Oct 2005

WHAT MADE MILWAUKEE FAMOUS (Made a Loser Out of Me)

(C&W song by Jerry Lee Lewis. Milwaukee is the brewing capital of the US.)

The recent Q3 US GDP release contained a statistic that surprised me, but helped make sense of one aspect of the way the world is today. The stat was the Employment Cost Index for the US economy, a broad measure of wage growth. The index was up 2.3% annualised. My immediate reaction was - "My goodness, that's low" - no better than the run rate of US inflation, maybe less and that means US workers are struggling to keep their living standards standing still. Indeed, real average hourly earnings in the US actually fell by 2.7% in September. And it really is a low number. That 2.3% annualised wage increase is the weakest since records began, back in 1981. This, 2005, is a year, after all, when General Motors has persuaded the United Auto Workers union to accept a cut in pay and benefits for 1.1 million workers, prompting UAW president, Ron Gettelfinger to complain about "importing Third World wages to the United States." And Walmart has warned its 1.3 million employees not to expect pay increases, because, as its CEO H. Lee Scott says, to do so would "eliminate our thin profit margin". Paul Samuelson, Nobel prize-winning economist, notes of the US - "We have a cowed labor force. Those GM workers who took health care cuts and wage cuts, they didn't do it because they were altruistic. They did it because they were scared."

(In passing, Steve Miller, CEO of Delphi, the effectively bankrupt parts supplier to GM, made a heartfelt plea to the American nation during recent interviews, describing the impact of global competition on his business, with unskilled jobs leeching out of the US. "Educate your kids", he begged. Pearson's business appears to be benefiting from a cowed labor force gazing into the abyss, with a strong performance in the US market pushing its 2005 School revenues up 17.0%. Education will be a great place to invest in for the foreseeable future, we think.)

In 1914, Henry Ford famously doubled the pay of his assembly line workers to $5.0 a day, because he hoped they could then afford to buy his cars. Perhaps Chinese agricultural workers can double their wages today, by moving to the city, but the US wage machine has stalled. And this really matters, for a variety of reasons. First, I've been trying to understand not only why the US stockmarket has been so dull this year, but why two great bull markets within it have also come to an end in 2005, namely those of Anheuser Busch, brewer of Budweiser and Walmart itself. In 1985, twenty years ago, Anheuser Busch's stock price was $4.45. It peaked at $54.0 last year. In 2005, Bud's price has fallen 20.0%. Walmart's bull charge extended from $1.65 in 1985 to a spike of $69.0 in 1999. It subsequently traded between $50.0-60.0 for the next five years, but has dipped 14.0% in 2005. The common denominator is the pain that Joe Sixpack, the archetypal US consumer, is feeling. Wages are flat, interest rates are up and he doesn't want to think about this winter's heating bills. US consumer expenditure dropped for the second month in September, the first back-to-back decline in 15 years.

Here is why Anheuser has taken the unheard of decision not to increase the price of Budweiser this October, for the first time in decades. Moreover, the scale of Anheuser's promotional spend, as it attempts, but fails, to hold onto its 50.0% share of the domestic market, has knocked earnings for 2005 down a likely 12.0%, the first fall in over a decade. We UK investors must keep an eye on SAB/Miller. Miller is one of the beers that actually made Milwaukee famous and its aggressive pricing, attacking Bud, has forced the competitive response from Anheuser. SAB still earns 20.0% of EBIT from North America (and rather more of group sales), although the profit contribution is likely to be 10.0% lower for this year than analysts expected. Unhappily, SAB's strategic thrust into Latin America is also likely to antagonise Anheuser, LATAM being both on its doorstep and a big ambition. There's an unwelcome similarity with the malaise that has kept both the two largest Japanese brewers, Kirin and Asahi, at fractions of their 1980 share price peaks, as each have been forced to cut prices to maintain volumes in a declining beer market.

