MACRO MATTERS Transcript 9/13/2013 #1012

September 25, 2013

CONSUELO MACK: This week on WealthTrack, the big investment picture top rated international economist Nancy Lazar and number one strategist Francois Trahan on why the U.S. is the place to invest and China is in trouble. A WealthTrack exclusive with both is next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. If there is one lesson investors have learned from the financial crisis and its aftermath, it is that macro matters. The risk on/risk off market of the financial crisis, where the vast majority of assets moved in lockstep in reaction to a monetary policy move, an economic number or political pronouncement is seared in the collective memory of investors. As you can see from this chart, provided to us by this week’s guests, macro forces have historically had an oversized influence on stock returns. Over the last two decades for instance stock specific influences have accounted for about 28% of stock market returns on average, whereas macro forces have accounted for nearly 70%. Since the financial crisis that influence has risen to nearly 90%.

But which macro events matter most? How much attention should you be paying to the Federal Reserve’s possible “tapering” of its massive government bond buying program? How about the slowdown in corporate profit growth and the fastest rise in price earnings multiples since the dot-com bubble? How much influence will the surge in domestic energy and manufacturing production have on the markets? And what about the slowdown in China?

These are all trends being tracked by this week’s guests, two investment research stars who recently joined forces with the street’s number one Washington analyst team of Andy Laperriere and Roberto Perli to create a new institutional research firm devoted solely to macro research. They are joining us exclusively on WealthTrack. Nancy Lazar, a founding partner of Cornerstone Macro will lead its economic research team. Lazar has been a coveted Institutional Investor ranked economist for the past 12 years, including being ranked number 2 for the past four. She is second only to Ed Hyman her former business partner with whom she co-founded independent research firm ISI group in 1991. Francois Trahan, also a founding partner of Cornerstone Macro, is leading its investment strategy team. Trahan has been ranked the #1 portfolio strategist by Institutional Investor for 6 of the past 8 years and #2 the other 2 years. I began the interview by asking them about one of their major macro calls- why they are bullish on the U.S. economy and markets.


NANCY LAZAR: There are longer-term growth engines for the U.S. economy today of which we’ve never seen the likes of. We’ve spent 30 years making our manufacturing sector more productive, and finally I think manufacturing is indeed going to be a leader in creating jobs, not just on the high end but for the low to middle income workers. So I’m bullish on the job outlook for the United States.  In addition, simultaneously we found this goldmine of natural resources, energy, not only natural gas but also now oil, and the multipliers from both manufacturing and energy are huge in that for every job you create in those industries, you create three other jobs in non-energy manufacturing-related jobs. So you’re building out Middle America the right way. I’ll say it. This is not politically acceptable. The right way, the private sector way without the government.

In fact, I think longer term this is also going to help to reduce our budget deficit, so that will be less of a concern for definitely there’s reason to be concerned about that, and at the same time the energy boom, excess labor, we do have higher unemployment we do currently have. Those forces are going to help keep inflation low in the United States, and so we have a period of slow to moderate growth. Let’s not get carried away. I’m not talking about rapid growth, slow to moderate growth because we do have excesses. We are still unwinding the federal government, the consumer debt. Slow to moderate growth with a low inflationary environment which will help keep interest rates lower than they otherwise would be. They’ll still go up, but lower than they otherwise would be. So just net a very solid economic environment which will be good net for financial assets.


CONSUELO MACK: And this is a long term. These are long-term structural changes that you’re talking about. So when are we going to see employment respond, or do you think it already has responded, and we’re just missing it?


NANCY LAZAR: Definitely this is a forecast, but there are signs that you are seeing in particular in employment. I’ve identified 15 states that are initially the biggest beneficiaries of this new theme from Michigan to Texas, and what you see in these 15 states is that manufacturing and energy-related employment are indeed more strong than they are in the rest of the country, and that’s leading to even stronger jobs in other sectors in each of those states. So it’s still very much a forecast. You have to dig into the data. Aggregate data, no, don’t show it, but I do think over time it will start to show, but that’s what makes it so exciting for me. It’s not like the dot com bubble in the late 1990s, something that could start quick and end just as quickly. It takes time to build out manufacturing, time to build out energy, and then the schools and the homes associated with those new industries. I like slow to moderate.


