No time for complacency
The rush for the exit doors in commodity exposed stocks intensified during April. As the disparity between resource stocks and financials widens it would be disingenuous to claim that stock selection is the dominant driver of investment outcomes. Advisers and observers will provide ample justification for ever declining valuations on resource stocks and perpetually rising ones on the financials and industrials enjoying favour, however, the seismic changes in the global economy and growth outlook which are most often used as justification are usually excuses for the behavioural traits which make it more comfortable to run with the herd. What is obvious in the current landscape is the effectiveness with which policymakers have incited the rush for yield. We’re all aboard the quantitative easing freight train, with the engine room now packed tight with drivers from around the globe. Despite an absence of driving experience and uncertainty as to whether the track will end up plummeting into a deep ravine, the passengers are currently rapturous over the high speed at which the train is careering through the countryside and applaud each new dab at the throttle. We have remained sceptics on the likelihood of quantitative easing (QE) providing any durable benefit, however, given the undoubted impetus it has provided to equity markets, our thinking probably deserves some explanation.
First, a brief recap on our perspective of the source of the problems. The infatuation with “growth”, despite a general lack of attention as to why it is universally a good thing and how it should be defined, has driven an extensive period in which credit is proffered to borrowers (either governments, corporates or households) as the fuel for growth. Once borrowed, money can obviously be used for a range of purposes, but it will have a tendency to inflate prices of assets, goods and services. When the majority ends up in higher asset prices (dominantly housing), credit growth is likely to be a major driver of income disparity. Every time the same house is bought for a higher price the borrower is shouldering a liability and enriching the seller. When it ends up in the price and velocity of goods and services, it will end up in the CPI. In our minds, the inflation which has been enduring in recent decades is dominantly the former. As a result, income disparity across the world is at a level where incremental borrowers are hard to find as most credit worthy borrowers are already geared to the eyeballs and the beneficiaries of years of asset price growth have no need for borrowing. Even at rates approaching zero, meaningful incremental borrowing cannot be induced. Desperate for fuel, central banks then purchase government or other fixed income securities to reduce the cost of bank borrowing and induce them to lend (banks have the somewhat luxurious position as the intermediaries between central bank policy and the end borrower for which they are permitted to take a handsome cut in between). To date, this process has assisted in supporting banks that would otherwise have been insolvent, but done little to stimulate lending. As an aside, finding a member of the banking fraternity to openly oppose QE is likely to present some challenges, as banks are wildly disproportionate beneficiaries. So what are the potential paths from here?
It is feasible that policies have just taken some time to operate and that bank lending accelerates from here. This could eventuate in either the household sector or the corporate sector. Re-acceleration in the household sector is almost certainly likely to result in a continuation along the path forged in decades past. Higher house prices, increasing wealth inequality and increasing imbalances. Re-acceleration in the corporate sector will either result in more highly geared enterprises and/or additional investment in organic or acquisition driven growth. Domestically, the bath being taken by any companies that have embarked on large capital investment programs (BHP, Rio Tinto, Origin, Santos etc.), suggests that a retracement is more likely. Internationally, while there is some scope for investment in countries like the US, most of the world (Europe and China in particular) is suffering from significant overcapacity across a broad range of industries, with rapid capex acceleration looking far-fetched.
The more likely path in our minds is that QE is simply a form of financing government borrowing with printed money. As central banks are becoming the dominant buyer of government bonds, there is no practical constraint on any government’s ability to introduce more money into the economy through debt issuance. In theory, even if every natural buyer deserted the market, as long as central banks are happy to remain complicit, the government sector can become the ‘engine of growth’, through continued deficit spending. Whether this is an impending disaster seems to depend on a few things. Firstly, if government spending can be productively directed and aids in reducing income disparity, it may not be a bad thing at all. If it is unproductive, as is more in line with historical precedent, things will end badly. Lastly, if the owners of other assets, including bank deposits, see their claims being devalued, much depends on how they react. As we’ve raised previously, no-one should be under the illusion that this process is meaningfully different from raising taxes, it’s merely more surreptitious. In summary, the process of using credit to inflate assets and drive income disparity has been decades in the making and has created much nominal growth and little real wealth. Unwinding it and reducing income disparity will be fraught with danger regardless of whether the path is one of austerity or government stimulus.
With this landscape in mind, it is not easy to answer the question as to how best to protect wealth on a medium term time frame. Our scepticism on financials (and banks in particular), despite the obvious allure of reasonably attractive fully franked yields, rests on some straightforward observations. Our aforementioned comments suggest to us that the forward looking risks in banking must necessarily be higher than in past decades. The process of aggressive credit growth and continual asset price inflation has accustomed investors to a backdrop of strong volume growth and minimal bad debt experience. It is feasible that the future is one of low credit growth and still benign bad debt experience, however, according a 100% probability to this outcome seems to us unwise. If we accept that the road ahead may be bumpy, and that holding asset prices high in an environment of turmoil may not be easy, banks remain a highly leveraged bet on asset prices. As Australian competitiveness erodes, capex from real businesses collapses and the commodities boom ends, we struggle to reconcile this with ameliorating risks for banks. With ANZ , NAB, Westpac and CBA all rising during the month, it’s fair to say investors didn’t agree with us during April.
Another signpost of interest during the month was the ability of Woodside Petroleum to rise 10% in a day by paying a special dividend and raising its payout ratio. Whether the move is more reflective of dividend mania or the potential for a moratorium on project and exploration disasters is unclear, but it’s mighty instructive on current investor behaviour in any case. In a similar vein, the sharp gold price falls during April may be a harbinger of a bumpier road ahead. Regardless of the reasons for the gold price fall (investors no longer believing inflation is an issue, outflows from commodity funds, supply from selling by Cyprus/central banks etc.), the move, and the commensurately larger move in most gold stocks, serves to highlight a precariously balanced financial system. This is no time for complacency.
Being early, in investment terms, is tantamount to being wrong. Significantly increasing the fund’s exposure to high quality resource producers over the past year has not been a wealth enhancing decision and the pain has escalated in very recent months. Standing in front of the apparently endless wall of selling as pessimism on the commodity outlook escalates is uncomfortable and increasingly lonely. If our views on the path forward are even vaguely correct, the protection offered by financial assets buoyed by artificial stimulus is likely to prove illusory. Accepting progressively lower returns and pushing yields lower without addressing the underlying causes of instability in the economic and financial system is creating larger problems for the future. As these trends continue our preferred course of action will be to seek refuge in businesses that offer real products and services, deliver them at the lowest cost possible and maintain sensible financial leverage against the earnings. Whether these earnings emanate from cyclical or defensive businesses is of little concern. We are more than prepared to endure the ups and downs of a cyclical business if the price of the business is likely to deliver a far superior return over time. Protecting wealth will almost certainly be a challenging pastime for some time to come, and while comfort and security can be found in following the herd, we’re fairly sure better long term investment returns will not.
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