Hitchhikers’ guide to instant wealth

A penny saved is a penny earned. It is especially usuful when companies are struggling to generate higher earnings during recessions, when demand and market expension are scarce commodity. Fortunately, nowadays it only takes four letters to achive higher returns: WACC. (Weighted Average Cost of Capital)

Thanks to cheap credit many of the hedge funds and activist investors could buy firms (usually using some credit in the first place), replace some equity with cheaper loans, and get the money out of the company while earnings numbers have been boosted too.  However, higher leverage or gearing on the balance sheet should make the investment more risky and cheap, higher earnings and multipliers compensate for the effect. Veni, vidi, vici; too good to be true.

The eye-watering returns seen on stock markets recently are fueled by these takeovers, or as a metter of fact, why would the management wait until the takeover, they can initiate share buyback programs too. Financial engineering within and higher multipliers outside the firms.

Luckily, we can not say that the market went full nuts. The widening spread between equity and debt returns reflects the understanding of this situation, and also indicates some kind of market efficiency. But back to the original question…

Is this kind of financial engineering essentially wrong? Boosting the ‘wealth-effect’ or decreasing savings through buying back equity could be beneficial for a troubled economy. Could be…

The problems with the argument is that it is superficial. First of all, the majority of these shares are held by higher income classes, whose marginal propensity to consume is naturally lower. Secondly, the lack of interpretable interest payments demolish the effect of compounded interest.For example, since the low interest policy savings rate has actually risen in the US. Low interests not only increase the NPV of assets, but also liabilities… pensions for instance. Last but not least, the combined effect of the last two factors can easily lead to overvaluation (let’s not overuse the ‘B’ word). After the buyback it is plausible that our investor would like to buy more shares using the returned money. The real economy would not see a dime before the prices of financial instruments are over the roof.

Why is it important now? Recently the S&P 500 buyback index once again surpassed its older brother. With a US fiscal expension on the horizon monetary policy could pass the baton to the fiscal policy, and switch into tightening mode. Taking away the punch-bowl would certainly hurt today’s valuations and ratios. There are no instant riches, and there is no free lunch. The tailwind of cheap credit can easily turn into a headwind.

 

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Arithmophilia

Investors got really excited about Trump’s fiscal policy proposal lately. It seems that the 30 years of bond bull market might reach its end, or at least take a break, as investors started to dump bonds on higher inflation expectations. While global central banks tried to generate economic growth and higher inflation for years now, they might not be satisfied with the outcome.

Alright, lets see the facts first. Real money supply doubles since the Great Financial Crisis, mainly due to QE programmes, partly to higher money demand on behalf of households, and deleveraging of the advanced economies. Meanwhile, output gaps are closing. However, overall demand is still sluggish, rather the lack of investments, demographics, and human capital depreciation contributes to a lower potential GDP level and narrowing the gap. One way or another, extra capacity shrank in the economy, easing deflationary pressures, which isn’t homogen in the first place. For instance just take a look at housing, education, or health care numbers.

Subsequently, on top of all of this, comes the new fiscal stimulus, promising infrastructural developments (roads, bidges, The Great Mexican Wall, etc.), and tax cuttings. Eight years after the GFC, economy at full employment, output gaps shrinking. However, one shouldn’t be blinded by the macro picture, the manufaturing sector (consisting of many of the new President-elect’s supporters) still struggling with a production slack. The sector still recovers from cyclical(?) unemployment, low labour force participation rates, and high overcapacity.

Although the fiscal spending could consume much of this overcapacity, benefiting the sector, but again, the rest of the economy is running on (nearly) full steam. The spillover effects would just increase the prices through economic bidding, but wouldn’t bring any significant amount of new products on the market in the short run given the constraints. In real terms manufacturing workers would bring less home, which would certainly increase employment, but the overall sector would almost certainly be worse off. The already working people would give up more than the new entrants earn.

Conclusively, the policy can more than easily end up harm the economic interests of the people it aimed to help, and could cause a spike in short term inflation number, since the rest of the economy is facing constraints. Or maybe I totally misunderstood the new policies intention, and it only wants people to look at nice big numbers.

Capacity and despair

After Brexit the big money got it wrong again, and mispriced the odds of a Trump victory. The primary reason is that betting odds are ‘not democratic’, if one has ten times the money as the average it takes ten others to even up the odds. However, during the election/referendum the rich guy will still only worth one, he might be enough to give a false impression about chances and ‘public opinion’.

“How could this have happened?” millions asked around the world after the results came in on the 9th of November. My short answer: capacity constraints.

Since the dawn of time and economics the workers had to compete with technology. Don’t get the wrong idea, this has nothing to do with capitalist institutions, or free trade, nor modern economics. There is only one ultimate goal here: produce more with the least possible effort made. Wheel, plow, sails, spinning jenny, just a couple of capital instruments which made tens of thousands people’s labour redundant (and the individual more efficient), but, over time, this spare capacity can be used in other sectors of the economy. Unfortunately, this restucturing and retraining can not happen overnight.

That was the capacity part, now lets see the constraint. Because of certain compensating effects capacity gains have to be mean reverting over time. If there is a sudden change in technological progress and the structure of the economy the pool of workers contributing will shrink rapidly, compensating for the efficiency gains. Redistribution will become more problematic, and the redundant workforce will advocate the return to the old world order.

This helplessness and despair are surfacing on nowaday’s political stage, and it seems to be gathering momentum, even if the idea goes against centuries of economic progression.

Between a rock and a hard place

Following the result of Brexit referendum in June the Bank of England did not hesitate to implement further steps in monetary easing (further in the meaning of additional to already loose conditions after the great financial crisis). The pound, already nose-dipping to multiyear lows, fell further, stemming inflation in prices denominated in pounds.

The spiking inflation got Britain into an interesting situation. While the rest of the world is struggling with zero lower bounds of nominal rates in order to lower the real rate, the British economy has the inflation card, which (given the constant nominal policy rates) can lower real rates and support business investment. However, even with lower real rates, incentives to invest in an economy potentially losing its passport to the world currently biggest free trading bloc are deteriorating. I believe the main driver of business investment will be the conditions of access to the single market and/or the availability of labour, not the rate of interest in the upcoming years.

On the other side though, low real rates and spiking inflation could harm consumption. First of all, as the referendum result ‘came out of the blue’ with financial markets not pricing it, higher inflation erodes real savings, resulting in a higher propensity to save in the long run to make up for the loss in retirement savings for instance. Secondly, higher inflation adversely affects real income. During the recent weeks several other journals, blogs, and articles argued that increasing price levels would hurt real income, hence depressing the engine of growth: consumption.

Even though, it is difficult to argue against the conclusion that higher inflation has a gross negative effect on real income, since the terms of Brexit are still unknown, I think it is a bit premature to make a call on future real income trends. Labour demand depending on business investments, and supply influenced by immigration are just as crucial in determining real wages as inflation rates. Consequently, we are dealing with (gross) negative influence on consumption, and positive on business investment, but the big question mark is still there regarding the eventual terms and conditions of Brexit.

Given that consumption accounts for 60 percent of GDP in Britain (making it one of the least open economies among G7) one should keep a keen eye on real rates and currency movements. Since British people voted for isolation future economic planning should primarily focus on keeping domestic purchasing power high. In today’s business environment, where nominal yields are scarce, a small increase in policy rates could suffice to support the pound, without making credit terms significantly worse. Dealing with such circumstances and uncertainty it is not straightforward whether easing or tightening monetary conditions would benefit the economy on the long run.

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