Uber’s IPO next month is set to effectively “ring the bell” at the top of the post-2008 equity bull market on Wall Street. True, it is now expecting to be valued at a “bargain” $91bn, rather than the $120bn originally forecast. But as the Financial Times has noted:
“Founded in 2009, it has never made a profit in the past decade. Last year it recorded $3.3bn of losses on revenues of $11bn.”
And Friday’s updated prospectus confirmed that it lost up to $1.1bn in Q1 on revenue of $3.1bn. In more normal times, Uber would have been allowed to go bankrupt long ago,
So why have investors been so keen to continue to throw money at the business? The answer lies in the chart above, which shows how debt has come to dominate the US economy. It shows the cumulative growth in US GDP since 1966 (using Bureau of Economic Analysis data), versus the cumulative growth in US public debt (using Federal Reserve of St Louis data):
- From 1966 – 1979, each dollar of debt was very productive, creating $4.70 of GDP
- From 1980 – 1999, each dollar was still moderately efficient, creating $1.20 of GDP
- Since 2000, however, and the start of the Federal Reserve’s subprime and quantitative easing stimulus programmes, each dollar of debt has destroyed value, creating just $0.38c of GDP
After all, if one ignores all the hype, Uber is just a very ordinary business doing very ordinary things. Most people, after all, could probably run a serially loss-making taxi and food delivery service, as long as someone else agreed to keep funding it.
Yes, like the other “unicorns”, it has a very customer-friendly app to help customers to use its service. But in terms of its business model:
- When one takes a ride with Uber, the driver often also drives for Lyft and for the local taxi firm, and her car is often also the same car
- This means that in reality, Uber’s main competitive advantage is its ability to subsidise the ride or the food bought via Uber Eats
DEBT HAS CHANGED FINANCIAL MARKET BEHAVIOUR
This addiction to debt on such a scale, and for such a long period, has changed financial market behaviour.
Nobody now needs to do the hard graft of evaluating industry dynamics, business models and management capability. Instead, they just need to focus on buying into a “hot sector” with a “story stock”, and then sit back to enjoy the ride. The chart above from Prof Jay Ritter confirms the paradigm shift that has taken place:
- It highlights how 80% of all IPOs last year were loss-making, compared to around 20% before 2000
- The only parallel is with the late 1990s, when dot.com companies persuaded credulous investors that website visits were a leading indicator for profit
Like other so-called “unicorns with $1bn+ valuations, today’s debt-fuelled markets have allowed Uber to raise money for years in the private markets. So why has Uber now chosen to IPO, and to accept a valuation at least 25% below its original target?.
CORPORATE DEBT IS INCREASINGLY FUNDING STOCK BUYBACKS TO SUPPORT SHARE PRICES
The above 2 charts from the Wall Street Journal start to suggest the background to its decision:
- They show the ratio of US corporate debt to GDP has now reached an all-time high at 48%. The quality of this debt has also reduced, with the majority now just BBB-rated and with record levels of leverage
- BBB ratings are just above junk, and most major investment managers are not allowed to hold junk-rated bonds in their portfolio. So they would have to sell, quickly, if this debt was downgraded
The problem is that much of the corporate debt raised in recent years has gone to fund share buybacks rather than investment for the future. President Trump’s tax cuts meant buybacks hit a record $806bn last year, versus the previous record of $589bn in 2007. According to Federal Reserve data, investors sold a net $1.1bn of shares over the past 5 years – yet stock markets powered ahead as buybacks totalled $2.95bn. As Goldman Sachs notes:
“Repurchases have consistently been the largest source of US equity demand. Since 2010, corporate demand for shares has far exceeded demand from all other investor categories combined.”
THE FED’S RECENT PANIC OVER INTEREST RATES HIGHLIGHTS THE STOCK MARKET RISK
Against this background, it is not hard to see why the US Federal Reserve panicked in January as 10-year interest rates rose beyond 3%. For years, the Fed has believed, as its then Chairman Ben Bernanke argued in November 2010 that:
“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”
Rising interest rates are likely to puncture the debt bubble that their stimulus policy has created – by reducing corporate earnings and increasing borrowing costs for buybacks.
Uber’s IPO suggests that the “smart money” behind Uber’s IPO – and that of the other “unicorns” now rushing to market – has decided to cash out whilst it still can, despite the valuation being cut. They must have worried that in more normal markets, they would never be able to float a serially loss-making company at a hoped-for $91bn valuation.
If they really believed Uber was finally about to turn the corner and become profitable at last, why would they accept a valuation some 25% below their original target of less than a month ago? The rest of us might want to worry about what they know, that we don’t.
