Quitting equities or bonding to bonds? Conundrum for asset managers

In this blog we have already touched on the debate between so-called ‘active’ and ‘passive’ investment strategies. For vehicles investing in public securities, another debate lies in the choice of the asset class mix between equity and bonds.

 

What is the core trade-off between equity and bond?

Credits: Tectona Partnership

If we go back to corporate finance theory, this choice represents a trade-off between risk and expected return for the investor:

  • Bonds are generally safer (because they are repaid first in case of financial distress) but upside is capped in case of great performance as the lender is promised a fixed coupon which is set ‘once for all’.
  • On the other hand, equity holders capture all the upside if the company overachieves but are the first to get swept if the company goes under.
Historical returns for S&P500 (annual and 5-year trailing average) and 3-month US Treasury bills. Source: Aswath Damodaran, NYU

Historically equity returns have tended to be more volatile than bond returns – which reflect the risk that security holders bear. For a particular year, it is difficult to predict which class will perform best, although equity tends to offer a better return when considered over a sufficiently long period of time – equity investors are rewarded in the long-term for their acceptance of short-term risk. This phenomenon is captured in corporate finance theory by the ‘Capital Asset Pricing Model’.

An illustrated summary of the CAPM principles

 

Why is this debate making headlines again?

The general public and the asset management industry have reignited for a few months now. Today’s environment offers a mix of extremely low interest rates (UK 10-year government bonds yield less than 1.5% p.a.) and the lack of worldwide economic growth (3.4% in 2016 according to the IMF’s latest forecasts). In that context asset managers struggle to deliver satisfactory net returns to investors – who claim that the meagre returns they could get are almost entirely eaten by management fees.

Furthermore US market indexes all reached all-time highs over the last quarter, which has led investors to believe that the inflection point is approaching. Money has been fleeing equity funds to feed the bond market. The fact that some governments and even companies manage to borrow at negative interest rates only means that investors are ready to take a ‘sure, but small’ slap rather than risking of being hit much harder by leaving their money naked in the unpredictable turmoil of equity markets. In September BlackRock was estimating that $10trn of cash was earning a negative yield while $70trn was staying ‘on sidelines’, waiting for worthwhile investment opportunities.

Historical evolution of S&P 500. Source: Yahoo Finance

Low interest rates are also becoming problematic for ‘defined benefit’ pension funds, which guarantee a certain amount to their contributors. Those guarantees are based on assumptions regarding the evolution of interest rates, inflation, stock market performance etc. whereas the future promises are set in stone. Given the compounding nature of interests, a small drop in interest rates relative to expectations translates in billions of pounds of deficit: £710bn to be precise, according to a recent PwC report quoted by The Guardian.

 

How are investors reacting?

As explained above, to maintain a similar level of expected returns in an environment offering diminishing interest rates, investors need to take on more risks. In particular, following the 2008 crisis financial services regulators have forced banks to withdraw from riskier types of lending (taking the form of ‘high-yield bonds’) and this void is now filled by asset managers ready to finance more financially fragile companies in exchange for a decent return.

More risks from the same expected return, as explained by the CAPM

This obviously does not go without bad surprises. Lenders to the energy sector for instance took a hit earlier this year as commodity prices have suffered ups and (more often) downs.

 

If bonds are such a safe heaven, why are we hearing about a ‘bond market crash’?

Interest rates in developed economies have been running close to 0 for years now. As explained earlier, asset managers have massively bought bonds maturing in years in order to protect their capital. Although interests are indeed protected, the market value of the bond may be at risk if interest rates go up again – a move that the US Fed has already initiated.

To be clearer, let us assume you buy a bond (called ‘Bond A’) for $100 in order to get an annual (fixed) coupon of $1 for the next 10 years. Let us also assume that immediately after you purchase this bond the interest rates go up by 1% and that now for $100 you have a bond (called ‘Bond B’) paying an annual (fixed) coupon of $2. If you try to sell Bond A in this new environment, you will never receive an offer close to $100 – why would an investor pay the same amount to get a $1 coupon and a $2 coupon? In simplistic terms, the yield difference is approximately $1 over 10 years, i.e. $10, so you should expect this $10 difference to be reflected in the initial purchase price. If Bond B is still worth $100, Bond A will now trade around $90, i.e. you will suffer a c.10% loss on your investment.

