Jumping at shadows
Befuddled is probably a term which characterises the state of mind of many seasoned investors at present. The past year has been characterised by low and easing volatility, anaemic trading volumes, but on the whole, reasonable investment returns and an absence of crises. In a world which remains plagued by enduring and as yet unresolved financial problems in just about any jurisdiction that you’d care to name, this would probably have been a smoother than anticipated path. This tranquillity will undoubtedly be welcomed by policymakers as their grand plan almost always involves instilling consumers with sufficient confidence to ensure consistent and rising spending, further borrowing and the all-important low (but positive) reported inflation. None of our long term concerns have been assuaged and most have been somewhat accentuated. There is a very material risk that we are jumping at shadows in our growing concern. It is undoubtedly in our nature to focus disproportionately on protecting capital and there are many instances in which your returns would have benefited from greater risk appetite. Regardless of our awareness of these tendencies and our constant efforts to improve their application, we will not be making a U-turn in the near future. Hemingway’s typically sardonic observation in ‘The Sun Also Rises’ always comes to mind: “How did you bankrupt?” “Two ways. Gradually, then suddenly”. Most do not recognise the unsustainability of their path until it’s too late and when you start investing on the basis that you’ll be able to sell it to a greater fool, the risk you may one day be looking in a mirror starts to elevate.
One thing that we can say with the utmost confidence is that it is virtually impossible (in the absence of luck) to know in advance when financial, political and economic systems suffering decades of accumulated intervention and manipulation reach breaking point. Fortunately, it is generally easier to know whether risks are accumulating or abating. Rather than betting the house on the identification on an inflection point, we aim to respond rationally to the environment. If risk is increasing and valuations are rising, we should be reducing risk (selling expensive and financially leveraged cashflows), if it is falling and valuations are falling we should be increasing risk appetite. The same logic applies to equities overall, and sectors and companies within it. If our views of sustainable cashflow don’t change and the price for the debt and equity combined falls, we should become more optimistic about prospects for future returns, not less. Despite the complacency that stems from growing periods of apparent calm, we have little doubt that risk is increasing.
Ever lower interest rates have seen the financial system become ever larger relative to GDP over recent decades. The unwavering focus on growing GDP at all costs has diverted attention from the increasingly larger doses of debt necessary for increasingly smaller payoffs in terms of GDP growth. Bank loans, bank assets and broad money are all at levels never before seen relative to GDP. On the other side of the equation, however, is an ever increasing asset value to offset the debt. Whether this ever larger pool of investment capital is described as a ‘savings glut’ which is supressing returns on capital everywhere as it searches for income, or a ‘healthy household balance sheet’ doesn’t really matter. Both sides of the balance sheet are growing, yet the income in between isn’t moving much at all. As we have raised previously, we believe the coincident growth in these balances is destabilising. When incremental borrowing serves only to inflate assets rather than improve income, it exacerbates income disparity. Those approaching or in retirement do not borrow to invest productively when already asset rich. If they are borrowing, they are generally punting asset price rises in their SMSF. Young borrowers are being duped into entering an overpriced housing market with ludicrous leverage to keep the Ponzi scheme on track. The only way they can be kept solvent as incomes fail to keep pace with debt balances, is ever lower interest rates. Like Alan Greenspan, comments mentioning irrational exuberance eventually give way to spurious justifications for sustainability forwarded by those with a vested interest in papering over cracks.
The winners are intermediaries clipping the ticket on one or both sides of the balance sheet. If you’re lucky enough to be called a bank you’re entitled to a healthy cut on both sides. If you’re a super fund you just lobby for more regulation to force some unwilling customers to pay for a product they don’t really want. Financial intermediation, the simple exercise of connecting borrowers with lenders has never been more lucrative. Whilst not wanting to spoil anyone’s party, sooner or later someone needs to realise that unless we start driving the income line (through investing productively), musical chairs isn’t going to cut it as a long term strategy. If I see another chart extrapolating superannuation system growth out to 2050 where we magically quadruple the assets and solve everyone’s retirement needs, I’m going to be sick. The size of the asset pool (moving in lock step with the liability pool) is irrelevant if income isn’t moving with it.
