Central Bankers need to talk to Equity Analysts about Balance Sheets
August 26, 2022
The article below is a slightly extended version of one posted on the Livewire site, that can be found here
The Annual Central Banker jamboree at Jackson Hole this weekend is likely to feature the usual set of earnest presentations about Growth and Inflation and the need to ‘control inflation expectations’, ignoring the proverbial elephant in the room; after a decade of QE and Zero Interest Rate Policy (ZIRP) that failed to produce high street inflation (though plenty of asset price inflation), do we really think that the current inflation problem was either suddenly due to this policy, or more importantly that it can be ‘cured’ by reversing this policy? More important than this is the question “Will our response actually make things worse?” Sadly, the answers are ‘No’ and ‘Yes’.
The big problem with most central bank policy is that it is based on econometric modelling, which is basically a fancy way of saying ‘I remember last time’, which is fine as long as all the variables stay the same – which of course they never do. Moreover, the ‘last time’ tends to be from a country (usually the US) and a period (the last 50 years) which is almost certainly no longer relevant or appropriate for the country in question, let alone for the whole ‘West’ to move in lockstep behind the Fed. A more sensible approach (in our view) would be to look at the impact of changing interest rates on an economy in the same way an investment analyst does when looking at the effect of changing interest rates on the free cash flow of a company. In doing so they ask three simple questions that Central Bankers appear never to do:
- How much debt is there on the balance sheet?
- Is it fixed or floating?
- When does it need to be refinanced?
In answer to the first question, there is no value in looking at the average debt over the last five years, what matters is the balance today. Obviously if it has materially changed, then the impact of changing interest rates on future cash flow will also be very different. Imagine the reaction if an investment analyst based their cash flow forecasts in response to changing interest rates not on the actual balance sheet, but on the average sensitivity over the last 30 years of companies in the same sector, but in a different country? Similarly with the second question and indeed the third, the risk to the enterprise and its cash flows is dependent on that balance sheet structure.
In economic terms this is extremely important, because the West has accumulated enormous amounts of household mortgage debt over the last fifty years and while in certain countries, notably the US, this is long term and fixed rate, in many other countries, most obviously the UK, Australia, New Zealand and the European countries that were grouped as the PIIGS (Portugal, Italy, Ireland, Greece and Spain) it is largely floating rate, or short term fixed that will need refinancing. They are thus far more sensitive to changes in rates – either than the US, or than they themselves have been in the past. As such, each of the central bankers should be asking the three questions with respect to the current situation in their own economy. Except of course they won’t. The groupthink and the faith in the models is too great.
In the UK for example, there is GBP1.6trn of mortgage debt outstanding, but the official statistics from the FCA don’t even discuss the fixed v floating ratio and the data seems very hard to find. Apparently most mortgages are fixed, but they are usually less than 5 years, many below 3 years and the latest data does show almost 30% of new mortgages being remortgages, suggesting a reasonably short duration ‘book’. A quick back of the envelope calculation suggests that 5 year mortgages taken out 5 years ago would jump from 2.1% to 3.2%, 3 year mortgages taken out 3 years ago would jump from 1.5% to 3.25% and similarly 2 year mortgages taken out 2 years ago would jump from 1.86% also to around 3.25%. The current Standard variable Rate they would otherwise face as their fix rolled off would be around 5.25% (!) At a current refix, the jump would be equivalent to around GBP17bn in extra mortgage payments – equivalent to around 5% of total UK disposable income.
The best thing the Central Bankers could do this weekend is to learn from the investment analysts and look through the lens of the balance sheet to assess potential impacts of their policy on cash flows. Had they done so previously they would have had early warning of the housing booms in all the countries listed above as they chased the Fed ever lower, as well as the busts that followed when they raised rates again. An important aside is that the US can refinance their mortgages as rates fall – and thus benefit from better cash flow – but are protected when they rise again. Thus, as is now happening, the US household will be largely protected from Fed policy, while many in the rest of the West will not be. Following the Fed has asymmetric payoffs.
More broadly, Politicians and Policy makers beyond the Central Bankers should also adopt the framework of the Investment Analyst and consider the metric of EV/EBITDA in the context of free cash flow and the impact of all policy on growth. EV, stands for Enterprise Value, which is defined as market cap plus net debt, with the important lesson that if you add debt to the balance sheet, your overall Enterprise Value will only rise if that debt is seen to be enhancing future cash flows – if not, your market cap will fall by an amount greater than the debt. You can invest, but can’t simply borrow, your way to prosperity. Second, EBITDA, is the total Earnings Before Interest Tax and Depreciation, the cash flow available to meet the costs of running the business and, while it is the appropriate denominator for assessing a company in the light of its balance sheet, we should not lose sight of the fact that both interest rates and tax are deducted and that free cash flow (or in economic terms disposable income) is only after these variables are taken into account. As such, with one side of government raising taxes and the other raising interest rates, the impact on disposable income or cash flow will be significantly greater than the models might suggest.
The bottom line, as the academics gather in Wyoming, is that by applying a standard, model driven approach to a widely disparate set of national balance sheets they risk, once again, imposing completely inappropriate policy on a number of economies, when a simple, investment analyst, indeed banking, approach to the problem would be so much better. For investors, the lesson is that the economies – like the UK and Australia – where the balance sheet is the most vulnerable to changing interest rates are the ones that will be hit hardest by the next round of central bank mistakes.