Pouring fuel on the fire

Schroders Martin Conlon March 2021

“I got chills, they’re multiplying and I’m losing control; Cause the power, you’re supplying, it’s electrifying."

I’m not sure Philip Lowe conjures the same sort of image as John Travolta, but for the central bank doves in command around the world, "You’re the one that I want" may well have been the theme song of bond investors for the past decade.

Whether central banks really are "losing control" is now pivotal, as monetary manipulation has undoubtedly been the electrifying force behind asset prices. Observing the importance of bond markets and the inflation outlook for equity markets is straightforward. But as the RBA pours petrol on an out-of-control property market fire, while talking about "output gaps," a desperate need for inflation and the role of monetary policy in creating jobs, one can’t help wondering whether the credibility earned over many decades is close to breaking point.

It is perhaps unsurprising that equity markets have mimicked the pattern of ever greater enthusiasm in bringing forward tomorrow’s returns.

Policymakers are trying to hold together the specious narrative around easy money creating "jobs and growth" rather than just shifting wealth around. At the same time, equity investors justifying ludicrous valuations for businesses promising revenue growth and profits in the distant future have hitched their horses to the same wagon.

The recent sharp sell-off in bonds has been and will doubtless continue to be met by ever greater intervention, removing any remote possibility of central bank balance sheets ever normalising. It will also ensure price distortion remains the order of the day, further spreading the yield curve and infecting all other assets that have traditionally relied on bonds as a benchmark against which to price.

Importantly, losing credibility and trust tend to have important ramifications when they are the basis for the financial system. Increasingly wild fluctuations in just about all assets highlight the scale of the challenge in operating a global price-fixing scheme. Amcor and Visy executives meeting in the pub to hold up the prices of cardboard boxes, as they did in days gone by, will be child’s play in comparison.

As corks in the manipulated financial market ocean, banks have recently drifted in the right direction. Results were solid, spurred by net interest margins beginning to recover and evaporating COVID-driven bad debt charges. Share prices duly followed the earnings trajectory, with most recording solid gains, albeit with CBA relinquishing some of its strong share price performance advantage over more accident-prone peers.

Our consternation over how current conditions can prove sustainable has driven very cautious positioning in the sector. In attempting objectivity across all sectors from a sustainability standpoint, we have no idea why pumping another $100 billion of additional lending each year almost solely into unproductive house price gains to foster increasing inequality should be considered differently to fossil fuel usage.

Our thinking and valuations have always been premised on the assumption the periodic losses which banks suffer as a result of making poor loans are the primary deterrent to poor lending behaviour.

Removing the losses removes the deterrent. Bank share prices have become ever more dependent on house price direction given the heightening proportion of loans deployed against the sector. Rising house prices equals safer loans. Depositors, via the RBA, are effectively being forced to provide free capital to enable borrowers to purchase some of the world’s most expensive houses. This assumes that ridiculously low mortgage rates will permit borrowers to service the debts, with resale offering the only realistic prospect of repayment. In this scenario, it seems unwise to extrapolate these current circumstances into perpetuity. As a strategy for sustainable policymaking, this seems to resemble the abandonment of renewable energy in favour of large-scale coal-fired power stations.

The recent New Zealand government requirement for the Reserve Bank to consider house prices in setting interest rates suggests that not everyone believes the "three wise monkeys" approach to policy setting is sustainable.

In this environment the reaction to the sale of ME Bank by its industry fund owners to Bank of Queensland was interesting. Our learned bank expert expected investors to look no further than the claimed earnings accretion. This is despite the fact the business was acquired in an auction process at a price above net tangible assets and, like nearly all smaller banks (including BOQ), had struggled to make anything more than mediocre returns for some years despite benign bad debts. More cynical observers thought investors might perhaps be sceptical of claimed synergies arising from the familiar path of provisions created via acquisition accounting. These synergies were delivered only on presentation slides and combined with ongoing adherence to a business model that involved:

  • being a relatively high-cost provider of commodity housing loans via mortgage brokers,
  • no new products, and
  • mediocre technology.

Learned expert 1; Cynical fund manager 0.

Elsewhere in earnings results, the task of separating the durable from the transient remained challenging. Earnings outcomes were for the most part solid. But with extensive JobKeeper payments being channelled directly from taxpayers to shareholder dividends (hard to believe the average nurse is pleased to be making a charitable contribution to the Solomon Lew retirement fund!), and revenue growth rates substantially distorted, using the 2021 financial year as a base from which to forecast will likely be unrewarding. These distortions should provide above-average levels of opportunity in the coming months and years, as those focused on earnings momentum investment are thrown a much higher than average percentage of curveballs.

The ever-greater doses of manipulation that will be justified in holding together a financial system that has lost most connection with the real economy (the bit that actually matters) seem likely to create ongoing, not to mention potentially violent, mood swings. It is always useful to remember that ongoing RBA bond purchases are just turning the bonds someone used to own into cash. In turn, this cash floods the banking system and is mostly redeployed into investment assets such as equities and property, not taken down to Bunnings.

Seeing a rise in bank deposits doesn’t always mean hard-working wage earners have tucked away more of their salary. The inflation these actions create still seems to us to be far more likely to be of the asset price variety as making cash an ever more painful investment just pushes holders into other avenues. This is incredibly damaging to the extent it drives vast wealth transfers and perverted incentives without anything like the fairness and accountability of the tax system. But it seems unlikely to drive much higher goods prices or wages.

The already vast scale of these experiments means it is virtually impossible to determine the scale of the bubbles which emerge, although it seems likely the price fixers are creating an ever more challenging game of ‘whack a mole’ in keeping things under control.

Ludicrous valuations for loss making technology businesses and Bitcoin are examples of the sort of ‘investment’ that these policies foster

The temptation of the government to take advantage of this free money and run ever-growing deficits seems far more likely to stoke the inflation fire. We don’t know but we’re watching closely.

While we may not relish the artificiality of the environment, the nonsensical overconfidence which some investors are implicitly placing in their ability to forecast the distant future (necessarily accompanying ‘valuing companies’ on revenue multiples, TAM (total addressable market) and the like) and the obviously frothy environment in searching for a fast buck, means more mundane businesses continue to trade at normal (but generally not depressed multiples). Many investors, large and small, are succumbing to the frustrations of missing out and the discomfort of maintaining discipline. This is unfortunately the anatomy of bubbles. As ever more investors join Australia’s version of John Travolta on the dance floor, the best opportunities aren’t right under the disco ball. ‘Stayin Alive’ may be more important in the future!

| A superpower torn down the middle cannot return to business as usual. And when the most powerful country is so divided, everybody has a problem - the geopolitical recession can only intensify |