The Days Ahead:

  • Fed and Bank of Japan meetings.

This Week:

  • The growth of the U.S. market compared to international markets.
  • The average age of top U.S. companies is way younger than other countries.
  • “Gales of creative destruction” at work.
  • The fluidity of the top companies in the US is un matched in other countries.
  • Plenty of headlines about Russia’s strong economy.
  • But they’re mistaken…GDP is a very bad measure for a war economy.
  • Sanctions are very leaky and they increase costs and logistics.
  • Russia faces labor shortages, population decline and low productivity and Investment.

The Old and the New

We wrote last week about the dynamism of the U.S. economy, noting that of the top 10 U.S. companies in 1964, only two remain in the top 50 today, with Exxon at number 16 and GE at number 44. Some have merged. Gulf Oil and Texaco were bought by Chevron in 1985 and 2001. Only one, Sears, has gone seriously south. It pioneered mail-order shopping and used to have 3,500 stores. It now has 12. It finally threw the keys to the Pension Benefit Guaranty Corporation in 2019, ending its existence.

A colleague pointed out that the fluidity of the top 10 names in the S&P 500 was one of the keys to U.S. capitalism and that the theory of “gales of creative destruction”, which says that new technologies and companies continually leapfrog and outgrow incumbents, was a major strength of the economy and capital markets.

Which led us to think about two things. How have some of the non-U.S. markets performed? And how does the age and history of U.S. companies compare to other countries?

On the first point we looked at major markets over the last 10 years. We’ve used local prices, to exclude exchange rate effects.

Figure 1 - graph showing top markets for the last 10 years
Source: FactSet 03/11/2024

Over 10 years, the U.S. has won hands down with a $10,000 investment turning into $33,000 for a straightforward investment in the S&P 500. Japan and Europe almost tie for second at $21,702 and $20,800. Emerging Markets, which led the way for the five years up to 2007, is a distant fifth at $14,200.

For dollar investors the total return for Japan falls from $21,702 to $18,000 and for Europe from $20,800 to $12,000. The poor returns are because of a combination of robust U.S. growth, a strong dollar and slow recoveries for Europe, the UK and Japan from 2008’s financial crisis and Covid-19. The collapse of Chinese stocks from 2007 did it for emerging markets. China peaked at 35% of the index. It’s now around 25%.

Along the way, Europe and Japan made plenty of policy mistakes and the UK traded privileged access to the world’s largest trading block for…well, to be determined. UK GDP grew 0.6% a year for the last eight years, after growing 1.8% for the previous 18 years and saw export growth fall from 4% a year to 0.7%. Sterling fell 35% over the same time. Only 32% of British people now believe that Brexit was a good idea, down from 52% in 2016. Whoops.

But we also wanted to look at the history of some of the world’s largest markets. A simple, but not fool-proof, proxy for the dynamism of a company is to look at how long it’s been around. So, we reviewed the founding dates of the top 10 companies in the U.S., Japan, France, Germany, Switzerland and the UK.  

Here’s what it looks like:

Figure 2 - Graph showing top 10 companies by year founded
Source: Company reports, Cerity Partners

The U.S. companies are shown in yellow with eight out of 10 formed after 1980 and four since 2000. Only Eli Lilly was formed in the 19th century. Berkshire Hathway was founded earlier but in its present, and much changed form since its textile company origin, dates back to 1965.

The average age of the top 10 companies in the U.S. is 40 years. If we exclude Eli Lilly and use Tesla, at number 11, it’s 27 years. The Methuselah prize, however, goes to the UK where the average age of the top 10 companies is 142 years. France comes in at 136, Switzerland at 132, Germany at 123 and Japan at a sprightly 85 years.

Figure 3 - Chart showing average age in years of top 10 companies
Source: Company reports, Cerity Partners

Now, we’d be the first to admit that many companies have not stayed static. Guinness, for example, merged along the way with many drinks companies to become Diageo. Astra Zeneca is an amalgamation of the British ICI company (born 1926) with Sweden’s Astra (born 1913). And, sure, growth through merger is a fine strategy.

But there’s only one non-U.S. company in the list formed after 1980 and that’s Softbank, which is more a venture firm than a company with proprietary technology and markets. If we go back to 1970, we can add SAP (a sort of German Salesforce) and Keyence, a genuinely innovative Japanese machine vision manufacturer.

