Wisdom, Age of Foolishness (18) “Beyond the Pale”[xix]. A direct connection between Israel and Russia was sought at the time when it was written of Netanyahu: “On his return to Israel it will be interesting to see if he shakes the hand of the Russian Bear”. His latest audience originated from “beyond the Pale” and proudly wore medals from the Soviet era. We would suggest that this event signals that the hand of the Russian Bear has now been shaken. At the ceremony, Netanyahu opined:
"Today we have a country, we have an army, we have the determination and we have the power, but with all this we know that the best defence against nuclear weapons in the hands of Iran is no nuclear weapons in the hands of Iran".
“Bad News Jeb”
Hillary Clinton Is Going To Love This Chart
On the subject of “Slam Dunks” and “Shock and Awe”, in Age of Wisdom (24) “The Short Good Friday”[xx] we suggested that “Team Clinton” (and the rest of the Republican 2016 hopefuls) have the edge over “Team Bush”. The fact is that Hillary Clinton is more of a Hawk than the whole of the GOP hopefuls put together[xxi]; and this is their problem. Clearly “Team Bush” seems to think so too; and is now deliberating over investing all of its political capital into what could be described as “Phase Two” of the dynasty. It seems that there are still too many painful memories of “W”, since the economy has still not recovered fully and waves of unemployed traumatised veterans are about to be repatriated in increasing numbers in the near future.
“Bush Phase Two”
Having tested the waters, it seems that “Team Bush” is concluding that it may be too early to directly re-engage in Presidential politics. Financial and political capital is therefore being invested in “Phase Two”, in the form of the son of Jeb. George Prescott Bush has the obvious affinity with the Hispanic vote, that his father has been recently making overtures towards[xxii] and that the GOP desperately needs. He just needs time and money to prepare his Presidential run. Both of these will come from Texas, as they did for Grandpa and Uncle George, if all goes to plan.
George P’s campaign to run for Texas Land Commissioner[xxiii] is funded by the private oil interests that he is supposed to regulate without compromise if he is successful. Only in Texas would one expect such conflicts of interest to be viewed as commonplace. One suspects that if elected, George P will promote the Renewable Energy business to balance his Big Energy credentials.
There are significant Federal energy subsidies, for Renewables as well as for Fracking, so the pork-barrel in Washington will no doubt be serving extra- large helpings to both troughs in Texas. A booming (“Carbon Neutral”) energy industry in Texas will provide the campaign funding and “sustainable economics” track record for a future President, as the nation hooked on cheap energy moves beyond “Peak Oil”. The script for the legend is perfect. It therefore looks as though the anticipated Clinton v Bush “Phase Two” for the Presidency is on hold, until Chelsea and George P have matured a little further.
“A ‘white’ dress for Monica Gate Phase Two”
In Age of Wisdom (24) “The Short Good Friday”[xxiv] we looked forward to “Phase Three” of the Clinton dynasty, heralded by the physical result of Chelsea’s co-ordination of her cycle with the Presidential Cycle; and tried to come up with an evocative Presidential name for the divine infant, based on the fact that he or she would not have the Clinton surname. “Clinsky” was discarded, because it sounded too much like Lewinsky.
By amazing coincidence, Monica Lewinsky’s “Phase Two” has also been coordinated with the Presidential Cycle in a new kiss and tell expose[xxv]. “Shame and Survival” has replaced Sense and Sensibility on the American bestseller list. Hollywood should be able to get this one out as a movie, in time for the 2016 Presidential election. A cynic would say that she is short of cash and is using her notoriety to maximise her income. A conspiracy theorist would suggest that she has been inspired by Republican partisans, who wish to erode the unassailable margin by which Hillary currently leads their field of hopefuls.
If Hillary has an Achilles Heel, it may be her husband. This is a gamble, because it risks bolstering Hillary’s reputation even further. What it does achieve however, is to replace civilised political debate of the issues with salacious tittle-tattle. Hillary’s petard has been hoisted by her predatory husband’s inflammatory past. The intended sublime inculcation, associates wife directly with husband’s actions; so that voters are encouraged to believe that they will in fact be voting for Bill and not Hillary. Hillary is tarnished by the Halo Effect of Bill. Since the Republicans currently have no platform and no coherent policies, the salacious tittle-tattle diverts critical attention away from their shortcomings. Who knows, perhaps it may even divert enough attention away from Jeb Bush’s obvious shortcomings to make him credible again.
Age of Wisdom, Age of Foolishness (23) “Painting by Numbers”[xxvi] suggested that the upcoming Bush v. Clinton contest would be civilised. The latest episode of “Monica Gate Phase Two” destroys any pretence of civility. It’s a dirty business and it is going to get a lot dirtier. The dirt on Hillary Clinton will be piling up thick and fast in John Boehner’s new “Select Committee” on the Benghazi Attack of 2012[xxvii]. This was not Clinton’s finest hour; and there are some within the GOP who intend to make the mud stick in an impeachable way.
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