Last November, I wrote one of my “most-read posts”, titled Global smartphone recession confirms consumer downturn. The only strange thing was that most people read it several weeks later on 3 January, after Apple announced its China sales had fallen due to the economic downturn.
Why did Apple and financial markets only then discover that smartphone sales were in a downturn led by China? Our November pH Report “Smartphone sales recession highlights economic slowdown‘, had already given detailed insight into the key issues, noting that:
“It also confirms the early warning over weakening end-user demand given by developments in the global chemical industry since the start of the year. Capacity Utilisation was down again in September as end-user demand slowed. And this pattern has continued into early November, as shown by our own Volume Proxy.”
The same phenomenon had occurred before the 2008 Crisis, of course, as described in The Crystal Blog. I wrote regularly here, in the Financial Times and elsewhere about the near-certainty that we were heading for a major financial crisis. Yet very few people took any notice.
And even after the crash, the consensus chose to ignore the demographic explanation for it that John Richardson and I gave in ‘Boom, Gloom and the New Normal: How the Western BabyBoomers are Changing Demand Patterns, Again’.
Nothing seems to change. So here we are again, with the chart showing full-year 2018 smartphone sales, and it is clear that the consumer downturn is continuing:
- 2018 sales at 1.43bn were down 5% versus 2017, with Q4 volume down 6% versus Q4 2017
- Strikingly, low-cost Huawei’s volume was equal to high-priced Apple’s at 206m
- Since 2015, its volume has almost doubled whilst Apple’s has fallen 11%
And this time the financial outlook is potentially worse than in 2008. The tide of global debt built up since 2008 means that the “World faces wave of epic debt defaults” according to the only central banker to forecast the Crisis.
“WALL STREET, WE HAVE A PROBLEM”
So why did Apple shares suddenly crash 10% on 3 January, as the chart shows? Everything that Apple reported was already known. After all, when I wrote in November, I was using published data from Strategy Analytics which was available to anyone on their website.
The answer, unfortunately, is that markets have lost their key role of price discovery. Central banks have deliberately destroyed it with their stimulus programmes, in the belief that a strong stock market will lead to a strong economy. And this has been going on for a long time, as newly released Federal Reserve minutes confirmed last week:
- Back in January 2013, then Fed Governor Jay Powell warned that policies “risked driving securities above fundamental values“
- He went on to warn that the result would be “there is every reason to expect a sharp and painful correction“
- Yet 6 years later, and now Fed Chairman, Powell again rushed to support the stock market last week
- He took the prospect of interest rate rises off the table, despite US unemployment dropping for a record 100 straight months
The result is that few investors now bother to analyse what is happening in the real world.
They believe they don’t need to, as the Fed will always be there, watching their backs. So “Bad News is Good News”, because it means the Fed and other Western central banks will immediately print more money to support stock markets.
And there is even a new concept, ‘Modern Monetary Theory’ (MMT), to justify what they are doing.
THE MAGIC MONEY TREE PROVIDES ALL THE MONEY WE NEED
There are 3 key points that are relevant to the Modern Monetary Theory:
- The Federal government can print its own money, and does this all the time
- The Federal government can always roll over the debt that this money-printing creates
- The Federal government can’t ever go bankrupt, because of the above 2 points
The scholars only differ on one point. One set believes that pumping up the stock market is therefore a legitimate role for the central bank. As then Fed Chairman Ben Bernanke argued in November 2010:
“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”
The other set believes instead that government can and should spend as much as they like on social and other programmes:
“MMT logically argues as a consequence that there is no such thing as tax and spend when considering the activity of the government in the economy; there can only be spend and tax.”
The result is that almost nobody talks about debt any more, and the need to repay it. Whenever I talk about this, I am told – as in 2006-8 – that “I don’t understand”. This may be true. But it may instead be true that, as I noted last month:
“Whilst Apple won’t go bankrupt any time soon, weaker companies in its supply chain certainly face this risk – as do other companies dependent on sales in China. And as their sales volumes and profits start to fall, investors similarly risk finding that large numbers of companies with “Triple B” ratings have suddenly been re-rated as “Junk”:
- Bianco Research suggest that 14% of companies in the S&P 1500 are zombies, with their earnings unable to cover interest expenses
- The Bank of International Settlements has already warned that Western central banks stimulus lending means that >10% of US/EU firms currently “rely on rolling over loans as their interest bill exceeds their EBIT. They are most likely to fail as liquidity starts to dry up”.
I fear the coming global recession will expose the wishful thinking behind the magic of the central banks’ money trees.
I well remember the questions a year ago, after I published my annual Budget Outlook, ‘Budgeting for the Great Unknown in 2018 – 2020‘. Many readers found it difficult to believe that global interest rates could rise significantly, or that China’s economy would slow and that protectionism would rise under the influence of Populist politicians.
