Rather than reward workers, executives are rewarding shareholders…and themselves. And here is what is wrong with the incentive structure for American executives. Because they receive the vast majority of their compensation from share options, executives are much more focused on pushing the share price up than with the long term welfare of all stakeholders. Not only are they spending less on traditional capex (i.e. plant and equipment) even though borrowing costs are near 5000 year lows and profit margins are high (see chart 5), they have been running deficits (i.e. borrowing money) to cover both capex and share buybacks.
Indeed, the last two times the corporate sector was bingeing to the same degree, the economy was on the verge of a recession.
So here we have the vast majority of consumers just about managing and in some cases stretching themselves through increased borrowing in order to carry on consuming so that GDP grows. Corporate America is choosing to leverage their balance sheets in order to boost share prices (and executive compensation), rather than increase salaries and invest for future growth. On the current course, we cannot see how these two trends continue. Surely it is a question of time until something breaks.
Of course, the theory of Trump’s tax plan is that corporate America will take the funds available from repatriation and lower tax rates, and use the cash to create jobs. Well, unless the tax code changes the incentive structure of executives away from share buy backs, we doubt very much that this so-called trickle down policy will work. The Bush tax cuts hardly helped in this regard, and corporate America has hardly shared the benefits of paying lower effective tax rates in recent years – tax paid is at the low end of historical ranges.
So here is our problem. We can identify a number of imbalances in the system, but until something changes, these imbalances can remain and even become more extreme. Central bankers remain wedded to models that don’t seem to work, and their policies are allowing many imbalances to build to unprecedented levels. Policymakers want us to focus on the shiny veneer that they have created for both the economy and financial markets, and yet they risk creating a system that is arguably more vulnerable than ever before.
The financial markets currently are much more focused on the shiny veneer. Equity markets are simply not suffering any downside price action to speak of and volatility is essentially at record low levels. This seems dichotomous with the vulnerabilities in the real economy. We believe that without real change in the way the economy is managed and the way monetary policy is conducted, the system will breakdown at some point.
If policymakers get ahead of the curve, and start implementing wide ranging reforms, then the process of tackling the real problems will be a lot less painful. If, however, we remain on the currency policy setting, we fear that we are headed for a great reset that will be painful for the vast majority. At the moment, policymakers are still wedded to their models which even they worry are broken. As a result, we fear that we will have to endure a great reset.
The timing of such a reset remains as elusive as ever, and with centrals bankers still trying to inflate everything, it is possible that the reset is years away. However, markets have a history of sucking in the vast majority of players just before the turning point. Anecdotal evidence suggests that in the big picture, more and more investors are getting swept up every month by the most hated bull market in history. All we can say is that the higher the market goes without an underlying improvement in the health of the broad economy, the worse the next bear market will be.
RMG Wealth Management