The topic of why and how the U.S. is able to invent markets, form new businesses and push aside incumbents, is a long one. We’d put it down to:

  1. No fear of failure. In the U.S. entrepreneurs can fail multiple times. It’s almost a badge of honor. Fail in a place like Switzerland and it’s a long climb back.
  2. Depth of capital markets. There are plenty of risk seeking pools of venture funds and private investment. In most other places banks are the primary source of capital. Banks are notoriously risk averse.
  3. Large domestic market. U.S. companies can reach massive scale without stepping out of their own borders.
  4. Free labor markets. U.S. workers move around 11 times in their life and stay in a job for four years. In Europe, people move four times and stay 11 years. In Japan it’s 12 years.
  5. Listing requirements. When the UK chipmaker ARM sought a public listing in 2023, it headed straight to the New York Stock Exchange. It was immediately valued at $51 billion and has since climbed to $129 billion, which would have made it the third largest company in the UK. ARM could command a higher valuation, gain more analyst followings, and more institutional interest than if it had stayed in the UK.

We’ve liked the changes going on in Japan for a while and think the market has more to run. European stocks are also attractive with some very impressive companies that still look undervalued. But for sheer youth, bravado and a willingness to turn industries and markets upside down in search of the new, the U.S. is the place to be.

Why is Russia’s Economy Doing So Well?

It’s not. We’d contradict The Economist which led with “Russia’s economy once gain defies the Doomsayers” and then proceeded to lay out its case.

On the surface it’s going fine. Here’s are the GDP and inflation numbers:

Figure 4 - graph showing Russia GDP
Source: FactSet, 03/12/2024

It shows GDP (in blue), which fell 6% in 2022 but has since picked up, and inflation (green), which spiked to over 16% and fell quickly in 2023 to reach 7.7% in January (chart goes to December). Russia also seems to have replaced the export markets it lost after the EU and U.S. slapped on sanctions in 2022. The biggest replacement beneficiary is China. Russian exports to China grew 150% (below, in the blue line) to a monthly total of $10.7 billion while exports to the EU fell 65% to €2 billion a month.

Figure 5 - graph showing Russia exports to EU and China
Source: FactSet, 03/12/2024

So far so good. Just replace the export markets and growth and inflation head back in the right direction. Carry on as normal. The Russian Ministry of Economic Development has a very nice outlook for the next few years.

But there are a couple of problems.

One, the trade patterns are inefficient. Armenia and Kyrgyzstan both emerged as big sanction beneficiaries, increasing exports to Russia by seven times and 10 times since 2022.  

Figure 6 - graph showing exports from Armenia to Russia per month
Source: FactSet, 03/12/2024

That’s quite an achievement and, given that Armenia’s GDP is around $14 billion, we’d say “good job exporting 25% of output to your neighbor.” But Armenia and Kyrgyzstan produce little that Russia needs. Both became entrepôts for Western goods headed to Russia.

These trade distortions are everywhere. So, while we’ve seen an 80% decline in German exports to Russia and a 95% decline in imports, German exports to the UAE rose 60% and UAE’s exports to Russia rose 37%. The UAE is an oil and gas economy and Russia has plenty of both, so any export increase is solely from Western goods.

We expect that under-invoicing, a traditional way to lower official flows, is rife. Meanwhile China’s exports to Kyrgyzstan, Kazakhstan, Belarus and Uzbekistan all rose between four to six times. They didn’t offload there. They headed on to Russia.

It’s not just sympathetic neighbors that are distorting trade. Poland, Spain, the Czech Republic, Italy, Austria and Spain all increased exports to Kyrgyzstan by a factor of four to six times. For the EU as a whole, exports to Kyrgyzstan, Kazakhstan, Georgia, Azerbaijan, Uzbekistan, Armenia and Belarus have risen from about $200 million per month each to $1,300 million per month each. The EU sanctions play book is miles behind that of the U.S. and poorly enforced. However, it creates extra costs and logistic problems for Russia.