CONSUELO MACK: One of your themes looking at how the market is responding to these fundamentals that Nancy is talking about is that inflation… I remember you telling me that inflation is the new Fed funds rate.


FRANCOIS TRAHAN: That’s right.


CONSUELO MACK: And that you’ve become, instead of a Fed watcher, you’ve become an inflation watcher. So talk about the inflation piece and how significant that is as far as your very constructive outlook on the U.S. market.


FRANCOIS TRAHAN: Well, the U.S. economy is unlike any other economy. 72% of our GDP is consumption, and so when you think about inflation, think of it as a variable tax rate on consumers. Inflation goes up. You have less discretionary income. Inflation goes down. It’s the exact opposite. You feel the equivalent of a tax cut. If you pay less to fill your gas tank, you have more money left in your wallet at the end of the day, and so for the economy that’s essentially the transmission mechanism. For the stock market, lower inflation usually translates into higher multiples, which is exactly what we’ve seen this year.  We’ve seen a big decline in inflation courtesy of all these problems happening elsewhere in the world, the slowdown in China, Abenomics in Japan, and what it’s doing is it’s helping lift P/Es. So the P/E this year has carried the stock market. 80% of the return this year has been from the P/E. P/E has given us almost 200 points on the S&P.  So if it wasn’t for all these events taking place and the consequence, this decline in inflation, I think the stock market would be 200 points lower.


CONSUELO MACK: So why is it that inflation translates into higher price/earnings multiples, and then we’ll talk about this phenomenon of higher price/earnings multiples which is also very different than we’ve seen in the last decade.


FRANCOIS TRAHAN: Right, well, it won’t work this way in every economy. You know, when you think about the economic textbooks, they treat every economy the same way, and the U.S. economy is not your generic textbook economy. It’s unusual. There is no other economy like this where consumption is such a dominant share of GDP. So inflation has essentially become the discounting mechanism for multiples, if you will, but at the same time it’s interpreted by the stock market as a source of stimulus, and so it doesn’t matter where lower inflation comes from.  This year most of it has come courtesy of a downturn in China, and so I would tell you, you know, that China’s problems is America’s opportunity. That’s almost the way to think about it, and it’s very different from what we’ve had in the post 2000 world where China was growing very, very rapidly. Inflation became kind of the big buzz word in the U.S., and multiples compressed for 10 plus years.


CONSUELO MACK: As all the commodity prices went up, that was a big inflation…


FRANCOIS TRAHAN: That’s correct.


CONSUELO MACK: …because of China’s growth in demand.


FRANCOIS TRAHAN: And we’re starting to see the unwind of that, and we’re starting to see multiples expand.  We believe that’s going to be a permanent fixture. So we’re able to grow our economy right now at a pretty interesting rate, pretty rapid rate without generating inflation because the rest of the world is slowing, allowing us to keep inflation at bay. So non-inflationary growth in the ‘90s is what people called Goldilocks, and I’m not telling you the 90 is the perfect proxy for what we’re living through, but it’s the last time that we had a market led by expanding multiples. It’s been a while.


CONSUELO MACK: So why don’t earnings matter as much anymore, and why do price/earnings multiples matter more? You know, how did this switch happen?


FRANCOIS TRAHAN: Investors over the last decade haven’t had to think about multiples because they were a one-way bet lower. In the last decade, we had earnings going up, and we had multiple going down, and so the only path to a higher stock market was via higher earnings, so we’ve all become conditioned to think that earnings is the only thing that matters, and yet this year that conventional wisdom has failed you, because if you’re looking at earnings, you’re going to see a pretty lackluster story. You look at the stock market, it’s phenomenal. The S&P’s up almost 20%. It’s incredible, and in the context of the ‘90s, there are years where earnings are almost nonexistent, and the market goes up 25%. Now there’s a new recipe for the market, and it’s via multiples.


CONSUELO MACK: So what’s changed in the emerging markets, and why is the U.S. once again do you think going to be the driver of global growth?


NANCY LAZAR: So the United States is really the driver and the anchor for global growth. There has been a major structural shift in the BRICs in particular, EMs in general over the past decade.


CONSUELO MACK: Right, emerging markets, the EMs, and BRICs, Brazil and Russia and India, China.


