Have we become comfortably numb?
The growing chasm between the financial and real economy was highlighted further during results season. As has happened globally, the liquidity manufactured by central banks has flowed almost solely into asset prices, providing almost no impetus to the revenues and profits of anyone other than those closest to the liquidity. The profits of those fortunate enough to have revenue driven by or connected to asset prices remain healthy. The economy remains an action replay of the structure that gave rise to the financial crisis (an ever narrowing economy based on asset price speculation and ever lower interest rates), yet observers are hoping for broad economic recovery. Call us sceptical, but without change in structure or incentives, we have an uncomfortable feeling that the same policies will eventually give rise to the same problems. As banks remain incentivised to lend almost solely against housing and continue to be rewarded handsomely for this role, we suspect they will not suddenly prioritise business lending. Nor will an increasingly pressured manufacturing and real economy find a rationale to suddenly build significant new capacity and create new jobs. The important questions from an investment standpoint are twofold. Is the constantly increasing relative size of the financial economy a problem? Given the determination with which policymakers are defending the current economic structure, how sensible is it to stand against the tide?
Our answer to the first question is a resounding yes. As the duration of artificial stimulus continues to grow and what was intended to be temporary appears ever more permanent, the more insidious impact becomes the inability of companies and individuals to discern normal from artificial. To borrow from Pink Floyd ‘The Wall’, they have become ‘Comfortably Numb’. Our company meetings during the results season gave us plenty of evidence that most remain oblivious of the extent to which the current environment is artificial and of the difficulties in returning to normality. Insurers are still working on the expectation that interest rates return to levels of years gone by, airlines are expecting passenger numbers to continue growing at levels of the past 20 years, wealth managers are expecting the pool of superannuation funds to double over the next 10 years and retailers continue to add floor space as though mid-single digit retail sales growth is a fait accompli. Like Pink Floyd, they have become comfortably numb.
Part of the problem is the reliance on percentages rather than a focus on absolute levels. The CBA result showed a seemingly innocuous growth rate of 9% in its interest earning assets from December 2012. This happens to equate to a lazy $58bn. Despite the same growth rate in deposits, loans still grew $22bn more than deposits. We wouldn’t want to get too carried away with the newfound parsimony of the Australian population and the explosion in savings rates! This quantum of loan growth means that the absolute levels of loans are growing almost as quickly as at any time in Australian history. It goes without saying that most of these are housing loans which need to be supported by individuals’ income. Our long term caution stems from an inability to accept that the value of loans and the financial system in total, can continue to grow at rates well beyond that of GDP (the revenue of the country’s enterprises), as the interest on the loans must eventually be paid out of these revenues and profits. Interest rates can be progressively forced lower to improve the servicing capability of the population, but not indefinitely. The greater the proportion that gets stuck in asset prices rather than flowing through to GDP and profits, the more servicing capability deteriorates, absent a further reduction in interest rates.
On the question of how sensible it is to stand against the tide, we are resolute but circumspect. A financial system which continues to grow at rates beyond the income which supports it, becomes progressively more unstable. This description roughly encompasses the entire globe. At the time when this lack of income causes the artificially supported financial system to collapse, logic should dictate that the contraction in the financial economy should be far greater than that of the real economy (this is the only way equilibrium can be restored at an interest rate which resembles what used to be normal). This does not mean that the real economy will get off without contraction, but it does mean that the financial economy and the over-leveraged will wear disproportionate pain. The unknowable is when this happens and what further extraordinary steps will be taken in attempting to preserve the status quo.
Investor response to reported earnings was somewhat unpredictable. Reaction to reasonable results from businesses already trading on exceptionally high multiples was, in our eyes, wildly disproportionate and indicative of an increasingly frothy investment environment. Seek, REA and Carsales all had valuations requiring a hugely profitable future of uninterrupted profit growth, yet a small milestone along this path justified massive upward moves. Concurrently, Facebook paid US$19bn for WhatsApp, justified by its ‘number of monthly users’. For those of us who were analysts through the tech boom, Yogi Berra expressed it best, it seems like “déjà vu all over again”. Ramsay Healthcare, Magellan Financial, Henderson Group and Flight Centre were examples of stocks that added further to already exceptional gains over the past year. At the other end of the spectrum, gold stocks had a generally strong month, after an almost uninterrupted trend of losses in recent months. Alacer, Newcrest Mining and Evolution Mining were amongst the best.
The real economy generally fared less well, with reactions to profits from a broad range of businesses generally tepid. Goodman Fielder, Amcor, Toll Holdings, Coca Cola Amatil and Telstra were broadly indicative, although there were some exceptions in Boral , Bluescope Steel and Echo Entertainment. Don’t ask us to explain these as we can’t.
Accepting a global recovery as likely, should in our view, involve thinking through the path and being able to enunciate some of the milestones on the path to sustainability. It would seem insufficient to rely on soothing words from Janet Yellen or platitudes such as “doing whatever it takes”. The years since the global financial crisis have objectively resulted in an accumulation of significantly more debt while governments remain mired in perpetual deficit spending justified by totally unrealistic longer term forecasts. Despite these facts, most observers remain confident in recovery and seem to find little flaw in a system which allows governments to distribute largesse without finding a corresponding source of revenue. As crises gradually envelop an increasing number of industries; car manufacturers and airlines featured prominently in recent months, there still seems little acceptance of some basic economic facts. Wages must be paid from profits, profits are made from providing goods and services which others demand, and governments can only sustainably spend what they take from us in tax.
As speculative excess builds, asset prices are rapidly becoming the reason for optimism on future growth rather than an outcome of policies which restore economies to a sustainable footing. Our simple theory assumes that the eventual destabilisation of the financial system will be more painful for those that have been outsized beneficiaries on the way up. The more realistic management attitudes are on the prospect of the future being far more challenging than the average of the past decade or two, the more comfortable we are that they will protect investor’s capital. As investors increasingly reward over-priced acquisitions and short term earnings momentum, this attitude is becoming more important but no more prevalent by the day. Comfortably numb may yet again morph into uncomfortably alert.
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