Below is The Blackstone Group L.P.’s (NYSE:BX) conference call transcript about “The Ten Surprises of 2015”, featuring Byron Wien, Vice Chairman of Blackstone Advisory Partners LP, held on Thursday, January 8, 2015 11:00 am ET.
The Blackstone Group L.P. (NYSE:BX) is one of the world’s leading investment and advisory firms with Total Assets Under Management of $284 billion as of September 30, 2014. Its global portfolio includes investment vehicles focused on a global private equity, real estate, public debt and equity, non-investment grade credit, real assets and secondary funds.
Now on its 30th year, Byron Wien announces his list of this year’s Ten Surprises which includes US Federal Reserve “acting sooner than later” with interest rates hike by the first quarter, a cyber-terrorist attack on a “major money center” may take place to try to hamper the US economy, as well as Russian President Putin will resign before the end of the year. In the company’s press release, Wien’s “surprise” is defined as “as an event which the average investor would only assign a one out of three chance of taking place but which Byron believes is ‘probable’ having a better than 50% likelihood of happening.” Wien is a Wall Street veteran and recipient of the prestigious New York Society of Security Analysts (NYSSA) Lifetime Achievement Award. He is currently the Vice Chairman of the financial advisory group Blackstone Advisory Partners LP and acts as senior adviser to The Blackstone Group L.P. (NYSE:BX).
Host:
Joan Solotar, Senior Managing Director of External Relations and Strategy of Blackstone.
Good morning everyone. Thanks for joining us today. This is Joan Solotar, Senior Managing Director of External Relations and Strategy of Blackstone. So today, we’ll have the Blackstone Webcast: The Ten Surprises of 2015, featuring Byron Wien, Vice Chairman, Blackstone Advisory Partners. Following Byron’s formal comments will be an opportunity for you to ask questions.
If you look at the lower left hand corner of your screen you will see a Q&A box, feel free to click on that at any point to submit your questions anytime during the webcast. At the bottom of the console, you’ll see a series of widgets. This interactive feature will allow you to access additional functions by scrolling over them such as Twitter, Wikipedia, Download Slides and Refer A Friend. We plan to keep the webcast to 60 minutes, that’s including Q&A, and at the end of the PowerPoint, you’ll see a full list of disclosures. So if you’re wondering why you don’t see Byron on screen, he apparently challenged Andre Agassi to a tennis match and won the match but broke his hips so we have Byron dialed-in through audio. And with that, I am going to turn it over to Byron Wien.
Byron Wien, Vice Chairman, Blackstone Advisory Partners.
Thanks Joan. It wasn’t Andre Agassi, and that wasn’t even that hard a shot that I fell on, but here I am laid up. I hope it’s only going to be for a couple more weeks and the recovery seems to be going very well. Let me just talk about a few general themes for the Ten Surprises. First thing is, this is the 30th Year of the Ten Surprises. I started doing these in 1986 and the idea of it was that the Ten Surprises are all things that I think are probable but the average investor would give them no better than a one in three chance in taking place.
The goal of them is not to get a high score. I know this is Wall Street and everybody keeps score and everything, but my idea with the Ten Surprises is to stretch my own thinking and get you to think about some things that perhaps you weren’t thinking about in a certain way. There are a couple of themes that run through the Ten Surprises. The first is that the decline in the price of oil is a positive. It is a positive for consumers everywhere, it is a negative for some producers but some of the producers, I think on a geopolitical basis, will respond favorably to it and we’ll get into that with the actual surprises. The second is that the dollar strength is not a negative. That the United States will in essence benefit from that. It may hurt our exports but exports are relatively small, maybe 12% of total GDP, so I don’t think it’s a profound negative. So let me get into it, but before we do that, it’s worth taking a brief review of 2014.
The Ten Surprises there started out with my saying it would be a Dickensian market with a pretty sharp decline. I had it at 10% and turned out to be 8% and I said the market would be up 20% on a total return basis and it was up 15% at the peak on the total return basis. So that one worked out pretty well. I also said that the US economy would be strong, growing a 3% in the final quarters were 5%. And I also said unemployment would go to 6% and it’s 5.8%. The riskiest of all the surprises, the one that came through, I had the dollar dropping from $1.37 to $1.25 against the Euro and going to 120 against the Yen and it got to both of those targets and actually seated the Won against the Euro. I also said Japan would get to 18,000. It’s at 17,790 I think. I also said that the economy would run into trouble later on the year. And the fifth one, I said China would slow. I think they are slowing. Almost every parameter I look at where China indicates that they are slowing but they are not reporting it.
