Economic Outlook: Procurement Should Expect Headwinds and a Downturn Ahead
“It’s not about where the puck has been, it’s about where it’s going,” said Amol Joshi, Ivalua’s SVP of sales and business development. He was referring to Ivalua’s steady rise as a procurement technology suite provider, but it equally suited the macro economic update KKR’s David McNellis shared last week at an invite-only dinner in New York.
McNellis, the head of research for KKR’s Global Macro and Asset Allocation Team, gave his personal views on the macro economy upon Ivalua’s invitation.
“Tariff threats are making headlines since early 2018. You don’t hear enough about tariffs promoting economic growth via inventory accumulation, but that’s what we see in the data,” he said referring to the strength of ISM’s manufacturing PMI for the first half of 2018.
Inventory contribution to GDP growth is currently at 0.14% 1H18 whereas it was at -0.25% in 2017. McNellis is expecting a 4% U.S. GDP growth this year with inventory contributing 2%.
But as procurement professionals know, inventory buildup can slow growth as costs rise.
McNellis thinks the longer term impact — even if all possible tariffs go into effect — will not surpass a 1% drag on GDP.
“But those are just the direct effects of the tariffs,” he said. “There may be a secondary effect of consumers buying less as goods get more expensive. Businesses, especially retail, are trying to incur rising cost at present to remain competitive, but they will not be able to do so longer term. Also, U.S. businesses are deferring 5-10% of their investment spending at present, which can add up to 1% of GDP. It’s a big risk I’m watching out for.”
McNellis’ team has spoken to CFOs of 30 companies with specific exposure to the China-US tariffs. He mentioned the high degree of engagement as all participated in a 30-60 minute call. He concluded that at present:
- Portfolio companies are very concerned about overreacting to the tariffs as they don’t believe they are here to stay.
- Consumer companies are much more concerned about price inflation than industrial ones. The latter is receiving little pushback from clients regarding price increases. B2C companies are fearful but will likely pass cost increases onto the consumer.
- Many companies want to avoid overreacting in their sourcing and investment strategies, resulting in investment delays.
- Very few companies see the tariffs as positive.
- China is not directly retaliating with tariffs on U.S. companies with China-based operations; their concern is with the government rather than corporations. They are trying to embrace non-U.S. companies to indirectly apply pressure.
“Inflation is ticking up a bit; moderately in 2018 but with some acceleration in 1H19,” according to McNellis, but he does not see this spiral higher in a big way.
He said that rather than observing unemployment rates, rental capacity is a better inflation indicator.
“In rental markets there is ‘owners equivalent rent,’ ” he said. “Half of that statistic is determined by rental price inflation. In rental markets, inflation is not out of control as a lot of capacity was built in recent years — that should be the measure to watch.” Ultimately, McNellis thinks demographics will keep inflation low. Labor force growth is traditionally tied to long term inflation and they remain aligned, he said.
It is interesting that the Fed and the current administration are at odds as they look at different indicators. For instance, the Fed is focused on the unemployment rate, whereas Trump looks at earnings growth. With the Fed controlling monetary policy, McNellis expects six hikes for 2018/2019. He mentions how this was a controversial view at the start of the year when only two hikes were predicted. He thinks the interest rates can get to 3.25% to 3.5% at cycle peak in 2019.
“In terms of commodities, spot oil prices are hiking due to supply deficits (OPEC production losses from Iran and Venezuela) and fairly strong global growth,” McNellis said last week. “It has pushed oil over $75, and this will be the factor in the next few months. I find myself now in agreement with OPEC expecting market balance in the next few quarters with non-OPEC production quietly surging in recent months and the U.S. production constraints being eliminated mid next year with increased Permian pipeline capacity (current infrastructure bottleneck). I expect oil prices to remain quite high through the first part of 2019, then falling to just below $50. Longer term, I expect prices at $60-65 over five years.”
