Want long-term inflation? Raise rates, now

janet_yellen_official_federal_reserve_portrait
Credit: Wikipedia

Central banks across the world have been trying to reignite inflation by injecting a massive amount of liquidity and buying financial instruments, most recently corporate bonds. In theory, a higher supply of money should devalue the currency, thus boosting both exports and domestic demand. In particular, demand translates into more investment, which is a necessary cornerstone for long-term growth. Needless to say, this classic monetary tool has been more than widely used over the last few months. But the target remains out of reach in many countries. Despite more than $1tn of debt now yielding negative interest rates, inflation barely climbed to 0.6% in the UK. The US Fed is considering raising interest rates again although inflation in the US is 2.2% and thus barely exceeds the official 2% target.

Credit: Getty Images
Credit: Getty Images

I have already highlighted in this blog the importance of confidence in driving the decision of individuals. When people are confident about the future (i.e. they can predict with relative certainty the future state of the economy and the implication for their personal wealth) they do not hesitate to invest part of their income in ‘non-vital goods and services’ such as domestic appliances, automotive etc. The same logic applies to companies – this is what we call investment. Today’s environment largely lacks visibility. Geopolitical concerns (elections in the US, France and Germany, Brexit in the UK, tensions in the Middle East) make economic decisions even harder to predict. As a consequence, despite the affordability of debt, households and companies prefer to save today in case the situation gets tougher tomorrow. The resulting drop in demand has been widely pointed out as a cause for low inflation or potentially deflation in some areas (e.g. food in the UK).

Not only are hyper-low interest rates inefficient, they are counterproductive, and central banks should raise interest rates as early as feasible. Let me explain. The excessive amount of non-invested liquidity has led individuals and companies to invest in financial assets such as bonds or funds. Venture capital funds have been particularly in demand given their risk-reward profile; they tend to be more risky than ‘plain LBO’ funds and according to theory should yield better expected returns. Unsurprisingly E&Y in its latest global venture capital trends report states that venture capital deal activity increased by 54% in 2015 to reach $148bn.

Flooded with liquidity venture capitalists are begging for start-up ideas to invest their money – given that the worst scenario for an asset manager is to show his investors that their commitments are sleeping at the bank. The number of start-ups has been logically soaring in all developed economies as a result, sometimes giving birth to incubators, the most famous certainly being Rocket Internet, and a few have been raising tens or even hundreds of millions of dollars to boost their development.

In the 2.0 economy, where marginal costs are almost non-existent and barriers to entry are low, ‘customer acquisition’ and ‘network effect’ are the new mantras. Rather than investing in expensive marketing campaigns, start-ups have decided to invest in prices, most often selling their services at a loss to ensure maximal penetration. Uber is a good example. Rides in London are on average 30% cheaper than a black cab. The company is present in more than 500 cities and has been valued at $68bn in its latest fundraising round completed last year. And yet, Uber reported $1.2bn in losses in H1 2016 – this raises a broader debate about the criteria for start-up valuation, which we will address in a later post.

Credits: bpplan.com
Credits: bpplan.com

Private investors have shown patience so far, hoping that the ‘hockey stick’ will materialise. And if it does not, investors often believe that it is simply due to a lack of scale and that further investment is required to ensure the user base is large enough to prove profitable. The stock market, conversely, has been indifferent to this thesis and very few start-ups have succeeded to make a strong enough profit to reach the IPO stage – a feature that differs from the 2000 ‘dot-com’ bubble.

Exit of VC deals: IPO vs. M&A (value in $bn). Source: E&Y.
Exit of VC deals: IPO vs. M&A (value in $bn). Source: E&Y.

My point is that for months now many aspects of our daily life have been ‘subsidised’ by increasingly risk-seeking venture capitalists and that behaviour has largely been driven by the abnormally high amounts of liquidity made available by Central Banks. Paradoxically, these start-ups have most often been bringing down prices and ultimately favouring deflation, pushing Central Banks further away from their initial objective. I am not saying that price cuts are always bad. But in this case price cuts have only come at the cost of corporate losses – simply put: value destruction.

