Whiskey and Car Keys
April 12, 2021
The following is the text of an article submitted to Australian Financial Review – albeit with a title added by us. We do this on a regular basis, but since it is behind a paywall many of our readers can not see it and so we reproduce it here. The AFR article will have been edited, so this is a ‘rougher’ version (as well as slightly longer)
Whatever one thinks about the wisdom or otherwise of the official response to the Coronavirus, one thing is certain, we have seen a structural shift in monetary and fiscal policy and this has extremely important implications for savings and investment everywhere. Put simply, the concept of Modern Monetary Theory, where there is seemingly no limit on the amount of money governments can print and their central banks can buy, has become (un)official policy and all asset prices are having to adjust. Bonds, rightly, are worried about inflation, while commodity prices and the equities and credits that are exposed to them are also having to recalibrate their pricing power as well as their potential sales and margins.
When assessing potential inflationary pressures, we like to think of the economy in terms of its four key sectors; the household, corporate and government sectors and the financial sector that facilitates the cash flows between them and also, crucially, enables them to expand or contract their balance sheets. For it is balance sheet expansion that creates an imbalance in supply and demand (banks create money but no offsetting goods and services) and hence where demand exceeds supply prices move higher. Ever since the creation of Consumer Credit in the 1920s and widespread mortgages in the 1960s this has tended to be a household sector phenomenon and where expansion has been too fast, consumer price inflation and particularly real estate prices have responded accordingly.
Not surprisingly then, managing household credit has been a primary focus of central banks. In doing so they have rather neglected the expansion of Corporate sector credit – which tends to produce some volatility in the business cycle – and expansion here has periodically led to inflation in the things that corporates buy with their ‘free money’. Real assets obviously, but also other corporates and, indeed, their own equity as well, a recent and somewhat egregious habit among US corporate executives. Of course, since the GFC the Financial Sector has been expanding parts of its own balance sheet with widespread carry trades in fixed income as well as the creation of a wonderwall of complex, leveraged structures that in many cases seem more about the fees generated for the bankers than the returns generated for the investors. In this they have been very much helped by the risk management industry declaring that anything with low apparent volatility and/or low correlation with equity markets is ‘alternative’ and thus lower risk. Never mind leverage, liquidity or credit risk, or indeed the fact that a portfolio of private equity, private credit, leveraged loans and other ‘alternatives’ may all actually be exposed to a very narrow group of underlying corporate balance sheets, the ‘models’ say they are low risk and should be bought.
The same precautionary principle that is seemingly driving Public Health Policy toward Zero Covid has been driving Public Pension Policy to Zero Returns for a decade or more.
The quarter ended with both the collapse of Greensill and its leveraged products as well as the blow up of the Family Office run by Tiger Alumni Bill Hwang, who appeared to have been using regulatory loopholes such as being deemed a family office rather than a hedge fund that allowed him to not only avoid appearing on share registers, but by the use of swap markets with banks to establish enormous, but apparently hidden leverage. These will not be the last, and one positive aspect of the shift in power to the government sector will be an increased focus on some of the more ridiculous structures and products being mis-sold to investors. Less positive however is that having been given the keys to the proverbial Candy Store, politicians will not be giving them back in a hurry. The US increased fiscal spending by $3.2trn last year and this year has already announced a further $1.9trn of Covid ‘relief’ and a further $2trn for ‘infrastructure’. Unlike QE, which allowed the Financial Sector to expand its balance sheet but where much of the cash has been ‘hoarded’ or only led to inflation in the Financial Sector itself, this fiscal expansion is money that will go into the real economy and it will cause shifts in pricing power, ie inflation as a result.
Two obvious areas are commodities – and here Australia has experience of when China chose Fiscal expansion with the 2009/10 initiatives on housing and domestic infrastructure followed by the One Belt One Road initiative – and the Medical and Military Industrial Complexes. A third one is what we are starting to refer to as Bread and Circuses. After a year or more of furlough, the concept of something approaching a Universal Benefit or Universal Basic Income is gaining traction among many politicians and the places where that ‘free money’ is spent will also likely see prices rising.
The conclusion has to be that with Governments finally generating inflation there is little room for fixed income assets that yield less than equities and in particular less than those able to insert themselves in the expenditure pipeline coming from Governments giddy with free money.