“Was it worth it?”

By Robert Swift 

Forgive us for returning to an old favourite topic. Whether a decade of Zero Interest Rates (ZIRP); massive central bank intervention in capital markets; and generally kicking the can down the road, has caused more problems than it has solved, and how investors should prepare for (much welcome) change.

Initially it doesn’t look promising. Equity market volatility jumped alarmingly (aka the equity market fell sharply) as the incipient tightening of monetary policy caused a reappraisal of relative asset prices. It wasn’t only equities that fell in price in late January and early February. Most risk assets suffered.

Actually the equity markets are a little behind events. Tightening has been underway a little while with the USA in front and others following, with Japan probably at the back. If you look at the chart below you can see that central bank purchases of assets (to inject liquidity and keep rates lower) has been on a downtrend for a little while.

So the sell-off was slightly strange in that it was a delayed reaction to clearly available evidence that the great experiment was coming to an end. Who says equity markets are perfectly efficient?!

Sometimes the cure can cause side effects and this instance the “cure” certainly has. We accept that the first response to aggressively inject money made sense but for a decade?…We wrote recently about how unelected academics had tried a great experiment based on a false premise that goods and services price deflation was bad, and that a one size fits all monetary price (zero) was a terrible case of failing to understand the demographic and capital investment dimension to GDP. Adjusted for demography, the Japanese economy has performed well! Deflation there has helped facilitate increased consumer spending even with minimal wage growth. As we wrote late last year, ..“So enjoy academia and the lucrative lecture circuit as you retire and leave us to deal with the consequences”.

So what are the consequences of ZIRP which now appears to be unwinding with the proponents celebrating ‘mission accomplished’? Has the “cure” caused more problems than it solved? How should we position ourselves as investors during this transition?

Here are the consequences:

  1. There is now more debt than before the GFC – measured in total $ and relative to GDP, debt levels have risen. If debt was the cause of the GFC then more debt is unlikely to be a solution? I think this is a bit like Homer Simpson claiming that “beer is the cause of, but solution to, all life’s problems”?

Debtors must equal creditors so in that sense someone’s increased liability is also someone else’s asset but default risk is probably understated in markets currently, and asset carrying values, acting as loan collateral, are probably wildly off the mark in some markets. GE will not be the only company to have concealed the true and lower earnings power of its asset base. The true state of the pension fund obligations especially in the USA is alarming and higher interest rates cannot come soon enough for some towns, cities, and states. Check out www.pensiontsunami.com if you doubt us!

  1. There is not just more debt but more unequal debt distribution – This manifests itself in 3 ways, between generations, within countries and between countries.
  • Intergenerational inequality where asset rich older people have made out like bandits relative to younger people;
  • Within countries, where the wealth distribution is at dangerously unequal levels;
  • Between countries where some countries have continued to rack up debts to unprecedented levels, as measured by their Net Foreign Asset position. This includes Australia.

Those countries still in control of their own exchange rate can make the necessary adjustments (always with the proviso that future borrowing costs in the international markets will be higher) and those with social cohesion can rebalance their economies to a more sustainable type of growth through tax changes but many cannot do this.

The Euro straightjacket is currently forcing countries into debtors’ prison.  Chinese shadow banking or State-Owned Enterprise debt; UK consumer debt; and Australian mortgage debt all spring to mind as being dangerously elevated.

  1. Regulations have been increased aplenty.  Some are contradictory such as penalties for banks for not lending and yet imposing more risk capital requirements.  Some are dangerous, such as forced reductions in prop trading which provides liquidity to large asset markets such as credit, and Mifid II in Europe.  The only purpose of this seems to be to reduce the diversity of the capital markets’ participants and to make (lack of) liquidity a more dangerous risk to the system.

In an effort to make fees more transparent, governments in Europe have taken the nanny state view that clients and principals can’t be trusted to read the small print and to negotiate with each other in a ‘caveat emptor’ and ‘dictum meum pactum’ principles-based framework. Consequently, they legislate against small companies and reduce the diversity of the capital market eco system.

It is no surprise that the SEC is asking for liquidity risk reports from fund managers since they alarmed at manager asset concentration and its impact on market volatility in redemptions; meanwhile the Europeans try to insert more big government into the system and make liquidity less available. Brilliant.