They are reporting still 7% real growth. The sixth one is emerging markets to prove treacherous and that certainly was the case. So the first six came out pretty well, and then I ran into trouble. I said oil would go to $110 and actually, in June, went to $107 but then, as we all know, it collapsed. I said that commodities would do well because of emerging market demand and that wasn’t the case. The agricultural commodities declined in price. I also said that the 10-year Treasury Yield would rise to 4%. It started the year at 3% and dropped to 2%, so I got that one wrong. And finally, on the tenth one, I probably got that outright, I said the Affordable Care Act would have a remarkable turnaround. Everybody was pronouncing it dead at the end of 2013. It did have turnaround was nine million people signed-up but I thought that it would help but never pass in the November election and that didn’t turn out to be the case.
Okay so, here are the Ten Surprises. I’m sorry, The Also Rans for 2014. I’m not going to do all four of them but I am going to do one of them. Overcoming objections from the Cuban exile community, President Obama opens discussions on initiating trade and diplomatic relations with Cuba. A reduction in sanctions is proposed, as well as limited financial support in the form of bonds, quickly dubbed as “Castro convertibles.” So I got at least one of The Also Rans right.
Okay, here are the Ten Surprises for 2015. The first one, and I’m — I’m just going to comment on these surprises, just give you the highlights. You can see them posted on, in their entirety, on the Blackstone website. The essay with the Ten Surprises and Analyses of last year will be out probably today.
So the first one is: The Federal Reserve act sooner rather than later. I know everybody thinks that is not likely. The consensus view is the Federal raise rates in June, I think they may do it in the First Quarter. You can say why will they do it with Europe in such terrible trouble? I think Europe, Mario Draghi will ease and that will encourage people to buy Euro but I think the momentum of the US economy is strong enough for the Fed to take the first step. You remember, the first step is going to be small — the goals from 0.25 % to 0.50%. Those rates are still pretty low.
The key thing about the first surprise is that the yield curve will flat and that long rates will go up in sympathy with short rates. I think that is an important money-making opportunity. The second one is: Our luck runs out on cyber terrorism. Hackers from abroad attack a major money center bank and force it to close for five business days while they resolve the accuracy of its deposits and withdrawals.
There is nothing that our foreign enemies want more than to hamper the US economy and there is no way to do that more effectively than closing down the banking system or at least a part of it. So I think this is — we all know what the hackers did to Sony and that is only a glimpse of what they could do. The thesis behind this one is that the people doing the hacking are smarter than the people doing the cyber security. So I think this is a serious one to worry about.
The third surprise is that in spite of all the things that are likely to go wrong this year, I think the US market is going to have another double-digit year. The consensus view in Barron’s was 10% and the Wall Street Journal was 8%. I think it could be as much as 15%. I will show you in terms of valuation, revenues and earnings. Revenues will be up 4 (%) earnings up to 8 (%). There will be some share buybacks to do that and I think there will be some hopeful expansion. So I think we could have another double-digit year in 2015.
I think Mario Draghi finally will do something in terms of quantitative easing. I think it will work at the beginning but not have long-term effects. So I am concerned that quantitative easing won’t have the same effects in Europe that it might have had in the United States, although I am skeptical too, and I think Germany is the engine of growth there and the real problem in Europe is that the structural improvements that they needed to make when times were better were not made.
Number 5, I think Japan will be in trouble. Also they will do everything possible to pull out of their recession that appeared in the third quarter but I still think Japan is going to have a tough time of it. I think that Nikkei 225 will be flat for the year but I think it will be down in dollars.
The sixth surprise is that China finally admits it is isn’t growing up 7%. It is going to do something about it. What it is going to do is more fiscal spending but not on housing and estate or enterprises and roads and airports. It is going to do the spending on pollution control — air, water and land.
The seventh surprise is I think the price of oil finally has an impact on Iran. I think it brings Iran to the negotiating table and I think they will come to an agreement with the West on their nuclear arms development policy. I think that Iran realizes that they have very little to gain on that and they have a lot to lose. They want the sanctions lifted. They want to play a role in the economic opportunities that the West has enjoyed. I think they are going to move away from their nuclear weapons policy and I think that is going to be an important positive.
The eighth surprise, and this one I can tell you already is the most controversial, I think it is going to have — the drop in the price of oil is going to have a similar impact on Russia. I think Russia is really suffering under the sanctions. The revenue that they are getting from oil has declined sharply. Their foreign exchange reserve have taken a sharp dip down. I think they are going to become more conciliatory on Ukraine and possibly recognize territorial integrity of Ukraine giving some autonomy to Eastern Ukraine. I think this is — Putin I know enjoys a very favorable approval rating but I think that his abdication on this, his failure to respond effectively to the drop of the price of oil, the economic calamity that is facing Russia is going to cause his fortune to turn around and he will resign by year-end. Almost nobody thinks that is possible.