NANCY LAZAR: Pardon me. Emerging markets 15 years ago had very high unemployment rates, and they could grow rapidly for a sustained period of time without creating any domestic inflationary pressures. Now they’ve been growing too rapidly for roughly 15 years now, creating internally a tremendous amount of inflationary pressures highlighted by a collapse in companies’ ability to make money in that part of the world because their costs are going up much faster than the revenue can now grow.


CONSUELO MACK: And these are global companies that are…


NANCY LAZAR: Global companies.


CONSUELO MACK: …that are not able to make that much money anymore in emerging markets.


NANCY LAZAR: U.S. multinational companies who have spent the past 15 years not investing in the United States but investing in China, in India and in Brazil to take advantage of this, to be sure, which was very, very strong growth, but I think that era of being able to grow rapidly is over because they’ve created so much internal inflation. As a result, policymakers in these countries, China, India, Brazil, Indonesia, are now tightening policies. They are raising rates aggressively because long-term most policymakers realize how dangerous rapid inflation, indeed, can be. So you are now getting a decoupling between policy within the emerging markets and within the larger developed economies like the United States, Japan or Europe. We’re generally still in an easing mode. Interest rates are going to stay low for a longer period of time. In contrast, within these emerging economies, Brazil in particular, rates are rising. Indonesia, rates are rising. In China they have tightened, and in order to cool inflation, you have to grow slowly for a long period of time. This is not one quarter or two.




NANCY LAZAR: Years. They have been years building growth too quickly, and it takes years as we saw in the United States in the early 1980s when we had a … well, in the ‘70s … had a tremendous inflationary problem. It took three years of a severe recession to curb inflation in the United States, and so I think you are in a new era, not just in the United States on the plus side but within many of these emerging markets where they’ve put in place too much inflation that they will be much weaker longer than expected for, Francois mentioned five years, for the next three to five years. So globally a very, very different economic environment, one people don’t like to talk about but in the investment world we call it decoupling where the United States is, indeed, the leader. We don’t have inflation issue as Francois has highlighted. We have longer term growth engines, energy and manufacturing.

The emerging market turmoil is, indeed, sending many of these large companies that have done business in these regions that maybe it’s not such a good place to build business. So the theme is, if you increasingly sell it in the United States, you make it in the United States, you don’t have to deal with that turmoil within these other countries, higher interest rates, political intervention. Yes, our politics necessarily aren’t 100% business-friendly by any stretch, but relative to what you’re seeing, say, in China where they’re demanding you cut medical prices, car prices, fuel prices, milk prices. The government is demanding companies. That’s extensive negative intervention. We have issues here to be sure, but relative to the rest of the world, it is a pretty good place to do business.


CONSUELO MACK: One of the major investment themes that we have been covering for our nine years of existence on WealthTrack is the fact that you want to buy these multinationals that have 40, 50, 60% of their earnings from emerging markets. So forget that, Francois. Now those are not the kind of companies that you want to own, and what’s the substitute?


FRANCOIS TRAHAN: I think the stocks that will surprise folks are going to be the ones that tend to do well in an environment of lower inflation, and that tends to be the consumer stocks which have shocked people in the last year and I think will probably continue to do so now, not just cyclically but structurally. I think the world’s problems is the U.S. consumers’ opportunity. That was the ‘90s, if you remember the Asian crisis, the Russian default. Those were horrible crises on the ground, but there was always a silver lining for the U.S. consumer in the form of lower inflation, of lower commodity prices. And so we’re seeing a very similar dynamic today taking place. Now, also in a world where multiples compressed for 10 years and earnings expanded where returns were flat, income became very, very important. Dividend has become the buzz word on the street. Everybody wants to have a dividend fund in their portfolio.


CONSUELO MACK: Right. The other theme has been just the search for yield.




CONSUELO MACK: And so dividend-paying stocks until this year have done extremely well.


FRANCOIS TRAHAN: Exactly, but if you think back to the ‘90s, you never heard the word dividend. In a world of expanding multiples, dividends contributed very little to your return as they have this year. This year they explain about 10% of the S&P’s return, very, very different from the last few years.  So a lot of things are going to start to change, but I think the big surprise, you know, the bookends of a portfolio, if you will in my opinion, should be flipped around. The energy, materials, industrial stocks that did so well for so long I think are going to start to be the laggards. The disinflation beneficiaries, if you will, like the consumer discretionary names, the regional banks, things like that I think are going to surprise people for a very long time.


