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Custom-made shoes to fit your feet? Live in the shop?
In this presentation Century Management’s founder Arnold van den Berg explains why 3D printing is going to lead to an improvement in productivity and how this increased productivity leads to wealth creation. But this time, I believe the consumers will benefit.
The Wealth Creation Cycle according to Century Management
Century Management’s definition of Wealth
Obsolete manufacturing facilities
The drawbacks of this coming whirlwind of change to manufacturing companies is job losses and obsolete manufacturing facilities. Even though in Europe and the US many manufacturing jobs were outsourced in the last decade, there are still many plants left, employing still significant numbers of low-skilled laborers.
For example, what will happen with a bicycle factory in France which is now protected by EU import barriers against cheap Chinese bicycles?
If it doesn’t want to lose out against competition, it will have to start buying 3D printers, hiring engineers and designers and will have to start closing factories, firing production line workers and set up 3D printing hubs in every corner of the country, perhaps in every other bicycle shop.
Competition will be higher, competitive advantages short-lived
However as 3D printers will become cheaper every year, competitors will start appearing and key competitive battlegrounds will be intellectual property, safeguarding access to the latest 3D printers, materials, retaining the best engineers and most original designers and have a fine-mazed distribution network (bicycle shops with production facility?)
This will lead to very thin profitability margins and business models being turned upside down, there’s no EU import barrier to prevent this development.
What does this mean for investors?
After the technology sector, the heavy capital intensive manufacturing sectors will have their business models constantly turned upside down.
Owning a traditional factory could very well turn into a liability as competition turns abundant and profits turn into losses.
Subsequently fixed assets will have to be impaired and the debt used to finance these assets will be uncovered, leading to restructuring and losses for equity holders.
But debt is not the only liability, think expensive pensions, severance pay for redundant employees and more. Remember what happened to US car manufacturers with uncompetitive labor costs and obsolete car models?
Who will profit from this productivity gains?
For investors, productivity is a great gain, however 3D productivity will not be limited to the company you’ve invested in. It will rather be the new normal and if your company is not flexible enough to adapt…well forget all those stable cash flows you’ve counted on.
So run this scenario when you decide paying for a company’s future cash flows. How will 3D printing affect the business model? How much is current management thinking about or already applying 3D printing techniques?
Thanks to free competition in the end most productivity gains from 3D printing will go probably to the consumer. Manufacturers should prepare for an open competitive landscape and move first to safeguard their competitive position for the years to come.
Beware Myopic Politicians
A significant unknown are protective measures by myopic politicians to avoid 3D competition from destroying jobs. Pursuing this path will lead to temporary job protection, but uncompetitiveness and a dis-incentive to innovate and forcing their citizens to pay more than their peers in other countries. Leaving less money to productively invest in the economy. But unfortunately, career risk is also a strong incentive for politicians to make bad decisions.
See for a sad example Brazil’s expensive clothing prices and inferior textile industries. Ever bought clothes in Brazil? 4 times US prices and inferior quality fabrics. Middle and upper class Brazilians travel to US to buy furniture, electronics, wedding dresses, clothes and more. Hardly a sustainable and fair situation for the country’s population.
In an earlier article on this blog, I mentioned ageing is another ticking time bomb under economic recovery in Europe.
Yesterday the Economist has explained quite clearly why this is. Unfortunately they merely mention US data and leave up to imagination how the time bomb could explode, or better yet how it would look when rich world economies implode.
I will make an attempt to illustrate the consequences of reversion. But please remember:
– I am not clairvoyant
– the future could look much different
– no, my name is not Roubini
– and all the facts, data and graphs used are borrowed from the economist.com or other sources.
Baby-Boomers, a bubble deflating
Back to the issue at hand. The baby-boom generation has profited and is still profiting from the demographic dividend. As household and per capita income rose and spending per household decreased, more households were able to save up, invest in pension assets, purchase houses, companies and could stay debt free. Just think: income – spending = saving, and it will make more sense.
Rising numbers of working age (and more work), making more hours and with women entering the labor force all led to higher household incomes. At the same time people had less children, so less household spending lead to more capital to save and invest.
More savings and higher asset prices
For their article, the Economist mentions research by Liu and Spiegel (2011) who found a close correlation between number of middle age cohort (40-49) to old age cohort (60-69) and P/E ratios of equities indicating a larger group of middle aged savers* led to higher P/E ratios. Simply translated: more people saving and investing led to higher stock market valuations…
*People under 35 are often indebted and invest in houses not the stock market.