And I also think finally on this one that the price of oil would be moving up by the end of the year as a result of continuing demand from emerging markets. So I don’t think we’ve seen the last of $70 oil. For it to get back to over a hundred again anytime soon is more conjectural.
Number 9, I think this one, you’re going to have a buying opportunity in high yield bonds. They have taken a sharp hit because while energy is only 7 % of the US economy, it is 17% of the high yield bond market and it is not the whole high yield bond market down and I think there are going to be some big buying opportunities there.
And finally, Number 10, I think the Republicans are going to try to position themselves for victory in the Presidency of 2016 and the way to do that is to broaden their base. So I think they are going to try to prove to be the activist party and subsuming Obama and ObamaCare, they are going to try to pass legislation now that they have both Houses of Congress.
So you are going to see the move on their Keystone pipeline in spite of the Obama’s veto threat. There are going to move on immigration reform and think they are going to even suggest some big changes in the Tax Code. I think they are going to support Jeb Bush as their nominee because he can siphon off some of the Hispanic votes. They voted overwhelmingly for Obama and was 17% of the electorate in 2012. So, I think you are going to see the Republicans reposition themselves as the activist party.
So those are The Ten Surprises for 2015. I think you would agree they are surprises, some of them may be delusionary but we’ll see how they work out. Again they are to stretch your thinking, not to get a high score.
Then I have four Also Rans. Water becomes a preoccupation of environmentalists. There are hundreds of millions of people in China and India without safe drinking water and I think that is going to be the focus of environmental attention. To 12, internet commerce comes into trouble. You are already seeing now with the Uber and the New York City taxi medallion holders. I think Airbnb and Uber and other internet commerce companies are going to be forced to pay the same taxes and have the same insurance if they are commercial competitors.
Number 13, probably the one I have the least conviction about. This is that Brazil becomes the favorite of the emerging market investors. That would require Dilma Rousseff to become more business-friendly and not much sign of that so far but I think it is a possibility, but again I’m all [inaudible]. And finally, Number 14, already a lot of attention being paid to this: Hillary decides not to run. She wants to be the first woman President but she doesn’t want to be the first woman candidate to run and lose. And she is worried that Jeb Bush is a formidable competitor because of his ability to appeal to the Hispanics. She is also worried that she is too conservative for some Liberals and they will stay away from the polls. Obama only won by three percentage points. So Hillary has a lot to worry about if she loses some of the Liberal and Hispanic votes. Again, an Also Ran, or one worth thinking about.
Okay now, turning to Page 4, this is my “Radical” Asset Allocation. It is asset allocation and not a trading template so I make changes in it generally once or no more than twice a year. I have made some changes here and still has 10% in Global large cap Multinationals. That stays the same. It has 10% in other US stocks that stays the same. I have taken my European position down 5% because I am worried that Europe is going to have more economic difficulties this year, in spite of the quantitative easing. Have taken my Emerging Markets percentage down 5%. So both of those are now 5% better than 10%.
I have got now 10% that I can invest elsewhere. I am going to put 5% of it in the Hedge Funds because I think the market is going to be less correlated this years and long/.short equity hedge funds are going to do better. I still have 10% in private equity, 10% in real estate, 5% in gold — I’m not giving up, 5% in natural resources and finally, I will use the other 5% to increase my non-conventional high yield to 20%. So, I do have a fixed income component but it is high yield mortgages, leverage loans, mezzanine financing.
I can tell you that there is no portfolio anywhere in the world — and I have looked at a lot of them — that looks like this. This portfolio is radical. It basically has a whole equity orientation. It is designed to give you some ideas to think about because there are very few portfolios that have this kind of emphasis in non-conventional bonds. Turning to Page 9, the investors are still pretty optimistic, not as optimistic as they were the first few days of the New Year have sobered them up somewhat. So I don’t expect the market to run away here but I do think over the course of the year, you will see a 15% return.
The next Page, 10, shows that people aren’t as interested in the Stock Market as they used to be. You see that CNBC has moved their offices from New Jersey to Midtown and the viewership is down. All the business programs are down. Even though the market is flirting at an all-time high, people don’t seem to care as much as they used to. But I think that might return.
One reason people might be a little nervous is shown on Page 11. This bull markets is gone 70 months. The average of historical bull markets is 57 months. So we are pretty long in the tooth here but the fundamentals are very strong. I think we could be in a situation as we were in the 1990’s where the market performs in double-digits for a number of years in a row. The fundamentals are very good in the United States right now with 5% real GDP growth, auto sales strong, unemployment coming down, I’m looking for housing and capital spending to provide a positive. So my view is that 2015 is going to be a good year for the economy and the market.
