Tuesday, 25 September 2018

Time to face the music

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ON AUGUST 8 2007, BNP Paribas, France’s biggest bank, halted withdrawals from three investment funds because it couldn’t, so it declared, “fairly’’ value their holdings after US subprime mortgage losses. It was, most market participants would agree, the admission that marked the beginning of the global financial crisis from which we have yet to fully emerge.

Sure, the global economy is growing again, banks’ balance sheets – in as much as they are transparent to the casual observer – have been restored to something approaching health, and stock markets are making new highs by the month, if not the week. And yet, among more seasoned players, there is a deep sense of discomfort. Fed Funds at near zero, the ECB’s main refinancing rate at 0.05%, the UK’s base rate at 0.5% and the BOJ’s overnight call rate at 0.1%? None of them look right – or, at least, don’t feel right.

When the Federal Reserve first cut the Fed Funds target to zero in December 2008, I asked somewhat rhetorically how one would value a future cashflow when discounted over zero. Nobody ever came up with a proper answer – there isn’t one. An environment had been created in which most models used to establish fair asset values had gone out of the window.

THE ISSUE OF fair value not only affects equities. Not so long ago, two thirds of European government bonds were trading with a negative yield. You can, if you wish, spend the next two hours trying to explain to me how and why this came about, but I will still never really be able to understand why anybody would want to pay a borrower, even the German government, to lend them money and what right a central bank has to not only permit but to encourage such ridiculous behaviour. Thus, in their endeavours to avert whatever it is that they want to avert, our central banks have created an investment environment which makes no sense to simple minds such as my own.

Roaring prices for financial assets do nothing to encourage investment in plant and machinery, irrespective of how cheap it is to borrow. If a CEO’s comp package is driven by stock price performance – and he knows he only has a short time in the job – how can one blame him for going for broke, even if it means leveraging the balance sheet to the ying-yangs to raise money to pay for stock buy-backs? Borrowing money to buy back shares? Explain that to Mork from Ork. We might have become accustomed to the ubiquitous share buy-back game, but that doesn’t make it right.

We might have become accustomed to the ubiquitous share buy-back game, but that doesn’t make it right

ONE WAY OR another, financial assets have been on steroids for most of the past 15 years. It was not until long after the drugs were withdrawn between June 2004 (when Fed Funds were at 1%) and June 2006 (when they peaked at 5.25%, after 17 consecutive FOMC meetings at which rates were increased) that we ended up with a crash, the likes of which had not been seen in three-quarters of a century. The antidote became what we now know as ZIRP.

HANG ON … DID it really take from June 2004 to June 2006 (and 17 rate rises, which increased rates by 425bp) to bring markets to their knees? Yes it did. If so, why are we panicking about the prospect of a 0.25% Fed tightening in September? The answer is simple: we’re not scared of the rate hike, we’re scared of what it might tell us about the value of financial assets.

The extremely low rates have not only driven equities higher based on the effect they have on discounted cashflows, but they have also led to defaults in credit markets falling fairly consistently, thus creating a world in which nobody defaults and in which the skill of appreciating and the art of pricing of credit risk has been lost.

Cheap credit, low-yielding government bonds and expensive equities have all been knowingly engineered by central banks, and investors fear that one rattle of the rate tree might quickly see the monkeys drop. That’s not good. What is more troubling, though, is that it seems that the central banks themselves are fearful of what mayhem may ensue during early-cycle tightening. In 1994 it went horribly wrong but in 2004 it didn’t. Compare and contrast?

DURING THE 24-month tightening cycle from 2004 to 2006, the S&P ultimately rose by around 11.5 %. The difference back then was that the markets were still governed by their own demand and supply and were not forced down blind alleys by monetary authorities who will do anything they can in order to keep the blinds closed. During the same period, incidentally, 10-year Treasury yields rose from 4.64% to 5.13%, which is just over 50bp and not a lot in the greater scheme, especially when held up against an increase in the front end of 4.25%.

It might be fatuous to compare the normalisation of rates following the post-9/11 slashing by the Fed, but there was an air of certainty and confidence in the way it acted. Now there is fear on all fronts. There is, so we are told, nothing to fear but fear itself. That fear, however, is palpable and to me it seems that those most scared of what lies ahead are the central banks themselves, which have spent so much time intervening in markets. Relative to the financial efforts they have made, the results in terms of hard economic impact have been fairly modest. Thus, no doubt, the fear of what awaits if, as and when stimulus is withdrawn.

Sooner or later the Fed and its peers will have to hand back the pricing of assets to the market. Let us hope that it happens before the last of those who remember how it is done have given up in despair and retired.

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