Sizable political influence, less taxes
Various worrying facts on baby-boomers, profiting from political influence, are also mentioned:
- 7% decline in US federal tax rates alone between 1980 and 2011, yet there was no halt in generous spending on health care leading to exploding deficits
- Eschker estimates that Americans born in 1945 can expect almost $2.2 mln dollar in net transfers from the state
- The IMF finds that Americans aged 65 in 2010 may receive $ 333 billion in net benefits. Source: IMF WP 2011 Intergenerational imbalances
Some anecdotal evidence exists that for European countries the problem is currently even larger. In Italy current workers will pay 14% more pension related taxes than current retirees have paid in their lifetime.
Reversion to the long-run mean
So how would a reversion process look as the demographic pyramid is turning into the shape of a mushroom?
A vicious cycle
Remember the simple equation: income – spending = saving.
As the ratio non-working to working quickly deteriorates, and if mere gradual changes are made to subsidies for the non-working, the workers will have to pay an increasing amount in taxes. This leaves less household income to save and spend.
Just imagine: in France, public sector workers are paid out of the current account. What will happen when 1 pensioner on 10 workers changes into 1 pensioner on 2 workers? Will they cut pensions or raise taxes? Or both? Either way it doesn’t look good for general household income and savings. And France is not the only country with this problem….
Hence my hypothesis that current across-the-board austerity measures (subsidy cuts on daycare, schooling and tax hikes) are the beginning, but certainly not the end.
Increasing taxes, higher current life costs and expected higher future life costs will be a major drag on consumption, depressing employment and company revenues.
In Portugal lowering salaries and cutting back on deductibility of schooling already lead to various families taking their children out of private school and assigning them to free public ones, putting even more strains on public finances.
Less savings, higher costs of capital, lower asset prices
With less savings by the young generations and baby-boomers consuming their savings, less funds are also left to be productively invested in the economy, limiting economic growth and increasing the cost of capital for companies, depressing asset prices.
As P/E ratio’s fall and do not move back to recent historical means, companies will be sold for lower prices than historically recorded leading to value destruction for current company owners and higher required returns on capital by new entrants to justify current prices.
Entrepreneurs currently buying companies should beware that historical valuations and transaction prices are not representative of future exit prices and the opportunity costs of waiting to buy a business are high.
Be careful buying a house now
House prices are just another asset that have changed hands for inflated prices in the last two decades. According to an analyses of the economist houseprices in the Netherlands France and Belgium are 33%, 38% and 42% above the normal rent-to-income ratio and thus still have a steep decline to come.
This indicates the over-indebted generation until 35 are about to become more indebted unless they start withdrawing a larger proportion of their income from consumption and start repaying their debt overhang.
Asset prices would be stable if the generational numbers are stable, however as the baby-boomers are retiring they could decide to move to smaller houses, elderly homes and put their houses up for sale. This is expected to put more pressure on houseprices rather than less.
Often I hear, this time it’s different arguments from real estate buyers or agents, however an illustration on the reversion to the mean in real Dutch houseprices over the centuries leaves nothing to imagination.
Anybody still wanting to buy a house should stop listening to the brokers and perform at least some form of fundamental value analysis (e.g. rental value) or add the expected loss of value to the cost of purchasing vs. renting.
Can economic growth be the answer?
Now back to the macro picture (and the Economist’s storyline).
Economic growth for Europe has become a problematically distant vision and with less savings available for productive investments, this vision is more dream than reality.
Contrary, as costs of capital run up and returns decrease, it is probably natural to expect a period of increased bankruptcies, less jobs like we are seeing now in Spain and Greece.
Also be careful with recent 30 years historical evidence on growth solutions (e.g. Sweden, Finland). They are distorted by EU subsidies, EU accession and a rich world credit boom. Without such a catalyst and even worse, with similar problems in neighboring countries, the recovery will take much longer than historical success stories indicate.
Furthermore as I wrote in an earlier post, economic growth is just not possible as long as Europe doesn’t get on with restructuring its debt and keeps on muddling to resolve a debt overhang and an uncompetitiveness problem at the same time.
Does Austerity help?
Again the babyboom generation is still an electorate of size. Politicians are normal people living from election to election searching for short term solutions and compromises instead of visionary long term solutions.
With Spain’s insiders (babyboomers with fixed contracts) and outsiders (50% unemployed youth) the people paying for the austerity bills are the young. Unable to generate income, they cannot spend, save and become productive members of society. Unfortunately as soon as they find work, they also will have to start paying for the baby-boom bills , higher health care costs and education tuition fees for their children.