Looking at Page 12, you can see there is going to be a reversal here. The Fed has been easing – that is the light blue line. The European Central Bank has been restrictive. Now we know the European Central Bank is going to be more accommodative and it said it is going to raise rates and that is one of the reasons why the dollar is strong and is likely to stay strong. The Federal Reserve Balance Sheet in the last six years, having taken 95 years to get to $1 trillion only took six years to get to over $4 trillion and you see on (Page) 13, Mortgage-Backed Securities are a big part of that.
Looking at (Page) 14, you can see the dollar has been very strong against many currencies, not just the Euro and the Yen. So, across the board. And overall, it is up 20% from its low. So I think it can go a little bit further but probably not a lot further. Looking at (Page) 15, the World GDP growth has really come down. It has come down because of China with controlling over 10%. It has come down because of the United States which is operating at a slower rate and has come down because of the emerging markets. In June of 2010, World GDP was growing at 4.36% now it is 2.55% but that is still satisfactory. But it still doesn’t mean we are going to have bear-markets across the board. I still think that we can have a good market this year.
The world is more independent as we see on (Page)16. The IMF shows that the World Goods Exports are running in the 20s (%). So countries are interdependent on each other. Fortunately, the United States is not a big export economy so the US can do well even though our exports may suffer because of our trading partners. But that will be offset by the lower price of oil. Our trade balance is improving because the price of oil as our most important imported commodity and that is cheaper, and so even if we don’t have the same exports, we are hoping for, we still are likely to have a very favorable balance of payments.
Now let us take a look at Russia on Page 17. What you see here is that the Ruble has collapsed from 33 to 79 and their Foreign Exchange Reserves have plummeted. So Russia is in real economic trouble. Now, Putin has said Russian people are used to suffering and I know they are, God knows. Second World War was proof of that ability to endure pain but I think too much is going on here and my view is that the Russian people are going to move against them. The sanctions are hurting. He could lift the sanctions by pulling back from Ukraine and I think that is what he is going to do. I think he will be humiliated in the process and I think he will resign before the end of the year. As I said, I get more pushback on that than anything else but I think at least a part of Number 8 which shows a more conciliatory attitude on the part of pushing out of power of Putin is going to happen
Turning to Page 19, on the US, this is an important Page because Economic Cycle Research Institute, it accurately forecasts the business slowdowns in the United States in 2010, 2011, and 2012. It did not forecast one in 2013 or 2014 but now it is headed down. So this would indicate that we are in for some economic trouble. So far, we haven’t seen it yet but this is a leading indicator and it says we should watch out for it. If it turns out to be right, then we should have a softening of economic activity sometime in the middle of the year. I think that will be a temporary condition. I think the year will come in at 3% or better but this is a warning signal that we’ve got some tougher days ahead.
The real problem in the United States is Median Family Income. Page 20 shows that the Median Family Income today, real, these are real figures, not nominal, but real Median Family Income is lower than it was in 2007. So most of you on the line are probably in better shape than you were in 2007 because you have holdings in the stock market and because you have a house well-above the median price. So expensive houses and stockholdings have appreciated and that has really helped the Top 20% of the income stream. But the middle 60% have struggled all their own and the Bottom 20 (%) have actually lost ground.
Now that situation is improving. If you look at (Page) 21, wages are moving up. I think now wages are going to be rising at about 2.5% rate this year and that is going to be an important positive. That is on (Page) 21. On (Page) 22, we didn’t get the help this year that I thought we might get in Housing. Housing is definitely off the bottom but it hasn’t surged yet. With lower unemployment, higher wages and improving in the employment of 16-34-year-olds, I think there are going to be more family formations so I am looking to housing to be one of the favorable aspects of the economy in 2015.
Housing Starts are not contributing yet but I think that is going to turn around as shown on Page 23. House prices are still appreciating. They are not appreciating — as you see on Page 24 — they are not appreciating at 10% or better anymore but they are still appreciating at 5% and there is nothing that gets you to buy a house faster than knowing that it is going to be more expensive if you wait six months.
As I said, I also think Capital Goods is going to be a positive. Page 25 shows Capital Goods in a clear positive uptrend. Up until now, most of the capital goods spending has been for Labor-Saving Equipment, that has allowed the goods and services to get out the door with fewer workers. I think that is going to change. I think there is going to be more capital spending by small businesses. Optimism is improving. So I think that is going to be the second favorable thrust for the US economy in 2015.
Page 26 shows that we are now exporting more oil than we ever before. We have relaxed the requirements on US exports and that has helped our trade deficit as has the decline of the price of oil as shown on Page 26. And we should all celebrate the fact that now, the United States is the largest producer of crude oil in the world, more than Saudi Arabia and that is shown on Page 27. Russia is third and then comes China, Canada, etc. So we are producing oil at a healthy rate but we are still importing.