The argument about the ‘hunt for worldwide scale’ is dubious. Although this hunt is legitimate in a limited number of cases (social networks represent the most typical examples), entering new markets brings limited benefits to most start-ups. When Uber decides to enter Santiago, it cannot rely on network effect: the taxi drivers operating in Santiago are different from the ones in Singapore and the customer base is also very distinct. Given the very lean cost base, the only synergy it can expect is the brand power – which may not justify hundreds of millions of dollars of losses. And, even if you do so, you cannot prevent an aggressive competitor to emerge with even lower prices – only the depth of the investors’ pockets will make the difference.

My recommandation to Central Bank governors is thus simple: raise interest rates and clean up the mess. We will not find growth by artificially subsidising value-destructing activities. The fear of the next crisis and the willingness to avoid recession at all costs are leaving everyone in doubt. Take the hit, start from a fresh and economically sane breeding-ground and build again from there.

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Credit: www.ericnguyen23.com

The 5 economic trends that worry me (2/2)

[Continued from Tuesday]

3. The hype around FinTech

Last year the rise of Financial Technology (‘FinTech’) software and apps led some experts to predict the ‘disruption of traditional banking. The new providers of financial services would maximise the agility and cost efficiency provided by technology and as a result would kick the incumbents plagued by legacy systems and excessive layers of staff.

LendingClub_logoLendingClub, founded in 2006, was perceived as one of the standard-bearers of that shift. As a P2P lending company it offered to put individuals or small businesses directly in touch with lenders through an online platform – a mix of Uber and Match.com. LendingClub was claiming that it would enable small businesses to get easier access to funding while providing lenders with an investment offering a (relatively) decent return.  LendingClub was just taking a percentage of the loan as a one-off fee and therefore was not taking any risk.

In 2016 the picture is somewhat different, as Patrick Jenkins points out. Hedge funds and banks have replaced individuals and small businesses and have started securitising the loans – rings a bell? Poor credit risk assessment processes led to the first defaults, the departure of the CEO and a 25% share price drop. Compliance started to take its toll as the company grew. To command a technology startup valuation multiple, revenue growth requires LendingClub to accept an ever increasing volume of loans (new loans account for 90% of revenues), including riskier ones. And the company proved sensitive to credit cycles. As a solution, LendingClub started taking retail deposits to channel them towards its lending platform – basically what a traditional bank does, with a tiny bit of software on top. No quite disruptive any more.

Historical evolution of LendingClub's share price. A slow descent into hell... Sources: Yahoo Finance, author analysis
Historical evolution of LendingClub’s share price (in USD) since IPO. A slow descent into hell… Sources: Yahoo Finance, author analysis

In the meantime, regulators across the world are running behind and have not proposed a robust framework to monitor this new array of services yet – raising the risk to “systemic stability”.

 

4. Banks desperately looking for yield

Banks are by far the biggest losers of the negative interest rates policy implemented by Central Banks across the world. Their deposits do not generate any revenues any more. Worse, they are a source of cost. Given that very few banks have dared passing the cost through to the customer yet (i.e. charging current accounts), banks are now looking for more profitable investment to make up for the difference – notwithstanding the fact that banks have been massively streamlining their teams over the last 12 months. This implies taking more risks.

O&G companies for instance were granted higher quantums of debt at the time oil was getting close (or above) $150 a barrel – especially those involved in shale gas production. Those quantums backfired when the barrel dropped by more than 80% – shale gas then became almost unprofitable to produce. Despite the recent correction, the O&G industry has been suffering a series of bankruptcies as a result – 42 last year alone. In the US, car loans, student loans and credit cards balances and delinquency rates are also reaching abnormally high levels according to Le Figaro. By willing to invest at all cost, banks are becoming less and less concerned about the quality of their customers.

 

5. Housing market engineering is back in the game

I thought the 2008 mortgage subprime crisis would repel investors from the housing market for a while. I was wrong.

collapsinghouse
Credits: www.polizeros.com

According to TechCrunch, Opendoor, a company founded in 2014, “currently buys homes sight unseen when a home seller visits its site, asks for a quote, and accepts Opendoor’s bid, which the company comes up with based on public market information about historical home sales and its own proprietary data about market conditions”. Fortunately, the company selects its investments, not purchasing “any home built before 1960 [or] homes outside a $100k-$600k price range” – according to TechCrunch this still means that 90% of homes are eligible, so the criteria are not that drastic after all…

The startup’s balance sheet is currently worth “hundreds of millions of dollars”. Talking about profitability, its CEO “Opendoor isn’t focused on [profitability] just now”. Let us hope for them that the housing market does not decide to spiral down again.