The key risk from this last decade is whether inflation expectations have been ignited or not. Despite what politicians say, we really do not want inflation expectations back into the system. It may not take interest rates at 15%+ again to squeeze inflation out, but it will cause a nasty recession and we have less spare fiscal firepower than we did to counteract any recession created.

We accept that inflation is a slippery concept and some prices and wages show little signs of upward pressure. However, asset prices are specifically excluded from inflation indices and policy settings, and for those of you paying rail fares, tuition fees, and electricity bills will marvel at the low official inflation numbers being conjured out of thin air. Those of you whose consumer products now last shorter will also wonder how hedonic price adjustments seem to go only one way; the downward adjustment of goods now more expensive but deemed to be of higher quality than before.

If expectations have returned and the inflation cat is out of the bag, then we are in trouble and especially so those countries whose currencies are fundamentally at risk from capital flight. Net Foreign Asset analysis can reveal the dangerous ones and contact us if you wish more information.

We believe the steepening yield curve is positive for risk assets and a needed return to ‘normality’. We think it is just in time and therefore celebrate the end of the experiment, but we do need to see a sound replacement policy which has to be fiscal and designed to increase productivity – governments with money need to spend sensibly (roads, bridges, schools, railways, energy) and to encourage companies to also raise their spending to replace ageing assets and to create new. (We do not by the way believe in the “capital light’ miracle.

All companies must spend money to replenish their capital base or intellectual advantage. All so called ‘capital light’ companies need to spend on R&D which is an investment, and so fast is the technology and fashion changing, that their depreciation and amortisation rates are way too low and maybe the R&D is too? The accounting profession has yet to catch up with the new “capital light” economy and the schedules used allow for carrying value of obsolete products at too high a value.

So-called ‘capital light’ businesses will need to spend more and some will fail as fashions shift. We note for example the massive shift in advertising spend to online but there are many ad agencies which are slow to report impairment of their brand value. This failure to keep up will also become more apparent in software technology companies we believe).

Fiscal policy requires government cohesion which is not 100% certain in the USA or UK and Germany appears reluctant to allow debt forgiveness (effectively the same as fiscal spending) on a European wide basis. They need to let Club Med out of debtors’ prison and to allow centrally shared underwriting of Euro denominated bonds.

The two countries with firepower that are doing their bit? China and Japan.

For a sense of the current state of USA infrastructure, check out this report card from the American Society of Civil Engineers.

Companies with money also need to be encouraged to spend and in that regard the Tax Cuts and Jobs Act recently passed may help in the USA, as may the cajoling of Trump to USA companies to invest in America. All decisions are taken by humans and CEO approval to raise spending to levels which used to prevail is also a human decision

It is only coincident with the widespread adoption of executive share option schemes in the 1980s, that systemic private sector UNDER-investment has been obvious. Bill White an economist at the OECD has referred to this issue and specifically to the work done by Andrew Smithers in this regard.

So if we think that we have reversed course just in time, then in what companies and regions are we investing as the world makes this transition from monetary to fiscal priming?

  1. We are not going to cash. Returns on risk free assets are still very low and probably negative in real terms. The world is littered with fund managers who tried to time exposure to the markets and failed. If you zig when you should zag and zag when you should zig, it can be at a serious cost. Staying out of the USA because you couldn’t stomach Trump and wanted to wait for sanity cost you 40% in US$ terms and more in AUD$.
  2. We emphasise Value and earnings quality. We use a multi-dimensional model we call VMQ and we combine that with fundamental considerations of Accounting, Strategic, and Governance quality. We think companies which are poorly regarded have underperformed for too long and many show clear evidence of strategic improvement. Verizon, Macy’s, AES, DowDuPont, Cisco and Intel are all good examples of this.
  3. We think financials are still attractive and for many traditional banks a positive yield curve will lead to higher margins. For insurance companies, higher interest rates will improve annuity returns which have been promised to clients
  4. We like consumer and infrastructure themes in Japan and the rest of Asia. It is not just high-end clothing and tourism. It includes all kinds of financial services and will see increased demand. In this regard Aflac and Manulife are well placed as are Itochu and Mitsui Chemical.

One last important point to make early in 2018. We have seen very high levels of return from equities in the last 5 years. History tells us that future returns tend to be lower when historical returns have been above normal.

Expect 7-8% pa and you may be pleasantly surprised. Expect 12-15% pa and you are very likely to be both disappointed and to chase returns which are risky and prove to be illusory.

 

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