Page 28 shows that China and India are relatively low consumers. The US uses 21 barrels of oil, 22 barrels of oil per person per year. China less than 3, India less than 2. There is no way China and India are staying there and that is where our marginal demand is going to come from. How quick we will see then and how much we will see is indeterminate but I think years from now, the price of oil won’t be where it is today. It will be because of emerging markets demand. That will be the case.
Why did the price of oil decline in the first place? Was it a plan by Saudi Arabia or Russia or someone else? I think not. I think it was a simple economic force as shown on Page 29. There you see that the price of oil has essentially tracked World GDP. World GDP has been declining because of the factors I cited earlier and the price of oil is going down with it. There is also some evidence that the amount of oil used per unit of GDP which used to be — there used to be a roughly 50% correlation, not it is closer to 25% so that has been an important factor. The worldwide demand is slowing and worldwide usage in relation to demand is slowing and that is why the price took a sharp drop. I am sorry I didn’t see this coming beforehand but in spending a lot of time trying to analyze the causes, this seems to be the best explanation I have been able to find.
Now if you worry about the US energy area, look at Page 30. The hydraulic fracking wells in both North Dakota and Eagle Ford, Texas range are all profitable above $50 so I think that you are going to see all of the hydraulic fracking producers continue production but what they will hold back on is new investment.
Now if you wonder why so many middle class people are complaining, go to Page 31. In this cycle, profit margins have reached an all-time high. They are down a little bit from the peak but they are still way up there in relation to earlier cycles. But unit labor costs have not increased at all so the average worker drawing a paycheck every two weeks in the plant or a restaurant or hotel, their earning haven’t increased. Their dollar earnings haven’t increased and their real earnings haven’t increased and they have actually declined. So this is the biggest problem and this is the heart of the inequality issue and I think this is going to be a very important topic in the 2016 election. So this chart shows why corporations have done well and that is related to individual stocks having performed. But it also shows that workers haven’t participated, so if you are an average person in the United States, the economy has recovered, the stock market has almost tripled, but you haven’t benefited and you are having trouble making ends meet. I think that is going to be a key political issue in the next Presidential election.
Then there are some other factors. If you look at 32, you can see that the number of people and the percentage of workforce in relation to population is down. We used to have about 74% of the population, of the 16 – 54-year-olds working and about 72% of the overall population. But the numbers are down. They are moving back up again but they don’t look like they are going to get to the previous levels anytime soon. So there is a dropout rate in the workforce. But happily, the most productive and in the highest spending component, the 16 – 54 year-olds, they are improving their position. So we hope that the household formations and a better housing market.
Consumer Sentiment on Page 33 has come back but it is not nearly where it was in 2007. Consumer net worth is at an all-time high but that has benefited people in the higher ranges of income who have stock holdings and own their own homes.
But there are broader signs that the economy is doing well. If you look at Page 34, you can see that Bank Loans are increasing almost exponentially, so companies are willing to borrow to improve inventories. They are willing to ship. Rail Car Loadings are looking pretty good, a little more volatile than usual. But these are broad signs of how the economy is doing and I think the economy is doing well.
The most encouraging one is the new chart in this series. Small Business Optimism is improving and there is nothing that creates jobs faster than small business. There is nothing that is likely to improve capital spending faster than small business. So favorable trend in this indicator is very encouraging. Now let’s take a look at Earnings.
If you look at World GDP, that would argue that US profits are going to be pretty flat. But there are other indicators which argues against that. That was on Page 37. Page 38 shows something I am going to remind you of every time I make webinar and that is security analysts are always too optimistic. I had a 115 estimate for the S&P last year. Everybody else is 120. We will probably come in at 117 or 118. Analysts are always too optimistic. Be wary.
Now the next page, 39, shows that Revenues are — look at the right hand because the left hand is fourth quarter. Revenues are going to be increasing at 4% for the S&P 500. And the next page shows that Earnings will probably be expanding at about 8% for the S&P 500 because profit margins probably won’t improve much and will continue share buybacks.
Now here is the key page. This is the Median Multiple. I know a lot of people who think we are forming a bubble and many people arguing the market is expensive. But right now, the market is probably at about 17 times earnings. Bubbles occur 25 and 30 times earnings. We are nowhere near a bubble. I know I have said that at every webinar I have had and that has been the case pretty much since 2009. I am not arguing that the market is going back up to even 20 times earnings but if it goes to 18 or 19 times earnings, worth an 8% in its improvement, we could definitely have a 15% appreciation in the S&P 500 this year.
The next page, 42, shows the Shiller Housing Index. What this argues that the market should not be 2100 or 2000, it should be 1300. Shiller’s approach is different from mine. I use trailing 12 month-earnings. He uses normalized 10-year earnings which are held back by the 2008 – 2009 recession. So he comes up with the market being very expensive. My argument is the market isn’t cheap, it is fairly priced but before it is over, it is going to move to a higher multiple.