Meanwhile, Scott at Walmart recognises that his customers are suffering - "struggling to get by" - as he puts it. His response is a holiday promotion campaign - "the earliest and most aggressive campaign in our history". Across the pond, Walmart's subsidiary, ASDA, has picked up the same theme and announced last week that it is the first grocer to begin its Christmas promotional effort, cutting to the quick of UK consumer aspirations by slashing the price of a litre bottle of Smirnoff by £3.00. And this brings me to ask - to what extent is the UK implicated in this slowdown? The answer is far more than the ebullient level of the stockmarket would have you believe. One way to think about the S&P500's disappointing showing in 2005, down 0.5%, is to reflect that Energy only makes up 10.0% of that index. Nonetheless, of the forecast 12.0% earnings growth for the US market in 2005, no less than 72.0% of the uplift is accounted for by the Energy sector. In other words, 90.0% of the market has to share only 28.0% of the earnings progression, as the windfall gains for oil and gas companies crimp the margins of the rest. The UK is more strategically advantaged than the US in this regard, of course, with 25.0% in Energy and Metals, and those two sectors up 24.0% and 38.0% respectively. As those of us underweight these sectors can confirm - it has been hard work eking out returns elsewhere.

It has been particularly hard work making money out of companies close to the UK consumer. Everyone is conscious of the share price distress at Kingfisher, down 31.0% in 2005, or Morrison, -20.0%, or Next, -18.0%. Even such defensive paragons as Tesco and Boots have struggled too, both down c7.0% in calendar 2005. And the issue is one of slippage of both demand and pricing power. The Food Retail sector has lost 6.5% in value this year, while the General retailers are down 9.0%. By contrast, owning Tobacco, +25.0%, Pharmaceuticals, +23.5% and Beverages, +19.0% has been sensible, all sectors that tend to do well when investors are nervous about demand growth. Even long gilts have done better than consumer stocks, generating modest capital gains.

UK Retail sales have just declined for the eighth consecutive month and everyone in the industry is waiting for "normality" to return. But why should it? The fact is that an unprecedented 53 quarters of straight economic growth is coming to an end and does so at a time when UK consumers must come to terms with serving £1.13 trillion of household debt. Q3 personal insolvencies in the UK reached 17,500, which is the highest since records began in 1960. Our guess is that these conditions will not ameliorate for a long time and could get worse before they get better, possibly dragging the Banking sector down with them. The Banks have already drifted nearly 2.0% in 2005 and one waits for the unpleasant surprises - from HSBC's Household International subsidiary, for instance, whose special role in life is lending only to the most particularly financially challenged Joe Sixpacks.

I mustn't get too dyspeptic, we're not bears of the Anglo-Saxon equity markets, but we do think it's important to see the world as it is, rather than as stock market participants would like to believe that it is. For instance, there is the current inflation scare, reflected in the sell-off in government bonds of the last few months. The sell-off is real, but is the inflation? Core US inflation is actually lower than 12 months ago, despite the supposedly inflationary oil price. Ask Anheuser Busch about inflation, ask Mr Kipling about his ability to hold prices in the UK (RHM cites the need to increase "promotional spend" to counter disappointing demand for fancy cakes).

The truth is this inflation scare, like the one before and the one before that, has been triggered at lower levels of reported inflation than before. What investors will eventually come to understand is that these inflation scares are not so much signifiers of actual future inflation, but are themselves the mechanism whereby the capital markets prevent incipient inflation pressures from accelerating. In the 19th and early 20th centuries inflation was kept low by the self-regulating mechanism of the Gold Standard. Once the Gold standard was abandoned it took investors several decades before they realised that politicians would cheat them of their purchasing power whenever they could. Since 1981, though, when US inflation and long treasury yields peaked, the capital markets have acted as self-regulating inflation watchdogs, forcing up interest rates if they sniff policy errors or monetary laxity. These higher market rates have, to date, kept inflation blips confined to lower and lower peaks. We expect no different this time and this is why long bonds are a buy today and why the next trough in yields will be significantly below 4.0%, likely in an environment of deepening consumer gloom. At least the price of beer may be going down.

Nick Train
Nov 2005