MY ANNUAL BUDGET OUTLOOK WILL BE PUBLISHED NEXT WEEK
Next week, I will publish my annual Budget Outlook, covering the 2019-2021 period. The aim, as always, will be to challenge conventional wisdom when this seems to be heading in the wrong direction.
Before publishing the new Outlook each year, I always like to review my previous forecast. Past performance may not be a perfect guide to the future, but it is the best we have:
The 2007 Outlook ‘Budgeting for a Downturn‘, and 2008′s ‘Budgeting for Survival’ meant I was one of the few to forecast the 2008 Crisis. 2009′s ‘Budgeting for a New Normal’ was then more positive than the consensus, suggesting “2010 should be a better year, as demand grows in line with a recovery in global GDP“. Please click here if you would like to download a free copy of all the Budget Outlooks.
THE 2017 OUTLOOK WARNED OF 4 KEY RISKS
My argument last year was essentially that confidence had given way to complacency, and in some cases to arrogance, when it came to planning for the future. “What could possibly go wrong?” seemed to be the prevailing mantra. I therefore suggested that, on the contrary, we were moving into a Great Unknown and highlighted 4 key risks:
- Rising interest rates would start to spark a debt crisis
- China would slow as President Xi moved to tackle the lending bubble
- Protectionism was on the rise around the world
- Populist appeal was increasing as people lost faith in the elites
A year later, these are now well on the way to becoming consensus views.
- Debt crises have erupted around the world in G20 countries such as Turkey and Argentina, and are “bubbling under” in a large number of other major economies such as China, Italy, Japan, UK and USA. Nobody knows how all the debt created over the past 10 years can be repaid. But the IMF reported earlier this year that total world debt has now reached $164tn – more than twice the size of global GDP
- China’s economy in Q3 saw its slowest level of GDP growth since Q1 2009 with shadow bank lending down by $557bn in the year to September versus 2017. Within China, the property bubble has begun to burst, with new home loans in Shanghai down 77% in H1. And this was before the trade war has really begun, so further slowdown seems inevitable
- Protectionism is on the rise in countries such as the USA, where it would would have seemed impossible only a few years ago. Nobody even mentions the Doha trade round any more, and President Trump’s trade deal with Canada and Mexico specifically targets so-called ‘non-market economies’ such as China, with the threat of losing access to US markets if they do deals with China
- Brexit is worth a separate heading, as it marks the area where consensus thinking has reversed most dramatically over the past year, just as I had forecast in the Outlook:
“At the moment, most companies and investors seem to be ignoring these developments, assuming that in the end, sense will prevail. But what if they are wrong? It seems highly likely, for example, that the UK will end up with a “hard Brexit” in March 2019 with no EU trade deal and no transition period to enable businesses to adjust.
“Today’s Populist politicians don’t seem to care about these risks. For them, the allure of arguing for “no deal”, if they can’t get exactly what they want, is very powerful. So it would seem sensible for executives to spend time understanding exactly how their business might be impacted if today’s global supply chains came to an end.”
- Populism is starting to dominate the agenda in an increasing number of countries. A year ago, many assumed that “wiser heads” would restrain President Trump’s Populist agenda, but instead he has surrounded himself with like-minded advisers; Italy now has a Populist government; Germany’s Alternativ für Deutschland made major gains in last year’s election, and in Bavaria last week.
The last 10 years have proved that stimulus programmes cannot substitute for a lack of babies. They generate debt mountains instead of sustainable demand, and so make the problems worse, not better. As a result, voters start to listen to Populists, who offer seemingly simple solutions to the problems which have been ignored by the elites.
Next week, I will look at what may happen in the 2019 – 2021 period, as we enter the endgame for the policy failures of the past decade.
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“The 1950-2000 period is like no other in human or financial history in terms of population growth, economic growth, inflation or asset prices.”
This quote isn’t from ‘Boom, Gloom and the New Normal: How Western BabyBoomers are Changing Demand Patterns, Again‘, the very popular ebook that John Richardson and I published in 2011. Nor is the chart from one of the hundreds of presentations that we have since been privileged to give at industry and company events around the world.
It’s from the highly-respected Jim Reid and his team at Deutsche Bank in their latest in-depth Long-Term Asset Return Study, ‘The History (and future) of inflation’. As MoneyWeek editor, John Stepek, reports in an excellent summary:
“The only economic environment that almost all of us alive today have ever known, is a whopping great historical outlier….inflation has positively exploded during all of our lifetimes. And not just general price inflation – asset prices have surged too. What is this down to? Reid and his team conclude that at its root, this is down to rampant population growth.” (my emphasis)
As Stepek reports, the world’s population growth since 1950’s has been far more than phenomenal:
“From 5000BC, it took the global population 2,000 years to double; it took another 2,000 years for it to double again. There weren’t that many of us, and lots of us died very young, so it took a long time for the population to expand. Fast forward another few centuries, though, and it’s a different story.