CONSUELO MACK: So should the focus now be on domestic revenues and profits that companies that actually get the bulk of their financial business here with the U.S. consumer?




CONSUELO MACK: Is that basically a shift that you would…?


FRANCOIS TRAHAN: And that characteristic has worked really, really well this year, and I think that’s how people should think about the world. Now, it’s a completely different world in the one we’ve lived in.


CONSUELO MACK: Completely different for the last 10 years, right.


FRANCOIS TRAHAN: And 10 plus, but I believe that that’s the way to go. When you think about all the major regions around the world, the U.S., Europe, Japan, China, we all have structural issues, but the U.S. is the one that has a path out of them where we’ve cut our deficit in half in the last two years. We’re about to normalize monetary policy. We’ve come a long way on consumer deleveraging. We have a way out of these structural issues at a time when Europe hasn’t figured one out, where Japan doesn’t have one in my opinion, and where China … you know, China is like Japan in 1990. It has exhausted an economic model that worked so well for so long which was investments, but investments are now almost half of China’s GDP. They need to diversify.


CONSUELO MACK: So are you worried about an Asian crisis, another financial crisis in Asia?  I mean, should we be basically avoiding the emerging markets?


NANCY LAZAR: I would tread very lightly.


CONSUELO MACK: Like the plague?


NANCY LAZAR: I would tread very lightly in investing within companies that do a lot of business in the emerging markets and/or direct investments. Indonesian bond yields, for example, everyone’s been worried about U.S. bond yields and, to be sure, we’ve gone up to 3%. Indonesian bond yields …




NANCY LAZAR:… have gone from 5% basically to 9% in six months.


CONSUELO MACK: Wow, talk about losing underlying.


NANCY LAZAR: Reflecting your inflationary pressures. The Indian stock market, if you look at the headline SENSEX Indian stock market, it’s down about 10 to 15%, but if you look at their small and mid-cap stocks, they’re down 30 to 50%. Inflation is an egregious problem in these countries. Interest rates have to go up for a sustained period of time. Growth has to slow for a sustained period of time in order to get rid of the inflation. So yes, I would definitely be very cautious in investing within the emerging markets.


CONSUELO MACK: So one of my favorite headlines from a Cornerstone Macro report was that Middle America is now my favorite emerging market. Nancy, so can you just explain what you mean by that?


NANCY LAZAR: Fifteen, twenty years ago the investment community would fly over to China and India, Brazil to learn more about those economies, to see what investment opportunities they would have with this outlook for a very strong growth prospect. Now I think you have to do just the opposite. You need to travel to Middle America to see how the building of manufacturing plant or the expansion of the energy industry are creating new economies. I visited North Dakota earlier this year, Bismarck, North Dakota, and I didn’t go up into the actual energy area but to Bismarck and, indeed, you see it. They’re so excited that they’re building schools now in Bismarck, three new schools because people used to commute up to North Dakota and work in the fields. Now they are actually living in North Dakota. Is the cold in North Dakota much different than the heat down in Houston in the summertime? I mean, you can adjust. You can adjust to the different temperatures. So within the United States, North Dakota grew 13%, maybe even 14%. Their economy expanded by 13, 14% in 2012.


CONSUELO MACK: And this is because of energy of course. Right.


NANCY LAZAR: It’s because of energy, but it’s building not only of energy. It’s the multiplier. It’s the houses they’re now building or the hotels that they built, and now they’re building schools.  Those are characteristics of an emerging market.


CONSUELO MACK: Emerging market.


NANCY LAZAR: And it’s going to be great for job prospects in this country. You don’t have to get an MBA and move to New York and work on Wall Street anymore. You can …


CONSUELO MACK: Thank heavens.


FRANCOIS TRAHAN: The appeal of emerging markets typically over time is something that is low cost, usually wages and production costs. What the low cost of natural gas is doing in the U.S. is giving us a competitive edge on everyone around the world, and I think when Nancy talks about multiplier effect, that’s also what you’re referring to is the fact that businesses that weren’t viable in the U.S. are becoming viable because of the low cost of energy.