The other key note of caution we’d observe is declining volatility. In our experience, ebbing volatility is almost always associated with increasing risk. Predominantly a measure of panic and euphoria, we logically expect opportunities to make money to abound when panic prevails and risk to abound when euphoria prevails. In a world besotted by the need for more complex and costly measures of risk, possibly the most mind boggling concept is that risk measures still rely on volatility for guidance. For those who prefer to go straight to the asylum to ensure calm, soothing, sane advice, feel free.
At the equity market level, objective evidence of debt and equity capital being used for nothing more than transferring existing assets at ever increasing prices (no more income, but a bigger balance sheet on both sides) is plentiful. Lend Lease sold its stake in the Bluewater shopping centre in the UK at a 4% yield, a Cheung Kong led consortium bid around 1.4 times the regulated asset base for Envestra (given the bulk of the asset base is regulated, one couldn’t really ask for a clearer message that investors are prepared to settle for lower returns). More frustratingly, the flow of private equity owned assets continues unabated. Most were purchased in buoyant times at buoyant prices with excessive leverage, but the passage of time and progressively lower interest rates has allowed many lumps of coal to be turned into diamonds. We are doing our best to maintain a clean energy policy as most still look like coal to us.
Similar trends were evident across existing listed assets as the repricing of apparently stable cashflows at ever lower yields continued. REITs such as GPT, Goodman Group and Charter Hall typified the trend. Transurban digested the acquisition of Queensland Motorways for $7.1bn and moved higher. Anything with perceived risk in cashflows (particularly mining related) was consigned to the dustbin. As always, when the price becomes too high the apparently stable can morph into the risky.
The increasing dominance of financial services within equity markets and the increasing correlation of debt and equity markets with each other is a logical outworking of the environment described earlier. With the skyrocketing credit intensity of GDP evident globally, and the central bank surgeons applying ample doses of the same antidote, insulating capital from the inevitably undesirable correlation of assets will be challenging. This will particularly be the case if corporations succumb yet again to pro-cyclical behaviour at the worst possible time. Unerring discipline in the face of temptation is not amongst the characterisations we’ve observed in corporate behaviour. Capitulation to the lure of cheap debt and earnings positive transactions is more the order of the day. The wait for global leaders prepared to stand tall and take tough decisions has also been forlorn. We have primarily gnomes. As such, it appears almost certain that intervention of all kinds will continue until market forces overwhelm efforts to prop up an ever more unbalanced system. In the meantime, packaging annuities, lending a bit more than last year against ‘bullet-proof’ housing values and charging fees for managing superannuation will remain preferable to farming, manufacturing or digging up ore.
Our interpretation of the landscape obviously demands a strong preference for companies responding to a tougher and riskier environment with more conservative capital settings and one that will demand increasing conservatism if risk elevates further. Although we feel that many traditional industrial and mining businesses should provide solid insulation at present, this insulation can be quickly compromised if debt is added less than judiciously in both timing and quantity. History, and the increasing enthusiasm for M&A at the least opportune time, does not support our quest. In secondary and tertiary assets such as toll roads, shopping centres, ports, private hospitals and just about all highly favoured interest rate sensitive assets we believe it unlikely that the assumed dissociation from other businesses in the value chain is probable. Unless traditional businesses make profits from which to pay their employees, revenues for these secondary and tertiary businesses must eventually suffer, albeit potentially lagged. A 4% initial rental yield on a shopping centre will be of little use if all tenants are eventually bankrupt. As cost competitiveness versus international peers erodes in Australia, this remains one of our key concerns. On the positive front, plans for aggressive recycling of capital by governments such as NSW are steps in the right direction, as this could finally see new productive assets funded rather than continuing escalation in the prices of old ones. We would thoroughly welcome the opportunity to invest capital in part of the solution rather than in escalating the problem.
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