If you scale this phenomenon up, it is easy to imagine that asset managers do not want to be left with their bonds when interest rates move up. As Central Banks start quivering, investors are preemptively selling their bonds, lowering the value of the existing bonds and possibly precipitating the collapse of the bond market even before Central Banks begin to move – one of the numerous ‘self-fulfilling prophecies’ that markets contain. In this case the situation would be even more difficult to stem as the market for bonds is significantly shallower and therefore more unstable. Although we have not come to this extreme (yet?), the fact that debt trading now represents the largest profit driver for banks should make us think.

 

How will this all end up?

Credits: www.digital-reporting.com

Unfortunately no one knows. Optimistic experts believe in a soft landing where fiscal initiatives would revive economic growth (‘a la Trump‘) while interest rates would go up, progressively drying the excess market liquidity and enabling the markets to come back to more normal levels in a seamless manner. Pessimistic observers do not believe in such a smooth transition and believe that painful losses will have to be taken and bankruptcies will be unavoidable. What is sure, though, is that the world we are evolving in is uncharted territory.

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.

flower
Credit: www.ericnguyen23.com

Olympic Games – Small is not beautiful

Olympic-logoThe Olympic Games came to an end a little bit more than a week ago. Beyond the last-minute logistic annoyances, the United States showed the rest of the world that one more time they were dominant in the Olympic arena. Good surprise came from team GB, which benefited from years of investment and the partial ban of the Russian delegation to clinch the runner-up spot. On the other end of the rankings, almost 100 countries will fly back with no medal.

The question is what is the best predictor of a nation’s performance at the Olympics? First, we need to be clear about what we mean by ‘performance’. Limiting myself to countries which have managed to take a medal home, I have used the official medal table and I have allocated 5 points for a gold medal, 3 points for a silver medal and 1 point for a bronze medal – I could have used the gold medals only but this would have created an ‘edge effect’ as many countries have won no or very few gold medals. The official ranking (taking only gold medals into account) is largely preserved: only exceptions in the top 10 are France (with its famous ‘fear of winning’) and the Republic of Korea.

Points ranking according to our methodology.
Top 10 countries according to our methodology.

We can use a few macroeconomic indicators to assess whether they are correlated to the success of a given country. It is important to note here that a regression only enables us to conclude about the presence or absence of correlation and not about the presence of a causality effect. For instance, if we plot population on the X axis, we see that the bigger a country is, the more medals it tends to gather – with the notable exception of India, circled in red, whose poor performance has been largely documented throughout the event. So what we can conclude is that there is a correlation, but we cannot state that ‘a higher population leads to a higher number of medals’ (which is nonetheless probably true) or that ‘a higher number of medals leads to a higher population’ (if so we would have baby booms in the US every 4 years).

Regression log(population) (X) - log(points) (Y).
Regression log(population) (X) – log(points) (Y).

The Economist argues that the most significant driver is actually GDP. The correlation effect is also significant.

Sans titre
Regression log(GDP) (X) – log(points) (Y).

What it means, interestingly, is that GDP per capita correlates poorly with the ultimate country performance – contrary to what the same Economist article may assert. The nominal sizes of the economy and of the population thus prevail. This is understandable: more money overall tends to mean more investment in infrastructures, training etc. However, we would need to dig further as wealth created is not evenly allocated to the development of sports in each country.

Log(GDP per capita) (X) - log(points) (Y)
Regression log(GDP per capita) (X) – log(points) (Y).

Goldman Sachs performed a forecasting exercise using its proprietary Growth Environment Score (GES), which captures “important features of the economic, political and institutional environment that affect productivity performance and growth across countries”. Simply said, Goldman Sachs uses a multi-variable correlation instead of relying on one macroeconomic driver as we have done so far. The algorithm grants extra points for the last two hosts (i.e. Brazil and the UK) to acknowledge the important investment and support of the crowd. The accuracy obtained is remarkable.

Sans titre
Number of gold medals for top 10 countries: Goldman Sachs forecast vs. actual.

In its paper, Goldman Sachs states that “a country is more likely to produce world class athletes in a world class environment”. I took the statement seriously and checked for a correlation between the number of medals and the Human Development Index, which accounts for human well-being beyond economic considerations by including data on life expectancy and education, among other factors. A high correlation would be fantastic news: sports excellence would be a ‘by-product’ of the improvement in life standards. The result can be found below.

Regression HDI (X) - log(points) (Y)
Regression HDI (X) – log(points) (Y)

Although we could advocate for a slight correlation, the effect of human development remains limited compared with the one of money. This conclusion highlights a fact that is widely shared throughout the sporting world (including football, which we will deal with in a later post): human effort alone only returns sweat, but only with a wallet will it be worth its weight in gold.

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…]