Page 43 shows the various other assets. If you are not going to put your money into equities, what are you going to put it than into houses if you turn the rental that you’re likely to get on a house into a P/E. Houses or more expensive than stocks. Bonds are certainly more expensive than stocks. So in terms of those two alternatives, stocks are relatively attractive today in the US. Looking at Page 44, what we see is that Manufacturing Productivity has come down a lot from where it was in the early part of the new millennium. But it is still better than 2% which is more than satisfactory for an earnings improvement.
In Page 45, it shows that share buybacks are increasing at a pretty impressive rate or had been maintained at pretty impressive rate. Corporations have a lot of money in their balance sheet. What are they going to use it for? With increased dividends, that forces that taxpayer to pay taxes on it. They can buy their own shares back. That is a very tax efficient way to reward shareholders because it improves earnings and the shares are likely to go up. They can use the cash for mergers and acquisitions and buy a competitor, eliminate some sales and marketing people and some administrative people, but I think all of those are the tools that companies are using their cash more. So I think, I feel pretty solid on the idea that the earnings are going to increase 8% this year and that multiples will increase modestly.
As far as being worried about the market and the bulls cycle, usually the market keeps going for as long as 29 months on average after the first Fed rate hike. So, it usually takes more — Edson Gould the famous strategist in the 60’s said it took three steps for the Fed before the market stumble. Page 47 shows that the market is usually a leading indicator on the economy and usually leads the economy by seven months before it turn down. Page 48 shows the various parameters and what they usually look at before a recession is about to take place and what you see here is that virtually none of the indicators are in the position when it’s worth forecasting pending recession anytime soon.
In terms of our fiscal condition, Obama, I don’t think has made as much of this as it probably could have but no matter what we raise taxes to, they still seem to come in a 15-20% of GDP. Our government spending is less than Europe. Europe is a much more socialist place than we are. They spend 45 – 55% of GDP on various government programs. We spend less than 40. So we are exhibiting remarkable fiscal discipline in comparison to our European counterparts. What is really amazing to me is that the US 10-Year Treasury now yielding about 2% has a higher yield than the 10-Year Bonds of all of our major economic competitors.
Now you would think in Europe when they are spending so much money on government programs, their balance sheets don’t look as good as ours in many cases. They would have higher yields. Now why is this the case? Higher yields overall so low and why is the United States yield above those of places like Japan where the debt of GDP ratio twice high. And the reason is, there is so much liquidity out there. There are so many people with so much money — crude, those cash reserves during the recovery — and they are looking for a place to go to it and they are a little apprehensive about the equity markets right here because they argue that the US market has done well for a number of years and the situation in Europe and Japan isn’t too great and they are worried about China so they are looking for a place to park their money. And they are parking their money in treasuries and that is keeping the yields low and that is one of the reasons why I think you are going to make money in the high yield market in Surprise No. 9.
In the Federal Budget Outlook, we made major strides here on Page 53. Budget Deficit is at 2.80 of GDP down from 10%. The thing we have to worry about is what would happen if interest rates rose? Right now, we are only fine-paying about $360 billion to service our $17 trillion in debt. if interest rates were to normalize, it will repay 4% on average rather than 2. That would be a big hit to the budget deficit.
On Inversions on Page 54, one of the reasons the government got so exercised about inversions is that they were soaring and the government didn’t want that to happen and I think they — maybe not put a stop to it but certainly slowed it down.
Now taking a look at Europe. Europe came out of the recession when we did. Went back in the recession because of austerity and came out of the recession and now it looks like it might go back so that is why it is imperative that Mario Draghi try to provide some good amount of stimulus in order to keep Europe growing in at least a 0.50%.
On Commodities, it looks like it might be bottoming. That is on Page 58. I’m not convinced that that’s the case yet but there are some signs of it. Why would they bottom? Because the standard of living continues to rise in the developing world and the first thing you do is you eat better. So will it be to industrial commodities because I think the manufacturing in the emerging markets is slowing but it will, it could be to agricultural commodities but I am not ready to make that call yet.
Turning to China and the Emerging Markets, the Price-Earnings ratio of the emerging markets has risen but that is because of earnings disappointment. The markets — this is all in Page 60 — the emerging markets themselves have not done much. I think we may have another year of non-performance which is why I reduced my percentage there. The one I do like is India. I think India is going to be growing at a pretty good rate at 4% in high-tickets market. It has room to run. So of all the emerging markets, I’m most favorable to that one which is shown on Page 61.
