On 2018, and the breakdown of capitalism
Many fundamental investors (including ourselves) are struggling to make sense of market activity, with 2018 having been a poor year for both absolute returns and relative returns for the majority of fundamental active investors (including ourselves). Having complained about low volatility for a while, we are now being reminded to be careful what you wish for. The sentimental amongst us remember a time when a marketplace allowed informed buyers and sellers to exchange goods and services at prices which they believed reflected a fair deal for both parties. With equity market activity increasingly dominated by passive, quant, ETFs and high frequency traders, it’s hard not to feel like Dorothy talking to Toto in The Wizard of Oz; “I’ve a feeling we’re not in Kansas anymore”.
Whether these feelings of disquiet from traditional investors are of any consequence is debatable; however, examples of markets in which participants are better served by fewer players with far more market power remain rare. Low cost funds that piggy-backed on the price-setting of fundamental investors were eminently sensible; however, with these funds having moved from the passenger seat to the driver’s seat we are currently trialling the financial market equivalent of autonomous vehicles. As we end the year with markets moving 3% in a couple of hours and oil prices 10%, there seems to be some risk we’re driving at 160km/h and changing lanes while asleep at the wheel.
Jonathan Tepper’s book, The Myth of Capitalism: Monopolies and the Death of Competition, explores the themes of market concentration and power at a fundamental level in the US corporate sector. He observes the extent to which market concentration has increased since the early 1980s across a broad range of industries, and the increasing stranglehold that powerful companies have on regulators and legislators. The result has been “lower investment in the real economy, lower productivity, less economic dynamism with fewer start-ups, higher prices for dominant firms, lower wages and more wealth inequality. The evidence from economic studies is pouring in like a flood”. It is difficult not to observe the replication of this inequality in equity markets.
Rather than embracing competition as an integral part of capitalism, investors appear to be actively avoiding it. Regulated returns remain highly sought after, acquisition activity often has its genesis in supressing competition and maintaining prices, and high returns on capital are seen as the ‘holy grail’ rather than as potential for future competitors to attack. Rather than the problem being with capitalism itself, it seems there is a fair argument that the flaw lies in capitalism not being permitted to function. As we begin 2019, the question of whether economic inequality and its reflection in equity market inequality will continue unabated, or come under threat, is vital.
The role which interest rates have played in fuelling some of the issues above seem undeniable. Domestically, with APRA having taken steps early in 2017 to control profligate lending, mild falls in house prices are already causing back-pedalling, with interest-only residential mortgage restrictions set to be lifted in January 2019. As the only purpose of an interest only loan seems to be to speculate on capital gain, any claims of ambivalence to asset price direction by policymakers appear disingenuous. Deputy Reserve Bank Governor Guy Debelle reinforced this stance in a recent speech, referring to the “critical importance of keeping the lending flowing” and the “risk that a reduced appetite to lend will overly curtail borrowing with consequent effects for the Australian economy”. It is difficult not to see the incongruity in chastising banks for lending money to borrowers with virtually no prospect of repaying loans in the same breath as emphasising the need to find incremental borrowers at any price in order to keep the economy going. Banks, after all, are merely the conduit through which central bank policy is transmitted to the real economy.
The release of the ASIC report into buy now, pay later arrangements in late November highlighted similar themes. “Most users also believe that these arrangements allow them to buy more expensive items, spend more than they normally would, or make more spontaneous purchases”. Unsurprisingly, the conclusion of the report was for ASIC to monitor the situation — aka do nothing. The summation of these comments and actions seems clear. There is no acknowledgement that interest rates can only transfer wealth around the economy rather than create it, nor that exceptionally low rates may be a cause of inequality and the breakdown in capitalism. Ray Dalio’s book Principles for Navigating Big Debt Crises does not appear to be on their reading list. Changing conditions will almost certainly be driven by market forces, not regulators.
One area in which capitalism has seemed to function better has been the oil market. US shale oil and greater fragmentation of the market has hampered OPECs efforts to manipulate the oil price for some time, and the past quarter didn’t augur well for those hoping OPEC was getting its mojo back. Share prices for businesses exposed to oil price fluctuations were savaged, suggesting the confidence of most investors in a sustainable level of oil prices remains firmly anchored to the spot price. Origin Energy (-21.7%), Oil Search (-20.7%), Santos (-24.6%) and Woodside Petroleum (-18.8%) were taken to the cleaners, while Worley Parsons’ (-41.1%) partially debt funded takeover of Jacobs Engineering’s energy, chemicals and resources business coincided almost perfectly with the rollover of equity markets and the oil price, ensuring they amplified the pain. The special dividend and buyback funded by the proceeds of US shale oil assets by BHP (-1.2%) insulated it almost totally from any decline in the oil price. A 62 page presentation on capital allocation in November was also timed beautifully to emphasise BHP has turned over a new leaf. I’m undoubtedly too cynical, but I found myself harking back to some of the Midnight Oil lyrics of the early 80s; “short memory, must have a short memory”.
On the other side of the ledger, oil price beneficiaries such as Qantas (-1.9%) performed relatively well in comparison to the broader market. While the performance of Qantas in restructuring and improving the business has been highly laudable, some of the comments made by Jonathan Tepper in relation to the US airline market offered obvious parallels when it comes to the Australian airline industry. Investors have revelled in a strategy that has seen Qantas increasingly codeshare in the highly competitive international aviation market while harvesting its strong domestic position. One-hour domestic flights that cost almost as much as a flight to the US or Europe are probably seeing domestic consumers a little less excited than investors. No doubt the Canberra route will remain well looked after though as regular visits to the capital invariably prove useful for all good duopolies.
On this measure, players in the telco sector probably have some reason to feel short changed. Although consumer prices have generally been on a one-way path south ever since the government sold Telstra to the unsuspecting public prior to building a wildly overpriced and ineffective broadband network in competition, the ACCC has raised concerns over the TPG Telecom (-24.4%) merger with Vodafone. Even though they aren’t even competing in mobile telecommunications as yet, the fact they might add further competition to an already competitive market has Mr Sims concerned. Fortunately, no such concerns arise in Transurban owning all the country’s toll roads, as long as they publish toll road traffic data. It must just be me whose toll road bill is rising a little faster than the phone bill!
The apparent certainty of regulated or stable cash flows which can be assumed to never fall and allow high levels of financial leverage at interest rates which will never rise has continued to win the day.
Pharmaceutical and medical device companies which avoid any level of price transparency or competition —and have bills funded by taxpayers and already command exceptionally high levels of profitability — have been similarly popular. Lastly, technology companies — which one might expect to be savaged in tough market conditions given low or non-existent levels of profitability and ebullient valuations — have remained largely impervious. The lure of potential dominance and the rewards of neutralised competition accruing to the likes of Google and Facebook remain alluring. Highly competitive industries such as retail and construction have continued to prove painful for investors.
We seem to live in the era of the increment. Attempting to look past the increment in data or earnings to form a longer run view of value has been painful. Behaviourally, investors with any ounce of contrarian inclination are struggling to recover from being run down by the quantitative freight train every time they step on to the tracks. It becomes progressively more difficult to step back on.
Equilibrium continues to feel some way off in our eyes as supposed capitalists justify their intervention while simultaneously ensuring capitalism does not function properly. While investing in the coddled has been lucrative as economic inequality is mirrored in the equity market, valuations reflect ever greater extensions of this inequality. Significantly lower valuations for those more subject to the vagaries of actual competition lead us to believe the shift back towards equilibrium will offer great opportunity when market forces become too difficult to overwhelm.
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