Beware of manipulated utopias
As a fan of dystopian classics such as Huxley’s ‘Brave New World’ and Orwell’s ‘1984’, I find their insights into the perils of searching for a manipulated utopia alarmingly relevant to today’s financial world. As rationalists, we’d suggest the benefits of manipulating asset prices and interest rates in the name of a healthier economy is, at best, an exercise in futility. To borrow from John Tuld in ‘Margin Call’: “It’s just money; it’s made up. Pieces of paper with pictures on it so we don’t have to kill each other just to get something to eat.” The recent ructions created in markets by relatively small shifts in bond yields serve to highlight the hyper sensitive nature of financial markets given decades of accumulated intervention. At the risk of oversimplification, it is worth summarising the themes that have dominated our thinking for many years now and the reasons for this hyper sensitivity as we see it:
• Asset values are the ledger that records respective claims on the resources of the economy. The quantity and price of money can only alter the distribution of ownership of these resources. “It’s just money; it’s made up.”
• The debt problem faced by most of the world is the accumulation of decades of permitting credit to grow too quickly. Rather than focusing on credit as the amount of additional money that is permitted to enter the economy, central bankers and economists have focused on artificially constructed inflation measures that concluded that 10% to 15% per annum credit growth was resulting in 2% inflation, justifying ongoing interest-rate reductions.
• This cavernous gap between credit growth and measured inflation facilitated a multi-decade asset-price boom and wildly disproportionate growth in the size of the financial economy relative to the real economy. Most western economies shifted production to lower-cost countries and have become disproportionately consumption based. Asset-price booms and bubbles triggered massive wealth redistribution and rewarded speculation rather than labour. Ongoing stimulus to consumption and a desire to support asset prices required ever-lower interest rates to spur more credit growth.
• Stability, equitable distribution of wealth and productive use of capital are promoted when credit growth is kept low and focused on productive uses. This has not been the case.
• The words ‘wrong’ and ‘mistake’ do not feature prominently in central-banker vernacular. Decades of exacerbating earlier ‘mistakes’ have created an ever-larger financial system balanced on an ever-lower interest rate. The ‘real’ economy, which produces goods and services and pays wages to eventually support the value of financial assets, has continued to develop and grow. This growth rate, however, has been nowhere near the rate of credit growth for many years.
• Financial-market volatility and risk emanate from the relative size of the numerator (the value of financial assets – stocks, bonds, property etc.) and the denominator (interest rates and profits). Having progressed to a level at which the numerator is exceedingly large versus history and the size of the underlying economies supporting the financial assets, while the denominator moves progressively closer to zero, hyper sensitivity relative to history is a mathematical certainty.
Having tracked the ‘financialisation’ of the Australian economy over the past few decades, the equity market engine has become ever more susceptible to asset values and discount rates for fuel. This creates great debate for us internally, as we attempt to assess the probability of sustaining an elevated and artificial numerator (policymakers will undoubtedly use every tool in their arsenal to this end) versus a reversion to higher levels of interest rates and necessarily lower asset prices. One thing in our mind is certain; while a benign period of stable and low interest rates and elevated asset prices is a distinct possibility, the possibility of a less orderly path is not insignificant. Additionally, lower asset prices do not necessarily need to be accompanied by falling goods and services prices. Intuitively, after a period when credit has flowed disproportionately into asset prices rather than consumer prices, it should be feasible for the reverse to occur.
Translating this picture to a sector and stock level, these debates take different forms. For some sectors, metals and mining, for example, revenues and costs that are grounded in the ‘real’ economy leave our concerns largely limited to the levels of financial leverage used to amplify risk in what are generally volatile businesses. Although cycles of supply and demand and the often-savage impact that these have on commodity prices will remain intact – evidenced in skyrocketing coal prices, relatively buoyant iron ore prices and languishing oil prices, demand growth on a global scale is relatively stable. Even in markets such as steel, in which China has been guilty of adding excessive supply, global volume growth cannot hold a candle to global credit growth levels. We remain extremely comfortable in the ability of these businesses to digest more challenging times in interest-rate and asset-price markets, given the limited impact of credit on their cycles. We also believe the diversification benefit to portfolios that are now wildly over-sensitised to asset-price and interest-rate moves is dramatically under appreciated. Shorter-term moves in commodity prices, which are driving substantial stock-price moves such as Whitehaven Coal (+23.7%), South 32 (+6.6%), Alumina (+8.2%) and Fortescue Metals (+11.1%), remain unimportant as drivers of longer-term value. Our views on the value of these businesses remain anchored on a longer-run view of prices, with most remaining attractive on this basis.