NANCY LAZAR: And it’s a domestic source of energy, and given the international turmoil, we’re unique as a developed country that has a domestic source of energy. Utility prices used to follow fuel oil. Now utility prices follow the price of natural gas which is obviously very low. Japan does not have any natural source of energy. It’s very sad actually, and given the problems they’re currently having up in Fukushima with the leaking of the radioactive water, odds are they’re not going to be able to turn on any of their nukes in the near future. Germany is banning their only natural source which was also nukes, and so at the end of the day we sit in a very … this energy renaissance, it puts the United States at a very, very different position than any other, not only EM, but any other developed economy except for maybe Canada.


CONSUELO MACK: So how do I invest in this new Middle American emerging market that Nancy’s talking about?  What’s your strategy there?


FRANCOIS TRAHAN: Well, there’s a lot of different ways to do it from, as you mentioned earlier, when you pick stocks, instead of using dividend as your sole criteria, start to look at percentage of revenues derived domestically, and you’re going to find opportunities everywhere, even in the industrial sector which people generally believe is completely driven by the rest of the world and the emerging markets in particular. If you look in the broader indices, and you’re willing to look at the small caps, you’re going to find 96 stocks in the industrial sector of the S&P1500 that generate more than 80% of their revenues domestically.


CONSUELO MACK: Interesting.


FRANCOIS TRAHAN: So there’s plenty of opportunities. So I think over the next three to five years domesticity, if you will, is going to pay off big for investors.


CONSUELO MACK: New investment theme.  So speaking of specific investments, One Investment for a long-term diversified portfolio, what would you have all of us own some of, Nancy?


NANCY LAZAR: I would just continue what Francois mentioned, U.S.-based industrial companies, not only from potentially stronger domestic revenue growth but also the potential for mergers amongst them and/or international investment which is just starting to happen, so I think internationally you’re going to see some of these larger industrial companies see this opportunity in the United States very similar to what happened in the emerging world over the past fifteen years, but instead of buying companies in China or India, they increasingly buy companies, the small and mid-cap stocks that Francois mentioned in the United States, and so …


CONSUELO MACK: Is there a vehicle that you’ve identified?


NANCY LAZAR: As of now, no, other than Francois’ screen that lists 96 companies that get 75, 80% more of their revenue domestically. It sounds like a good place to start for me.


CONSUELO MACK: All right. Your One Investment?


FRANCOIS TRAHAN: I would say take it a step further. Believe in the U.S. consumer. I think the retail stocks are going to be … they have been. They’re going to continue to be the big surprise. If you look at how retail performs as a group, as a sector, it’s basically the same thing as U.S. inflation trends, and so if you believe this story, this structural story of inflation that remains low and contained, I think what you want to go for is a retail-based ETF, and there’s plenty to choose from in that group.


CONSUELO MACK: All right, terrific. Thank you so much for joining us for a WealthTrack exclusive, the two of you together for the first time as co-founders of Cornerstone Macro, so Nancy Lazar and Francois Trahan, lovely to have you here on WealthTrack.


NANCY LAZAR: Thank you very much.



CONSUELO MACK:  At the end of every WealthTrack we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s Action Point follows the example of Nancy Lazar, Francois Trahan and their colleagues at their new firm Cornerstone Macro. It is: don’t be afraid to invest in yourself. We talk about outside financial investments every week on WealthTrack, but the best investment you can make is a personal one, maximizing your own productivity, creativity and happiness.


Lazar, Trahan and their fellow co-founders gave up top level positions at outstanding firms to focus on their first professional love, pure macro research in economics, policy and strategy with people they admire, respect and like. Without realizing it they followed the counsel of my former college professor, world renowned mythologist Joseph Campbell, who told all of his students to “follow your bliss.” It’s the best single piece of advice I have ever received.


Next week’s guest has done exactly that as well. Fixed income star Kathleen Gaffney recently left her long time, high profile position at Loomis Sayles to start her own bond fund at Eaton Vance. Is this any time to launch a bond fund? She’ll explain why it is for her. If you missed any of our past WealthTrack interviews you can find them on our website, plus discussions of a more personal nature with our guests and original research from our sources in WealthTrack Extra. Have a great weekend and make the week ahead a profitable and a productive one.









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