4 Key Themes:
- The shift from the monetary to the fiscal is significant. The biggest Quantitative Easing (QE) cycle was around 2017 when the Fed had not turned down its balance sheet pushing lower on interest rates on assets, creating a bull market due to valuation expansion.
- Expect a modest headwind starting October 2018, largely driven by the U.S. in near-term
- The combination of tax cuts and budget deals could increase the budget deficit to 5.6% of GDP in 2019. This is a major inflexion point where valuations have stopped creating the tailwind.
- When talking valuation expansion it’s favoring quality and growth investment. “Buy complexity, sell simplicity” as demonstrated by Bloomberg’s price-to-book index showing the valuation premium of U.S. growth stocks versus U.S. value stocks at the most extreme since 2000. “Given the flight to quality, individual credit picking and understanding relative value across all spread assets can add material alpha in today’s market,” McNellis said.
- Corporations shedding assets or operational improvements are creating opportunities. The rate of return on foreign direct investment is declining. Japan has emerged as one of the most compelling pure play examples of corporations shedding non-core assets and subsidiaries. (Buyers have done a lot of deals there investing in non-core orphans.)
- Consumer behavior is changing, pursuing experiences over things – and that makes investors more interested in backing services and experiences over goods. Consumers also wrestle with fixed cost taking up their budgets (rent, technology, healthcare expenses) reducing spending on goods (especially in a brick-and-mortar setting).
- This is also demonstrated by Chinese millennials; they save less and allocate three times more of their income to leisure than Chinese overall.
- With more than six times as many millennials in Asia than in the U.S. and Europe combined, the Asian millennial will reshape the global consumer market.
- China’s overall spending power is smaller than the U.S. today, but this will shift within the next five years.
On economic risks, McNellis offered this:
- Growth has been overly dependent on financial conditions, which are tightening, albeit from low levels. Money supply is actually below nominal GDP growth.
- Margins are quite high, and rising oil prices are two big headwinds on the horizon. Operating margins are at peak levels relative to history.
- High leverage, low implied default rate — in 2016 the implied default rate hit 8.3%. Today we are at 0.6%, which is a risk. And investment-grade leverage risks is quietly testing record levels again (how many times EBITDA are companies willing to take on)
- Models continue to suggest an elevated risk of an economic downturn within 24 months, but household debt defaults have been extremely low (in great part that they have not been allowed to take on debt) which may offset the growing storm clouds.
- A changing political regime — the human component: China entering the WTO and rapid adoption of technology were the inflection points. Global populism is close to highs not seen since prior to World War II — and the potential disruption this may cause is a risk.
China Growth, U.S. Recession
“Should we be concerned about slowing Chinese growth?” one attendee asked. “Likely not,” said McNellis, “as China has quietly been infusing money into Chinese banks to buy struggling (state-owned) companies and will likely succeed in stimulus, we will not see as much of a growth reduction as we may expect.” However, he warned that if the tariffs stay in place over time, the other shoe will drop. Companies are taking the target hits right now, but as time goes by, they will move capacity from China to other emerging markets, he said.
“Over the next five years I am assuming recession at some point. Right now, I assume that will be mid-2020,” McNellis said, noting he too does not have a crystal ball. This is in part because the Fed hikes run out.
When an attendee pointed out the rarity of a recession in an election year, McNellis acknowledged it’s a topic of debate among economists but he thinks there is more than a 50% chance the recession could be forestalled to 2021 through stimulus measures by the administration.
He added that he was not terribly concerned about the U.S. economy.
“If you look at construction, corporate investment and consumer spending levels, it looks closer to mid-cycle right now,” McNellis said. “What’s happened is that we have scar tissues from the financial crisis which has kept people and companies from spending too readily, causing asset build-up.”
He said he believes Europe is in an earlier cycle with double the scar tissue. As the saying goes: When the U.S. catches a cold, the rest of the world gets the flu. But he thinks a recession will be milder in Europe and emerging markets than that.