 

Some hope: Investors seem to have learnt (part of) the lesson

After a euphoric 2015, investors seem to wake up (some of them hungover) and are becoming more realistic about the true potential of ‘disruptive’ investments.

First, raising equity has also proven increasingly difficult for startups since the beginning of the year, especially for those seeking very large cheques (greater than $100m). In Q1 2016 $25.5bn got invested in startups globally, an amount down 8% yoy. When they manage to do so, the financing package comes with increasing strings attached, even for well-established brand names. The bond Spotify issued in March contains an ‘bomb-ticking’ interest rate which strongly incentivises shareholders to look for an IPO in the short to medium-term – in substance, creditors are asking the company to become palatable for the stock market as a whole and not just a series of cherry-picked investors.

logoSecond, the ‘real’ value of existing investments is being re-assessed. BlackRock, for instance, decided to cut its valuation of DropBox by 20% last October. Rocket Internet, the controversial startup studio, lost 18.5% of its equity value in two days in April after it revised the valuation of some of its investments downwards. On a side note, Carl Icahn, the famous activist investor, recently revealed that his fund Icahn Enterprises had a net short position of 149%.

Donald_Trump_August_19,_2015_(cropped)Politics is also joining the party. In the US, the Presidential Election held later this year represents a clear source of uncertainty. Candidate Trump has already declared that “we [were] in a bubble right now” and has been criticising the role of the Fed in the construction of that bubble. The kind of mitigating action that Mr. Trump would implement to negate the bubble still remains unclear at this stage.

Credits: www.fineartamerica.com
Credits: www.fineartamerica.com

What’s next? Because of the excessive amount of liquidity in our economy, value destruction has reached a scale never witnessed before. This is clearly not sustainable. When the liquidity tap will stop flowing, there will be boats left stranded on the shore. But to which extent? Will we ever come back to a pre-crisis environment? I do not believe so either. As I mentioned in an earlier post, I think the answer is in-between: we need to give birth to a ‘new normal’. I fear, however, that the delivery will not be painless.

The 5 economic trends that worry me (1/2)

Normal-Rockwell-Boy-on-High-DiveMany experts agree to say that the current economic environment is something we have never witnessed before. Despite negative interest rates – $10tn in total, now including some high-quality corporate securities – global growth is expected to remain limited – only 2.4% forecast in 2016 according to the latest World Bank report – as well as inflation – for 2016 the OECD forecasts 0.06% in France, 0.43% for Great Britain and 1.07% for the USA despite encouraging unemployment figures. This environment makes the hunt for growth significantly more challenging than in the past and has thus favoured the emergence of behaviours that, taken together, may well threaten the stability of the economy in the medium-term. Although the reader may find many more, I have taken 5 examples which have particularly struck me over the last few months.

 

  1. Stock markets reaching all-time highs despite weak macro indicators

The weak growth prospects expressed in my introduction have not deterred investors from massively buying stocks. Last week the S&P500 reached a level only 0.5% below its all-time high, lifted by a slight recovery in oil prices and the increased likelihood of a Fed Reserve rate ‘status-quo’ in June. This has come on top of the second longest bull run in the S&P’s history – the longest lasted from 1987 to 2000. And yet it is difficult to identify the ‘hard facts’ that investors base their bullish assessment on.

theres-a-new-most-bearish-strategist-on-wall-street“If you look at U.S. stocks on a global perspective, to be touching or near that high is pretty phenomenal. “Yet when we look forward, we’re struggling to find that next source of growth. Maybe the drag has passed, but where is the growth going to come from?” (Gina Martin Adams, Wells Fargo Securities LLC)

As Benjamin Graham, the famous value investor, claims in his book The Intelligent Investor, we may have switched from an investment strategy, where people believe in the true intrinsic capabilities of the firm they invest in, to a speculative strategy, where people believe that they will be able to sell their shares to someone who puts a higher valuation on them, irrespective of the company’s performance. The former is characteristic of a potential bubble.

 

2. Unicorns and unicorpses: party like it is 2000

the-18-billion-london-tech-unicorn-thats-struggling-to-pay-its-staff-is-worried-about-going-bustFor those unaware, ‘unicorns’ are companies which have managed to raise equity with an implied valuation exceeding $1bn. Not so long ago, the ‘unicorn’ club was made of a handful of companies with (i) proven business models, (ii) established profitability and (iii) huge opportunities for global growth. Today, the ‘club’ has grown to 150 members or so, all of which cannot claim to tick the three boxes mentioned above.

First, entrepreneurs have realised that being labelled a ‘unicorn’ could turn out to be a real marketing tool and business booster. Some of them decided to enter through the service door by actually raising a relatively limited amount of equity (let us say in the single-digit millions) for an even smaller share of the capital (let us say 0.1%). As a consequence, the firm manages to qualify for the ‘unicorn’ label, even if clearly no investor would be willing to pay close to $1bn for the entirety of the company.

Furthermore, to make up for the lack of revenues, entrepreneurs have come back to the non financial-related KPIs made famous in the late 1990s to support what ended up being the ‘dot-com bubble’: number of users, number of clicks, number of hours of videos uploaded on website etc. Growth is not about top line or EBITDA anymore as taught in corporate finance classes but measured by the notion of ‘increased engagement’ and ‘scale’ instead. Spotify, for example, managed to raise equity last year based on a $8.4bn valuation despite not having made a profit yet. This is easier than in the 2000s given that, as rightly pointed out by Terence Fung, the new ‘Web 2.0’ is mainly about B2C applications rather than B2B software which contributed to the ‘dot-com’ firms’ reputation.

20150210005716!Slack_IconFinally, some startups benefit from potentially inflated growth prospects. Slack has managed to raise $200m of equity based on a $3.6bn valuation in April. The company is nonetheless far from shaking the industry at the moment. It offers a simple chat app and is currently used by 2.7m daily active workplace users, only 800k of which are paying at present. Each paying customer is therefore implicitly valued at $4,500.

2015 witnessed soaring unicorn valuations but 2016 and 2017 may bring those valuations down to earth, a forecast trend that has given birth to the term ‘Unicorpse.

[To be continued on Thursday…]

‘Irrational Exuberance’ striking again?

Prof. Robert Shiller
Prof. Robert Shiller

I thought today’s economic environment was perfect to reread Irrational Exuberance, the book written by Nobel Prize-winning Yale University professor Robert Shiller. Prof. Shiller made himself known to the general public by predicting the ‘dot-com’ bubble in the 2000s as well as the housing market collapse in 2007-2008. Coincidentally, no later than last year Prof. Shiller granted us with a third revised edition of his book which analyses the two aforementioned events to identify behavioural patterns leading to market instabilities.

Chapter Four, ‘Precipitating Factors: The Internet, the Capitalist Explosion, and Other Events‘, lists and discusses the triggering factors that were specific to the economic context at that time. The section entitled ‘Twelve Precipitating Factors That Propelled the Late Stages of the Millennium Boom, 1982–2000‘ resonates way too well in the light of the rise of ‘disruptive’ technologies and social media. Below are some quotes which I found particularly striking.

Because of the vivid and immediate personal impression the Internet makes, people find it plausible to assume that it also has great economic importance. It is much easier to imagine the consequences of advances in this technology than the consequences of, say, improved shipbuilding technology or new developments in materials science. [...] It could not have been the Internet that caused the growth in profits: the fledgling Internet companies were not making much of a profit yet. But the occurrence of profit growth coincident with the appearance of a new technology as dramatic as the Internet created an impression among the general public that the two events were somehow connected.

Do not get me wrong: some of the largest technology companies (by market capitalisation) completely justify their valuation because of the value they create. Nonetheless, one cannot help but think that some of the technology-related ventures created over the last couple of years (with a special attention to loss-making ‘unicorns’) were lifted by the abundance of liquidity in the market and the investors’ search for yield in a depressed environment.

New technology will always affect the market, but should it really raise the value of existing companies, given that those existing companies do not have a monopoly on the new technology? Should the advent of the Internet have raised the valuation of the Dow — which at the time contained no Internet stocks?

The impact of social media and ‘Uberisation’ still remains to be quantified, as the impact of the Internet was in the early 2000s. But here again caution is paramount. As an example, asset-light Fintech companies were expected to put the traditional banks out of business. We now see that those companies have benefited from an extremely favourable credit environment and struggle as soon as the tailwinds fade.

What matters for a stock market boom is not, however, the reality of the Internet revolution, which is hard to quantify, but rather the public impressions that the revolution has created. Public reaction is influenced by the intuitive plausibility of Internet lore, and this plausibility is ultimately influenced by the ease with which examples or arguments come to mind. If we are regularly spending time on the Internet, then these examples will come to mind very easily.

This sentence is very applicable to today’s trend. A vast majority of the successful emerging companies target the B2C market and actually very often make the ‘B’ closer to the ‘C’ by ousting intermediaries – think about Uber or Deliveroo. The change has settled in our everyday life, which makes the examples even easier to remember.

Anticipation of possible future capital gains tax cuts can have a favorable impact on the stock market, even when tax rates actually remain unchanged. From 1994 to 1997, investors were widely advised to hold on to their long-term capital gains, not to realize them, until after the capital gains tax cut.

Calls for a fiscal stimulus as a way to reinforce the already-implemented monetary ‘quantitative easing’ have been growing. Although in the UK the next budget will only affect the corporate tax rate, investors are right to believe that the fiscal burden may loosen soon on capital gains as well.

Although there is no doubt at least some truth to these theories of the Baby Boom’s effects on the stock market, it may be public perceptions of the Baby Boom and its presumed effects that were most responsible for the surge in the market.

Structural drivers such as demographics are indeed among the most popular discussion topics when it comes to predict the outlook of both the stock and the housing markets. Prof. Shiller nonetheless warns us that our (sometimes) self-fulfilling anticipations and expectations may actually be stronger than the real effect.

As further evidence that the media growth was boosting the stock market, we now know that after the peak in the market in 2000, business reporting took a major hit in reaction to declining public interest. Hip business magazines like Red Herring, the Industry Standard, and others went out of business.

As sole writer of this blog I have to plead guilty. As many other media, I have probably paid a disproportionate amount of interest to the evolution, past and future, of the housing market.

In a non-experimental setting, where people’s focus of attention is not controlled by an experimenter, the increased frequency of price observations may tend to increase the demand for stocks by attracting attention to them. [...] The rise of gambling institutions, and the increased frequency of actual gambling, had potentially important effects on our culture and on changed attitudes toward risk taking in other areas, such as investing in the stock market.

Our environment, including social media conversations, provides us with many opportunities to be part of the stock market ‘game’ and many platforms have leveraged the parallel with gambling, making their platforms increasingly entertaining.

In a survey of home buyers in 2004, Karl Case and I asked: “Do you worry that your (or your household’s) ability to earn as much income in future years as you expect might be in danger because of changes in the economy (someone in China competing for your job, a computer replacing your job, etc.)?” Nearly half of our 442 respondents (48%) said they were worried. Some of them said that one motivation for buying their house was the sense of security that home ownership provides in the face of the other insecurities. [...] One might call this a “life preservers on the Titanic theory.” When passengers on a ship think the vessel is in danger of sinking, a life preserver, a table, or anything that floats may suddenly become extremely valuable, and not because these assets have changed their physical attributes. Similarly, at a time when people are worried about the sustainability of their labor income, and there are not enough really good investment opportunities, they may tend to bid up prices of all manner of existing long-term assets in their efforts to save for the dangerous lean years seen ahead. They may not manage to save more in real terms. They may hold such assets even if they now believe the assets are overpriced and in danger of losing value in the future.

The sense of geopolitical and economic insecurity remains persistent – today a poll revealed that 86% of French people believed that the situation “had not improved for the French population in general”. In that context individuals tend to rely on ‘safe’ investments such as real estate and bonds, despite the very poor returns offered by the latter.

Sans titreWill we witness another 2000-type market crash in the short-term? I do not believe so. However, I do think that the Central Banks’ decision to open the liquidity tap to an extent never been witnessed before has led investors, i.e. the general public, to increasingly disconnect their thinking from the real fundamentals of our economy. The way the two converge again will tell us whether we are heading towards a ‘soft landing’ or a ‘bubble burst’.