In the Netherlands the government recently decided pension funds should calculate their present value of liabilities with an artificial investment rate (UFR), so pension cuts can be avoided at costs for the young. Another indication the balance of power tilts into the baby-boom direction and the bill of austerity will be paid later.
Politicians are almost understandable, let’s not forget, general austerity in Argentina led to overthrowing of various governments in two weeks and an eventual exit of the currency peg, a debt default and loss of savings and pensions. Who in her right mind would want that for her political career?
As long as the young are unorganized, don’t speak up and the pain is far away and spread out, the youngsters are just an easier target for austerity.
Inflation as a solution?
This looks like the easiest way out, decreasing the real value of debt (mostly of younger generations until 35) and decreasing the real value of savings and pensions of everyone, but to a larger proportion that of the elderly as they have accumulated more net assets in pensions, housing and savings.
With the political weight the baby-boomers still bring to the table the question is whether inflation will be accepted and will result in pension cuts or lower pension benefits for the less organized younger generations.
Researchers of the St. Louis Fed, indicate the answer is no. They find as a country ages the tolerance for inflation decreases.
Asset managers beware of inflation!
A large issue also with inflation is the current general regulatory and asset managers consensus, that government debt and high grade credits are the safest assets around.
- Due to this ‘herd’ like consensus the Dutch government bond yields currently at lowest level in almost 500 years
- Corporate bond yields are at their lowest levels since 1958, and just 1.1 percentage point away from their all-time low in March 1946 (2.5%).
- And the current spread between European dividend yields and German bund yields, are at an all-time (320 bps).
Picture: Please not these are stock prices (not yields or P/E levels) versus bond yields.
As soon as inflation will appear on the horizon the ‘herding’ effect will work reversely and take its damaging toll on the average portfolio manager and their average investment portfolios of Credits and Treasuries. Taking away yet another portion of the saved up wealth by (future) pensioners.
Equities and inflation
However don’t consider equities to be a safe haven from inflation either. The evidence on the relationship between inflation and company returns are terrible too.
In a famous article in Forbes (1977) Warren Buffett documented that actually nominal returns are fairly stable over decades at 12% (McKinsey now increases this to 13.5%) and higher inflation decreases realized returns to investors and vice versa. This conclusion is in 2010 again confirmed and explained by McKinsey in their 5th edition of Valuation by Koller, Goedhart and Wessels.
As economic growth seems far away, austerity messes with company revenues levels and inflation will hit savings and pension assets, there’s no overall solution helping us out. In hindsight we will discover what have been the best picks. I have a hypothesis, but I will save that for a later post.
My Conclusion (Yours could be different)
Younger generations should start realizing they are on the losing end of the wealth transfer. Current tax bills are high and increasing, leaving little room to save up for costs of education of their children, healthcare and anything currently subsidized by the state (children’s daycare, elderly homes etc.) Unfortunately also their assets (houses and pensions) decline so they will have to start working harder, spend less and invest smarter.
The baby-boomers will have to be smart as well. Selling they’re company and house now is better than tomorrow and they’ll too will have to eventually count on some harsh pension and subsidy cuts.
Asset managers should finally do away with trying to replicate benchmarks, because the benchmarks have a high chance of trending downwards and consequently the capital they manage. In investing, the case for bottom-up value investing becomes stronger and many investment decisions made based on recent data will prove value traps (remember real estate, banks?)
The differences in wealth between the well-prepared and the average population will become larger (again)…and in general, it looks like the ‘rich world’ should prepare to become poorer…
As we muddle through the debt crisis in Europe, the believe in a happy ending is fading away fast…many papers and proposals are published and discussed, but many of them lack a practical approach, are short term solutions, increase moral hazard and lack a comprehensive overview…perhaps because the real and exhaustive solutions are too painful?
Two strategy consultancies have published their highly interesting analyses and come to some different conclusions on what should be done.
McKinsey Global Institute proposes an orderly approach by taking successful Nordic deleveraging in the 90’s as a case example.
David Rhodes and Daniel Stelter of BCG, take into account the reality of political forces and come to a different conclusion for the Eurozone.