Possibly the most contentious is the banking sector. At more than 25% of the S&P/ASX 200’s market capitalisation, it is massively important for investors and the domestic economy. Our simplified picture of the banking sector is as follows: since 1991 credit has grown from around $350 billion to $2.6 trillion. Housing loans have totally dominated growth, moving from $80 billion to $1.6 trillion. Net interest income for the four major banks has grown from around $14 billion to $60 billion, allowing profits to rise from just over $2 billion to more than $30 billion. These profits are effectively a tax on the asset value ledger recording the liability that mortgaged homeowners have to depositors in return for the capital protection provided by bank equity holders. Even after tighter capital requirements from APRA, tangible equity is only around $200 billion, while bad debts are close to zero as booming house and asset prices virtually extinguish bad debts. Our conundrum is this; having presided over a massive increase in the leverage of the economy, disguised by ever-lower interest rates, we feel low credit growth and fairly stable revenue is the best-case scenario for banks, but even with an assumption of higher levels of bad debts, stability would see banks as fairly attractively valued. Profits of $30 billion are providing a more than adequate return of around 8% (fully franked) on major bank equity value of $380 billion or so. Every 25-basis-point increase in loan losses will extinguish around $6 billion of profits, however, unless these are recurring, the profit damage is one-off and profits are recurring. Loan losses of between 2% and 3% of loans (similar to the early 1990s) would extinguish $50 billion to $75 billion, while losses less than 1% of loans could be digested with less than a year’s profits. All this condenses to valuations that appear reasonable unless the deleveraging of the economy is more severe. To put this in perspective, if house prices were to collapse and bad debts skyrocket, extinguishing the total equity of major banks against housing loans would still leave loans of $1.4 trillion (assuming no losses elsewhere!), an amount still around 90% of Australian GDP. This explains why we don’t give central bankers an A for engendering financial stability. Pragmatically, it is why we believe they will move heaven and earth in trying not to utter that horrible phrase: “We were wwwrrrongg!”
Elsewhere, landmines are becoming more prevalent. Healthscope (-28.0%) provided yet another lesson in the purchase of squeezed lemons from private equity. Crown (-16.9%), Star Entertainment (-17.1%) and Sky City (-16.2%) suffered as the Chinese VIP gambling business incurred the ire of Chinese authorities, while AMP (-13.5%) suffered as the wealth-protection business endures the pressures of low investment returns and increasing claims. Having highlighted the imminent need to moderate an over-geared economy skewed towards asset speculation and consumption, it will come as no surprise that we expect plenty more landmines.
The high-level picture above illustrates the tendency towards myopia when the gradual impact of seemingly innocuous short-term moves accumulates into very large moves in the longer term. The fact that a wage-and-salary earner on a good salary of $100,000 a year could toil earnestly to save $10,000 a year for 10 years for a 10% deposit on a $1 million Sydney apartment, while the same amount can be made flipping an investment property held for 12 months bought with borrowed money, highlights the extent to which a system can become perverted. We remain extremely wary of the unintended correlations that are likely to appear when this process of artificial-wealth creation through creating more pieces of paper with pictures on them abates. The financial and consumption centric businesses that have dominated over an extended period are likely to require the same adjustments as the businesses in the real economy that have endured far tougher conditions over past decades. They will also emerge more efficient and stronger as a result. We remain strongly of the view that the time for investments strongly reliant on asset-price rises and declining interest rates has passed, while the sensitivities (in both directions) that accompany an artificially large financial economy may be more durable.
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274, AFS Licence 226473 ("Schroders") or any member of the Schroders Group and are subject to change without notice. In preparing this document, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be relied on as containing any investment, accounting, legal or tax advice. Schroders may record and monitor telephone calls for security, training and compliance purposes.