Now turning to China, the big question on everyone’s mind. Let’s never forget that China is a miracle. It has shown more ability to grow with virtually nothing when Mao died in 1976. When Deng Xiaoping introduced his reforms in 1978, it was about 1 or 2% of World GDP but it is about 12% of GDP now. No country has made that kind of economic improvement for over a period of less than 40 years. How has he done it? He has done it by increasing credit 15-20% a year. It can’t do that forever. Eventually, the economy has to take over by itself but it has to become more of a self-sustaining economy. Now it spent a lot of that money in improving the infrastructure and on housing — housing in first tier cities has come down a lot as shown on Page 63. I don’t think China is going to have a hard landing.
If you look at Page 64, its Debt to GDP ratio is about in the middle of the pack. In addition to that, property prices in the major cities are about where they are in other parts of the world. So we haven’t had a real bubble in China and you can argue that incomes are lower there but my belief is that housing is not going to drag China down into a hard landing. I think they are going to grow at 5 or 6% but if the second largest economy in the world grows at only 5 or 6 %, maybe it is the home to a lot of large numbers, that isn’t bad. It isn’t a mature economy yet. It’s per capita income is 1/5 of ours but it is an economy that has grown to the size where 10% growth is probably out of the question and even 7% growth is difficult.
If you look at Page 65, you could see that in 1999, it really reversed the economy from a consumer economy with the consumer at 45% in investment spending on state or enterprises in infrastructure 35%. By 2010, the consumer was 35 and state-owned enterprise and infrastructure spending was 45. Now they want to reverse that. There is evidence that they are doing that through the service economy. They have many more service workers. But service workers make less money than manufacturing workers so it does not have the same impact on income. Nevertheless, it does put people to work and takes them out of the country and that is a favorable trend. So China is on a favorable path to rebalance itself but it isn’t moving fast enough in my opinion. And that is one of the reasons why I think it will slow to all of the stated rate of 7%.
Turning to the final topic, Japan, Japan was in a pretty good growth phase but then set back in the recession in the third quarter and now I think Shinzo Abe will engage in more fiscal and monetary spending in order to bring Japan back on to a growth path. The reason I like Japan and have a 5% position there is that there are a number of companies that are attractively priced. The price earnings ratio for the whole market is attractive but their number of individual issues are very favorably priced.
In terms of the Yen, I think it can appreciate a little bit further but probably not a whole lot further and I think much of the Japanese government debt recalled 50:15 internally if it can continue to expand now. So I think the Japanese market can make some progress but what with the depreciation in the currency, I think it will probably be flat for the year.
Okay those are all the comments I wanted to make to you formally today and now, I’d like to turn it back to Joan Solotar for the question and answer period.
Question & Answer Session:
Joan Solotar
Great Byron. We have quite a few questions coming in and as you can imagine, there is really not a meeting you can have with an investor where energy doesn’t come up so we have a few on that. I will start with the energy topic. First, can you reconcile lower energy prices with the view of a China slowdown. Aren’t they one of the great beneficiaries of the drop in oil?
Byron Wien
China and India are great beneficiaries. As I showed you in that chart, China is using less than 3 barrels of oil per person per year, India less than 1. Oil is not the dominant factor in the Chinese economy. Food and housing are the dominant factor and food and housing are not coming down in price the way energy is. So, I view it as a positive but I don’t view it as something that is a profound boost for the economy, and just because China and India are such low consumers per capita, but I don’t think it is going to have a more dramatic impact on overall economic growth.
Joan Solotar
So taking the reverse, in the US, we are obviously big consumers of energy and a drop has a positive impact on consumers, then how much of a benefit to our economy do you think that is?
Byron Wien
I think it is a big benefit because everybody has a car in America, most families have two. The average family drives 15,000 miles a year, uses a thousand gallons of gasoline, peak to trough gasoline is a down about a dollar a gallon so the average family with a median income of roughly $50,000, the average family has got another $1,000 tax-free in its pockets and it is very likely. So those families are very likely to spend it. So I think it is going to an important plus and it will be an important plus for industry too. Energy is an important component of manufacturing, and of agriculture, and of everything else and with it down in price, that should help profitability of corporations across the board.
Joan Solotar
And you mentioned the marginal demand clearly going to rise from emerging markets, how are you factoring that into your medium to long-term outlook for oil?
Byron Wien
I think the price of oil is going up. Five years from now, I am convinced that it will be well above the current level. It may not be 100 but above it will be above 70 and I think that could happen much sooner than that. So my view is that within three years, it will be 70 because of emerging market demand and I suggested in the 8th Surprise that it could occur this year. That would be a big surprise however.
Joan Solotar
Yeah. With all the liquidity that is being pumped into global economies, are you concerned at all about inflation?
Byron Wien
Well usually the questions I had been getting emails on is on deflation. I am not concerned about inflation. With oil down here, with agricultural commodities down with almost every parameter down and as I have said in the past, inflation is really a function of wages and house prices. House prices are going up 5%, wages are going up 2.5% and the commodities are going down. So, my view is, inflation may be a problem several years in the future but not a problem now.