Second, Russia is running a war economy and wars are not sustainable ways to grow. Here’s where GDP becomes misleading. The broken window fallacy is at work. It states that if a shopkeeper’s window breaks, the glazier comes round and repairs it for $100. Because GDP only measures gross product, the repair cost factors into GDP and GDP is $100 greater. But commons sense tells us that this is nonsense, otherwise you could build a thriving economy breaking windows. The correct answer is that, yes, GDP goes up, but the repair costs could have been spent on something more productive and thus another part of the economy loses. An asset, the window, was destroyed and must be replaced. Or, as the original author says:

“Society loses the value of things which are uselessly destroyed. Destruction is not profit.”

Russia has a lot of broken windows.

Estimates of personnel killed in the Ukraine war range from 66,000 to 120,000 with another 315,000 wounded. Obviously healthcare costs rise and workers become increasingly difficult to find, which pushes up inflation. Emigration hasn’t helped. It’s estimated that 10%, or 100,000, of all tech workers and another 400,000 educated employees left the country.

Ukraine has sunk 20 major naval vessels. In the U.S. the price of a frigate is about $800 million. Even assuming Russia’s lower production costs, that’s probably a loss of around $10 billion. It’s also lost 8,800 vehicles. There’s another $211 billion of estimated losses in capital goods, and ongoing costs of supporting military operations.

Russia’s GDP growth thus looks decent, at around 3% growth. But up to a third of the budget, up 300% from 2021, is directed to the war effort, either producing hardware or spending on war related social payments. The country has no access to high tech imports, so innovation takes a back seat. The Russian economy is going backward in the sense that it must spend more on basic supplies, munitions and materials and less on productivity and capital. There are many signs that infrastructure is fraying, with a massive breakdown in heating equipment last winter and some 30% of civilian aircraft out of service. A new Barents Sea to Bering Sea pipeline is vastly more expensive than the ruined Nord Stream lines.

How much of Russia’s economy is spent on the war? Moscow isn’t keen to publish the number but it seems to be around $120 billion out of a budget of $400 billion or 22% of GDP. The net number is higher because of the destruction of hardware, weakened infrastructure and productivity losses. We know that the “war industries” sector has grown 40% and construction by 12% since 2021 but every other category, including mining, transport, trade and manufacturing are down between 8% to 35%.

A full-blown war economy can produce impressive numbers. It needs a compliant treasury and central bank (checks notes, yes, Russia has those) and a tolerance for inefficient spending. But underneath that, retail sales are slipping, exports are half what they were two years ago, it no longer exports gasoline, the current account is down 80%, oil and gas revenues down 25%, inflation is high, and policy rates are at 16%. The budget deficit has doubled in the last two years, but is funded from the $180 billion national wealth fund, so has not yet hit taxes. Debt servicing is around 9% of the budget and rising fast.

As the Bank of Finland politely points out:

“[Russia’s] 2024–2026 budget plan currently seems rather optimistic as the ongoing war in Ukraine and other geopolitical instability pose large risks to government finances.”

The pace of growth is not sustainable. Russia’s economy is not doing well. It’s driving up prices and producing fewer productive goods, while all the time repairing windows. A recession or reckoning can’t be far away.

The Bottom Line

Both major inflation reports, the Consumer Price Index (CPI), which tracks what consumers buy, and the Producer Prices Index (PPI), which tracks prices up to the point of final sale, came in hotter than expected.

The core CPI was up 0.4% against an expected 0.3%. But it was up 0.358% and rounded up, so was not that far off. The main culprits were rent, which was up 0.5% and used cars, which was up after falling for months. The two combined are around 12% of the core inflation basket.

The headline PPI was up 0.6% against an expected 0.3%. The numbers are volatile month to month and we’d expect the slowdown to continue. Still, both price measures show that the Fed’s job of slowing inflation to 2% is no easy ride.

Retail sales rose slower than expected which was a surprise after January’s decline of 1.1%. Retail sales are not adjusted for inflation so in real terms are growing at about half the rate of inflation.

You’d think with higher inflation and lower retail sales, the bond market would call it a wash and not move much. But the 10-year Treasury yield rose from 4.05% to 4.30%. The big question is not whether rate cuts are on the table in next week’s Fed meeting (they’re not) but what the Fed predicts for the rest of this year. Will it be 0.5% of cuts or 0.75%? Or something else? The market seems to suggest the lower number.

Stocks reached an all-time high last Friday but have drifted lower by around 0.2% this week. There’s no bad news but a break and consolidation seemed overdue.

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Art of the Week: Kylie Manning (b. 1983)

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