The new abnormal
Now is a dangerous time to turn a blind eye to the key drivers of future returns: valuation and purchase price. If the past decade in equity markets has taught us anything, mispriced money has resulted in some deeply ingrained beliefs and behaviours that are now unsustainable.
Ferris Bueller would be proud. The RBA’s day off set the cat amongst the pigeons. That free market interest rate pricing bore no resemblance to the market price should have been obvious. It did not stop those accustomed to turning up at the auction every day to sell their overpriced bonds to an overly enthusiastic buyer using taxpayer’s money leaving stunned. Whether or not cash rates rise or massive market intervention continues, the RBA Board statements of late 2020 indicating they were “not expecting to raise the cash rate for at least three years” seem extraordinarily ill-considered. Professing certainty on suitable monetary conditions a good way into the future offers an even money chance of looking stupid. Doing it in a time of pandemic and massive stimulus increases the odds.
Fuelling credit growth
The job of painting the Australian economy (alongside most others around the globe) into a very tight corner has been torturously slow and built on extremely simplistic beliefs. As the western world exported all of its goods production to China and received cheaper goods in return, there was an apparent absence of inflation (as long as you ignored housing, education and healthcare). Though the sources of these falling prices had nothing to do with us and showed no signs whatsoever of bothering anyone or causing delays to the appetite for growing consumption, they were the excuse for endlessly reducing the cost of money. Stimulating credit growth, the lifeblood of the financial system is the real reason. Lower interest rates are just the tool. You want more volume, lower the price. It is also the reason most policymakers are now stuck in the corner with paintbrushes and no paint. Bank depositors are currently being offered zero interest in return for the opportunity to make loans with virtually no possibility of repayment against some of the world’s most outrageously priced property. The chart below shows how increasing loan size and ever higher multiples of household income have provided all the fuel for credit growth in the past decade.
Housing represents around $2 trillion of $3 trillion in total loans, and investor loans nearly $700 billion of the $2 trillion. As has become the norm over recent years, bank shareholders now seem more concerned with whether banks are able to match or outpace system growth (finding barely creditworthy borrowers willing to punt on ever rising property prices faster than competitors), with the leaders (CBA, Macquarie) rewarded and the laggards (ANZ) punished.
Restoring sustainable balance
In an investment landscape purportedly concerned with sustainability, we would love to hear an explanation of how and why this isn’t a Ponzi scheme and how this forced theft from depositors differs from a tax. Using tax proceeds to fund wealth redistribution to asset owners assisted by numerous tax exemptions makes the process wildly more unsustainable.
The contention over whether inflation will durably accelerate is important to the extent which the rate of theft from depositors will increase without at least allowing interest rates some scope to rise and ameliorate a portion of this theft. Balance can only be restored to the system if borrowers and speculators are actually exposed to potential loss, transferring wealth in the opposite direction.
Unpacking the complex interaction between stimulus, supply chain interruptions, de-globalisation and under investment giving rise to inflationary concerns is tough. Our cynicism of economic models professing to explain the myriad of behavioural and fundamental interactions remains high. Like traffic jams (exactly what is happening in ports currently), complex systems always present the possibility of apparently small interruptions causing vast impact. Pallet shortages, trucking backlogs and labour availability do not seem to have rapid solutions. In labour in particular, ingrained belief that a university degree equals higher wages might well be challenged. The butterfly effect is alive and well. On a longer-term basis, one of the primary reasons we expect the odds favour rising inflation is the impact of energy prices. The task of rebuilding the world’s energy infrastructure to remove emissions is vast.
As Vaclav Smil has pointed out, despite massive investment in renewables, the past few decades have seen the world’s share of energy produced from fossil fuels reduce marginally, from around 87% to around 83%. Reaching net zero in the next few decades cannot happen without investment and technology solutions on a much larger scale. Current energy prices are providing returns ranging from dismal to mediocre for most (Origin Energy and AGL are domestic cases in point), despite ageing infrastructure and increasingly chronic underinvestment as the financial capital of the world runs quickly away from the necessary task of sustaining and improving fossil fuel based energy supply whilst planning and building the renewable solution. All logic suggests vast required investment will need to be supported by a vastly greater pool of revenue, only enabled by higher prices. Surprisingly, many companies still seem comforted by the ability to sign a PPA (power purchase agreement) at virtually no premium to current electricity pricing, allowing them to feel better and avoid sacrificing competitiveness. Unfortunately, facilitating the transition cannot possibly be costless and requires higher energy prices to be accepted. The reaction to Rio Tinto’s announcement of increasing capex by US$7.5 billion to fund an acceleration of emission reduction targets across its business to 50% (Scope 1 and 2) by 2030 met with an unsurprising response. The share price fell sharply. Rhetoric aside, when it comes to solving emissions, enthusiasm wanes when it means sacrificing returns.
Research versus reality
Despite interest rate markets reflecting increasing unease at being ripped off by central bankers locked into obsolete and unsustainable economic models, the harmful butterfly effects are obvious to those without ostrich tendencies. IPO activity remains frenetic and speculation rampant. Investors are piling into options bets on Tesla to increase in value from an already insane US$1 trillion valuation level and cryptocurrencies continue to go mad.
While an expectation of higher interest rates should theoretically challenge valuations of distant cashflow projections, Xero, Altium, Appen, HUB24 and Netwealth all trounced the performance of the broader market. Even a seemingly well-researched short report on speculative darling Vulcan Energy barely dented the fanciful valuation. Chaos theory reigns and fundamental research seems fruitless.
Debt funded acquisitions spruiking earnings accretion (hardly a tough hurdle) are met with enthusiasm. Nick Scali buying Plush, Telstra acquiring Digicel Pacific (with government assistance) and GUD acquiring Vision X Group were all examples of well-received acquisitions. Nevertheless, even the hurricane force tailwinds of virtually free money were insufficient to support the Aurizon acquisition of One Rail from Macquarie for $2.35 billion. Who would have thought asking shareholders to assume the risk on disposal of the coal haulage business with virtually no potential buyers and paying an outrageous price for the residual bulk haulage business wouldn’t go down well? Should only be a year or so before shareholders are asked to approve higher pay for executives tasked with running a larger and more complex business. Didn’t you hear, there’s a global war for talent?!
Dylan probably said it best; “There must be some kind of way out of here / Said the joker to the thief; There's too much confusion / I can't get no relief. Business men, they drink my wine / Plowmen dig my earth; None will level on the line / Nobody offered his word”. The pattern of the past decade in equity markets and the influence of mispriced money has resulted in some deeply ingrained beliefs and behaviours, many of which we see as unsustainable. The primary influence on investment behaviour at present is historic performance. Winners keep winning. Little attention is paid to the importance of purchase price in determining future returns. History would suggest this is an abnormal period.
While the evidence of how powerful the incentive of ever cheaper money has been on behaviour is undoubted, the corner into which ill-considered interest rate policy has painted us is increasingly tight and the costs increasingly obvious. Whether it is supply chain pressures, energy prices or a myriad of other possibilities which potentially initiate a butterfly effect in an alternate direction, we feel now is an exceptionally dangerous time to ignore valuation and purchase price as drivers of future returns. The 'Save Ferris' banners might not be sufficient to save rampant speculators should the pressures for central bankers to take a few more days off elevate further.
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