Turning it around, in terms of deflation in Europe where they did report some deflation – the price declines. I think Europe will show very little inflation but I don’t think Europe is going to be in deflationary environment. Particularly because I think because the price of oil is near a point where it will be bottoming. I don’t think oil is going back to $10/barrel. I think it is going to bottom in the $40s.
Joan Solotar
And how are you thinking about flows into US market? So if you have Europe going into more of a recession, that bond rates are incredibly low, stock markets there does not look to be a bargain relative to US, is that part of the thesis of a higher US market?
Byron Wien
Yes, the US is doing better than Europe, there is no question about it. It is really better than Japan. And the US market is the most transparent, the most highly-regulated market so many investors see it as the safest market. It is also of course the biggest market. So I still think you are going to see capital flows into the US.
But there is a final factor that I think is even more important and that is innovation. The US is still the cradle of innovation for the world, and fortunes in the stock market are made out of innovation — In technology, in biotech, in social network technology — most of those innovations are coming from the United States. So if you think that an economic growth plus innovation are the heartbeat in making money in the equity market, the US really is in a terrific position so I think we are going to see more overseas flows into the US as a result of those factors.
Joan Solotar
And do you think we can get to a point where we have Euro-Dollar parity?
Byron Wien
I know that are people talking about it. I’m fond of sticking my neck out but I’m not fond of having it cut off. So my view is that one to one against the Euro is too much to ask for but I can tell you that the day that happens, you are going to be able to get a plane ticket to London. In my view, the dollar will show some additional strength here but I don’t think it will go to parity anytime soon.
Joan Solotar
And Byron, where are you getting the most pushback?
Byron Wien
I’m getting a lot of pushback on the Russian Surprise. The people say that Putin doesn’t mind Russia suffering and that he is not going to yield on Ukraine. That he may run out of foreign exchange reserves but he will figure out some way around that. And that he won’t take the action that is really necessary in order to remove the sanctions and part of that is related to my feelings of the Russian people will turn against him and most people don’t believe that is likely, because the media will control that, or the military will control that. And I think that may be a too Draconian view of it. My view is that Russia is in serious trouble and some of it happened because of natural causes, some of it happened because of Putin and I think there is a turnaround coming there. Again it is a Surprise but it is the one that I have reasonable amount of conviction about, just as I do about the Iranian one.
The Surprises are based on not extrapolating what appears in the press daily. If you extrapolated that, you would assume that there never would be a Ukrainian deal and that Russia would always be hostile. But it is often good to think in this continuous terms and that is what I am trying to do in The Ten Surprises. What I am saying is, Putin is riding high after the Sochi Olympics. All of these things emanated after that. He was trying to press his bet and become acknowledged as the world leader of eminence when Obama, the punitive world leader was sagging. Yet it backfired on him. I think he realizes that there is time to get up from the table and walk away and that time has come.
The same is true of Iran. The Iranian people are yearning to participate in the good fortune of the 21st century. The sanctions are hurting Iran. The nuclear weapon isn’t going to help Iran that much. They should be more worried about ISIS and the Sunni incursion in Syria and Iraq. So, I think there could be an important change in Iran and Russia and if those things took place, that would be very positive for the economies and equity markets around the world, including Europe and Japan. So if all Surprises take place, other good things would happen. So that is what I am hoping for in the Surprises for 2015.
Joan Solotar
And just one final — I mean there is always something to be bearish or nervous about and so today with the Ukraine needing substantial amount of money, folks worried about Greece and the US talk about the wall of student debt continuing to climb, are there any of these areas that you particularly concerned with?
Byron Wien
Well, longer term I am concerned about the obligations of Social Security and Medicare but not near-term. But I am more concerned — the big worry I have in the Ten Surprises is the cyber attacks. I think that they are going to occur more frequently and more profoundly and if I am right on that second Surprise, and a major money center bank is closed and you have money in that bank, and you can’t put money in or take money out, and you are worried that when they open again, they won’t have your right balance, that is going to make you very apprehensive and going to make you want to hoard cash. We may go back to mattresses as a place of sort. So, I am probably more worried about cyber terrorism thank I am about student loans.
Joan Solotar
Right. Thank you Byron. A lot to think about. Very very interesting. Do you have any final comments?
Byron Wien
No, I think we are going to make some money this year and I think some good things are going to happen geo-politically. I hope I am right. But if I am not, believe me, I will be here a year from now to explain why things went wrong.
Joan Solotar
Well it is a great way to start the year. So thanks everyone for joining and we’ll see you next quarter. Thanks Byron.
Byron Wien
Big thanks to all of you for listening in.