Studying Sweden and Finland’s example, McKinsey discerns 2 phases of successful deleveraging:
- following recession, it will take 4-6 yrs to delever private and corporate debt while public debt continues to increase;
- the subsequent 10 yrs fiscal discipline and public debt reduction are needed;
- only after the private-debt reduction the economy will return to its pre-recession levels
Some worrying facts about this comparison:
- The UK and Spain haven’t begun yet to reduce their private debt levels (January 2012) – unfotunately McKinsey merely discusses these two EU countries.
- Therefore, McKinsey estimates, the UK and Spain are still about 10 years (!) away from reducing their private debt levels. Following the graph per above this implies they will take 20 yrs to reduce their total debt to sustainable pre-bubble levels (!)
- Sweden and Finland ran budget surpluses before their crises and joined the EU, stimulating foreign investments and export growth
- Debt reduction alone doesn’t increase competitiveness
6 critical markers of success
McKinsey identified 6 critical markers that policymakers should look for and emphasize in their policies:
- Is the banking sector stable? – It’s undercapitalized at best…
- Is there a credible plan for long-term fiscal sustainability? – Track records of Spain and UK are deficits not surpluses…
- Are structural reforms in place to attract foreign investment? – Are politicians able to loosen labour laws increasing unemployment and social unrest in the short term? I guess Ireland and Portugal are doing a good job, about Greece, Spain, Italy and France I am not so sure…
- Are exports rising? – First Spain, Portugal et al. have to resolve the cost of labour per unit of product (10-30% higher than Germany) and the worldwide economic slump is not helping?
- Is private investment rising? – Are politicians able to restore business confidence, especially in the periphery? I see many investors running for the exit with valuation multiples this low for European stocks and bonds…
- Has the housing market stabilized? Spain still has 1.5 million empty houses…
Can I conclude we are far removed from recovery and a delevered Eurozone economy?The key underlying questions I would like to ask are…do we have the time and patience to pursue McKinsey’s orderly Nordic-style road to recovery and more important...do our politicians have the guts and discipline to lead us through a 10-20-year recovery programme?
David Rhodes and Daniel Stelter of BCG explain, most likely, politicians will eventually be forced into radical action and they outline a painful but much shorter path to debt reduction…
Their analyses starts with sketching why reality will in the end catch up with politicians:
- current crisis is not only a government crisis, but also a competitiveness crisis
- uncompetitiveness dominates in periphery and hinders export growth and trade surplus
- no currency devaluation is possible for Eurozone countries to restore competitiveness
- real devaluation implies pursuing productivity and lower labor costs at the expense of high unemployment and political risk
- Eurozone banks are undercapitalized and can hardly take more losses
- aging of European populations won’t help, increasing health spending, decreasing workers per pensioner etc.
Reducing debt and increasing competitiveness at the same time seems incompatible and will cause serious social unrest
They mention the findings of Cecchetti, Mohanty and Zampolli (Bank of International Settlements) which provide another indication that there cannot be recovery without resolving the debt crisis first:
- debt becomes a drag on economic growth ones private, government or corporate debt moves in the 80-100% of GDP range;
- since 1980 debt to GDP quadrupled in real terms to a 300% to GDP today;
- they urge policymakers to act quick and decisively to prevent a vicious debt cycle spiralling out of control and put a further drag on growth.
Along these lines, Rhodes and Stelter conclude, we’re on the wrong track and that politicians have to eventually implement a real solution: debt restructuring before competitiveness can be restored. Interestingly they also outline how this should be done:
- Set the target: Total debt limit at a sustainable 180% of GDP with enforced limits at 60% private, 60% corporate and 60% government debt of GDP
- Relieve the debtors: write-off all debt above these thresholds (household, corporate and government)
- Secure the financial sector: the EFSF should take the lead to recapitalize banks and guarantee insurers’ payouts to policyholders. Effectively nationalizing the financial sector
- Arrange the funding: all Eurozone savings above a €100k threshold would suffer a ~35% wealth tax to pay for the restructuring operation
- Install structural reform and controls to prevent repetition: embedding the debt ceiling in constitutions, funding of all governments via eurobonds issued by EFSF, control mechanisms for private debt growth and a clear commitment to resolve pressing aging issues (helathcare spending and retirement age)
Unfortunately restructuring doesn’t solve the competitiveness issues, but it makes at least sure that the Eurozone can start fast with becoming more competitive and safeguard long-run prosperity for its population.
And achieving competitiveness? Well this will hurt too…perhaps leading to an eventual break-up of the eurozone. One problem at the time….
In March, Gregory Baer, deputy general counsel, presented a plan to policy makers and bankers to show the results of a hypothetical $50bn loss…
Read further at FT.com: