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

Press review – A few updates

Recent economic news have provided further substance to some of the topics we covered earlier this year. Selected examples include:

  • Apple revealed earlier this week declining yoy iPhone sales. The decline was however in the higher end of analysts’ expectations and resulted in a share price appreciation. Furthermore the company unveiled a strong increase in R&D spending (now reaching 6% of turnover), highlighting the hunt for the ‘next big thing’ to alleviate the still heavy reliance on iPhone which represents 2/3 of revenues.
  • Twitter’s results, on the other hand, disappointed investors which let the share price drop by 11% after the announcement. User base seems to have reached a plateau and the company has not found a way to profitability yet.
  • ‘Active’ investing is still haemorrhaging money while investors favour low-cost passive strategies.

The future of UK retail in 7 questions (2/2)

[continued from Monday]

Credits: gograph.com
Credits: gograph.com

5. How can retailers use innovation to stop the decline?

To embrace the change rather than trying to fight it in vain, retailers and department stores have started to invest in homegrown start-ups and accelerators. The win-win deal is clear: retailers remain at the forefront of technological innovation applied to their industry while entrepreneurs get instant access to a huge playing field for their products. Unsurprisingly, corporations have become almost as important as VC funds for the funding of accelerators.

Split of accelerator funding by primary source. Source: OpenAxel in the FT.
Split of accelerator funding by primary source. Source: OpenAxel according to the FT.

As previously mentioned, the online and ‘brick-and-mortar’ worlds will be more and more interlinked and the development and use of multi-channel CRM tools will play a great role in ensuring the coherence of the customer journey. Well-designed and innovative apps, allowing fast navigation, speedy checkout and nicely showcasing products will also boost sales – Asos is often mentioned as a ‘best-in-class’ example in that respect.


6. Should retailers own or rent their walls? Or should retailers simply sell their estate and move to an ‘online only’ model?

For years retailers have been told to own their walls. The cost of purchasing and maintaining their estate more than offset the sum of expected future rents which have been increasing at a fast pace – at least more rapidly than inflation. Furthermore, retailers were making a wise investment given soaring real estate prices across the country and especially in ‘prime locations’. Today, one can wonder if the equation still holds. Commercial real estate is expected to take a hit, crystallised by (but not only due to) Brexit, and rent inflation may cool down as a consequence.

This dilemma is worth considering as the ‘online only’ model represents a very difficult customer proposition which has been mastered so far only by a handful of players, including Asos or Made.com. Raising brand awareness and subsequently developing a brand image without any physical shop windows has proved an increasingly daunting challenge in an environment already saturated with incumbent brands. Furthermore, brands with a fading image lose pricing power – Uniqlo is one of the most recent victims of that rule.

Conversely a brand without any ecommerce operations is overseeing a strong growth driver. Some retail experts explain Primark’s recent under-performance by its absence of online shopping website – in this particular case, such a website would prove economically unprofitable for Primark given its low price points.


7. What will be the impact on the commercial property market?

The impact is still hard to assess. One could imagine that the change in culture, lifestyle and demographics, partly embodied by the rise of online, has made the need for physical retailers less obvious and therefore would expect a steady increase in the shop vacancy rate. Actually, the opposite is true: according to the Financial Times, the proportion of vacant shops fell to its lowest level since 2009.

Two possible cumulative drivers can be brought forward. First, service providers, such as restaurants, cafés and hairdressers, have taken the spots left vacant by retailers. Second, historically low interest rates have facilitated the access to debt and therefore boosted the creation of small business ventures – which this kind of service providers typically are.

In practice, though, bargaining power has started to move away from the seller. Two shopping developments have been sold at a significant discount to their original price – the transaction was completed pre-Brexit – and investment into retail property was down 54% in Q1 16 compared with Q1 15. More generally, brands will increasingly focus on prime locations where their products can be showcased at the expense of ‘tier 2’ areas such as suburban shopping centres whose transactional role will be increasingly filled by online shipments. As a consequence, some analysts believe that the UK market can now be covered with 80 to 100 stores as opposed to 200 in the past.

The UK retail industry is definitely facing challenges and shops have been asked with new roles. As announced, this will impact the demand for ‘brick-and-mortar’ sales locations – and ultimately the equilibrium of the commercial real estate market.

The future of UK retail in 7 questions (1/2)

Credits: gcmagazine.co.uk
Credits: gcmagazine.co.uk

Brexit has recently cast light on the future of the commercial real estate market in the UK. We will definitely tackle this topic in the near future. In the meantime, nonetheless, I thought it was worth getting back to the basics of one of the key underlying markets, i.e. retail, and ask ourselves 7 questions to understand the future of this market. Grocers and ‘non-food’ retailers follow different dynamics, I will therefore limit the discussion to the latter.

As usual, I thought this topic would be covered in only one post. In hindsight, I believe it would be more digestible to cut it in two halves – the second part will follow later this week.


  1. What is the current state of the UK ‘non-food’ retail market?

In a couple of words: not great. The recent misfortunes of BHS and Austin Reed are only the visible manifestations of a deeper trend. Total UK retail sales rose 1.2% on a 12-month average basis, the lowest growth since 2009. According to the latest British Retail Consortium – KPMG survey, in-store sales were particularly affected, falling 1.9% over the three months to June, and 2.2% on a like-for-like basis. The industry has been suffering from constant price pressure over the last decade.

CPI evolution for various perimeters. 2008 = 100. Source: ONS
CPI evolution for various perimeters. 2008 = 100. Source: ONS

Note : The informed reader will have spotted the ‘ups & downs’ generated by the bi-annual sales periods.


2. Are there winners though?

As in many other countries, online is the most dynamic segment of the UK retail market, although it is not immune to global market slowdowns – the latest BRC – KPMG online retail sales monitor reported a 9% growth of online in June 2016 compared with 18% a year ago. Massive online marketing initiatives such as ‘Amazon Prime Day‘ generate positive externalities for the online industry as a whole.

Source: FT
Source: FT

Looking at particular brands, Next, Ted Baker, New Look and pure online player Asos have reported relatively positive sales trends compared with their competitors.


3. Is it all about price?

No. Earlier this month Primark reported its first drop in like-for-like sales for 15 years, echoing the similarly difficult times Poundland is facing in the supermarket segment.


4. Can ‘brick-and-mortar’ sales still be considered in isolation from online? And can stores still be considered as pure points of sale?

Historically ‘standalone’ retail sales could be analysed using the following formula:

Sales = Footfall * Conversion rate * Avg. item price * Avg. quantity

Over the last few months, industry insiders have raised the alarm bell based on a drop in footfall and a very modest increase in average item price (see the clothing & footwear inflation chart above as an example) which have not been offset (yet) by a similarly significant increase in conversion rate (i.e. the share of visiting customers who end up making a purchase) and/or the average number of items per basket.

Unfortunately (or fortunately), one corollary of the previous answer is that this formula cannot be considered as valid any more. This is especially true in the UK where consumers buy more online per head than in other developed economies.

Today stores are increasingly considered as showrooms where consumers get to know a brand and its latest products, hence the refocus on prime locations. The trend is likely to accelerate given the progress made in ‘last-mile logistics’ as proved by Amazon or Ocado. Delivery from a warehouse to the end-customer’s house used to be complicated to plan and very often poorly (if not randomly) executed – actually it is still the case for the vast majority of retailers willing to enter the delivery space. As progress keeps being made in that space, we should see customers going to the shop to get information, then shop online and ultimately be delivered at their door or in convenient locations such as Amazon Lockers.

[to be continued on Thursday…]

Link(ed)In the dots

linkedin-and-microsoft-logosLast week Microsoft announced its intention to buy LinkedIn for a total consideration of $26bn. This is a big move, even bigger than the $22bn acquisition of Whatsapp by Facebook in 2014. The reason why I did not write earlier about it is that I was trying to understand the move. After a week thinking about it, I just cannot.

broken-linkedin
Credits: www.analyzingsocial.com

Well, for LinkedIn’s shareholders, the deal is hard to refuse: LinkedIn’s share price has been suffering since the beginning of the year as the market has become increasingly sceptical about the social network’s sustainable future growth rate. Worse, fundamental shortcomings have become more numerous and obvious: low user engagement (less than 25% of users connect more than once a month), unclear purpose (from networking the firm entered business news and professional education), struggling profitability (despite $3.2bn in sales, the company reported a negative net income of -$170m last year) penalised by low ad revenues (6 times lower than the ones generated by Facebook in the US) and a raising dependence on professional services as opposed to individuals (‘talent solutions’ now account for c.65% of the firm’s revenues, which will soon have a hard time justifying its ‘social network’ primary status). Microsoft’s offer, at a 50% premium over the pre-announcement share price, represents a godsend in that respect.

LinkedIn's share price evolution since 01/01/2016. Source: Yahoo Finance
LinkedIn’s share price evolution (in USD) since 01/01/2016. Source: Yahoo Finance

AAEAAQAAAAAAAAOIAAAAJGQzMGIwMWJmLTJlYjUtNDE2OC04YmE2LTkzZDJkNzJhZDhmMgTo justify this high price, Microsoft mentioned the competitive tension generated by the presence of Salesforce. One can never predict in advance how well an integration will work and to which extent synergies would have been delivered, but such a merger would have made more sense: the two firms serve the same purpose – i.e. connecting professionals, either individuals, marketers, recruiters or headhunters, in order to create business opportunities – and LinkedIn already integrates Salesforce’s Sales Navigator product. To close the loop, Microsoft made a $55bn offer for Salesforce last year, which was perceived as too low by the target’s Board of Directors.

In terms of valuation, LinkedIn’s forward PE ratio is one of the largest of the ‘web 2.0’ industry, only second to Yahoo! in the sample chosen below. This fact was true even before Microsoft made a move towards the ailing social network. Unfortunately, a forward PE ratio in the 40x+ area is a sign of perceived overvaluation, even for a tech firm – former holders of Yahoo! shares may not disagree on that one.

Price / Forward Earnings Benchmark using various LinkedIn share prices. Sources: CapitalIQ, Author analysis
Price / Forward Earnings Benchmark using various LinkedIn share prices. Sources: CapitalIQ, Author analysis

This deal is also haunted by Microsoft’s appalling track record in handling and integrating large acquisitions. Experts obviously have in mind the disastrous acquisition Microsoft did in 2014 when it acquired Nokia’s Devices and Services’ business for $7.3bn before writing-off almost the entirety of the acquisition assets less than 18 months later. At best, the Redmond firm managed to maintain a ‘status quo’, as it has done with Skype since 2011 – and questions about the rationale were already present at the time. As a consequence, Microsoft’s share price reacted negatively following the announcement – only a 2.6% drop, which nevertheless still represents $10.5bn of lost shareholder value.

Credits: www.cagle.com
Credits: www.cagle.com
Jeff Weiner
Jeff Weiner: a happy man

So why such an unexpected alliance? In terms of synergies, the pitch is not obvious either. Jeff Weiner, LinkedIn’s CEO, mentions in his email to staff that the deal will “massively [scale] the reach and engagement of LinkedIn by using the network to power the social and identity of Microsoft’s ecosystem of over one billion customers”. Not sure what that means beyond having Outlook download data from LinkedIn to give you information on people you will meet. More generally, and contrary to what the Financial Times may think, I doubt that Microsoft’s products, which are targeted at enhancing the work efficiency within organisations, will be able to gain much insight from LinkedIn’s vast amount of outside-in data.

Alternative hypothesis: is Microsoft betting on internal corporate networks? In-house social networks are indeed becoming increasingly trendy. Even McKinsey believes that social tools will help reshape the way businesses work in a number of ways – see chart below. But internal social networks struggle to gain momentum and more importantly LinkedIn is not one of those. Indeed, the tool is well designed to search for individuals working for a particular firm, but it is unable to tell you how the firm is internally structured.

Sans titre
Social tools carry a Prévert-style inventory of benefits

Another possibility is that Microsoft is trying to add content on top of its software offer. Social networks now represent the primary source of information for more than half of all online news consumers, and this trend comes with interesting ad revenues prospects attached. But LinkedIn is trailing Facebook or Youtube in that respect.

For me, the move was launched primarily to manage market perception. Microsoft is currently sitting on more than $100bn of cash & equivalents. This war chest cannot sit unused within the company for ever. There are only 3 solutions to that conundrum. One, Microsoft could pay hefty dividends as Apple did. The issue is that it would admit (as already highlighted on this blog) that Microsoft is running out of worthwhile investment opportunities. This is fine when you are Apple and sitting on hit products such as the iPhone, but much more worrying when you are Microsoft and holding onto an ageing operating system. Two, Microsoft could buy back some of its shares but this move would be uselessly expensive given that Microsoft’s shares trade near all-time highs. Three, Microsoft could pretend it is moving full steam ahead towards cloud computing, artificial intelligence and professional networking by making acquisitions. This is the path Satya Nadella and his team have chosen, a path similar to the one Marissa Mayer unsuccessfully led Yahoo! to, but targets in the space are scarce and, as the saying goes, “anything scarce should become expensive”. To make the bill more palatable, the acquisition is partly financed through debt which, given Microsoft’s AAA rating, represents a net cost savings – the tax shield amount more than largely offsetting the incremental debt interest costs.

Microsoft-LinkedIn-SlideShare
Credits: www.exoplatform.com

Although spectacular by its size, this acquisition strategy is not unique. Tech behemoths ‘of the past’ see that, after more than a decade of steady and healthy cash flows, the new wave of innovators, led by Facebook, Google and a tribe of unicorns, can in the relatively short-term jeopardise their business model. To fight against the new entrants, they cannot rely on their in-house innovation skills, which have aged together with the rest of the organisation. In a (final?) burst, they are now spreading their cash, hoping they will manage to integrate the right engines for future growth – think about Blackberry and its push in cybersecurity for instance. Massive war chests, overvalued (tech) stocks, cheap debt, ageing organisations: the perfect recipe for disaster and value destruction, sadly.

BSOD2