“As a result of the Industrial Revolution, lifespans and survival rates improved – the population doubled again in the period between 1760-1900, for example. That’s just 140 years. Yet that pales compared to the growth we’ve seen in the 20th century. Between 1950-2000, a mere 50 years, the population more than doubled from 2.5bn to 6.1bn.”
Actually, it was almost certainly Jenner’s discovery of smallpox vaccination that led to the Industrial Revolution, as discussed here in detail in February 2015, Rising life expectancy enabled Industrial Revolution to occur’:
“Vaccination against smallpox was almost certainly the critical factor in enabling the Industrial Revolution to take place. It created a virtuous circle, which is still with us today:
- Increased life expectancy meant adults could learn from experience instead of dying at an early age
- Even more importantly, they could pass on this experience to their children via education
- Thus children stopped being seen as ’little adults’ whose role was to work as soon as they could walk
- By 1900, the concept of ‘childhood’ was becoming widely accepted for the first time in history*
The last point is especially striking, as US sociologist Viviana Zelizer has shown in Pricing the Priceless Child: The Changing Social Value of Children. We take the concept of childhood for granted today, but even a century ago, New York insurance firms refused to pay death awards to the parents of non-working children, and argued that non-working children had no value.
Deutsche’s topic is inflation, and as Stepek notes, they also take issue with the narrative that says central banks have been responsible for taming this in recent years:
“The Deutsche team notes that inflation became less fierce from the 1980s. We all think of this as being the point at which Paul Volcker – the heroic Federal Reserve chairman – jacked up interest rates to kill off inflation. But you know what else happened in the 1980s?
“China rejoined the global economy, and added a huge quantity of people to the working age population. A bigger labour supply means cheaper workers. And this factor is now reversing. “The consequence of this is that labour will likely regain some pricing power in the years ahead as the supply of it now plateaus and then starts to slowly fall”.”
THE CENTRAL BANK DEBT BUBBLE IS THE MAIN RISK
The chart above from the New York Times confirms that that the good times are ending. Debt brings forward demand from the future. And since 2000 central banks have been bringing forward $tns of demand via their debt-based stimulus programmes. But they couldn’t “print babies” who would grow up to boost the economy.
Today, we just have the legacy of the debt left by the central banks’ failed experiment. In the US, this means that the Federal government is almost at the point where it will be spending more on interest payments than any other part of the budget – defence, education, Medicaid etc.
Relatively soon, as the Congressional Budget Office has warned, the US will face decisions on whether to default on the Highway Trust Fund (2020), the Social Security Disability Insurance Trust Fund (2025), Medicare Hospital Insurance Trust Fund (2026) and then Social Security itself (2031). If it decides to bail them out, then it will either have to make cuts elsewhere, or raise taxes, or default on the debt itself.
THE ENDGAME FOR THE DEBT BUBBLE IS NEARING – AND IT INVOLVES DEFAULT
Global interest rates are already rising as investors refocus on “return of capital”. Investors are becoming aware of the risk that many countries, including the USA, could decide to default – as I noted back in 2016 when quoting William White of the OECD, “World faces wave of epic debt defaults” – central bank veteran:
“It will become obvious in the next recession that many of these debts will never be serviced or repaid, and this will be uncomfortable for a lot of people who think they own assets that are worth something. The only question is whether we are able to look reality in the eye and face what is coming in an orderly fashion, or whether it will be disorderly. Debt jubilees have been going on for 5,000 years, as far back as the Sumerians.”
The next recession is just round the corner, as President Reagan’s former adviser, Prof Martin Feldstein, warned last week. This will increase the temptation for Congress to effectively default by refusing to raise the debt ceiling. Ernest Hemingway’s The Sun also Rises probably therefore describes the end-game we have entered:
“How did you go bankrupt?” Bill asked.
“Two ways,” Mike said. “Gradually and then suddenly.”
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London house prices are “falling at the fastest rate in almost a decade” according to major property lender, Nationwide. And almost 40% of new-build sales were to bulk buyers at discounts of up to 30%, according of researchers, Molior. As the CEO of builders Crest Nicholson told the Financial Times:
“We did this sale because we knew we would otherwise have unsold built stock.”
They probably made a wise decision to take their profit and sell now. There are currently 68,000 units under construction in London, and nearly half of them are unsold. Slower moving builders will likely find themselves having to take losses in order to find a buyer.
London is a series of villages and the issues are different across the city:
Nine Elms, SW London. This $15bn (US$20bn) transformation has been ‘an accident waiting to happen‘ for some time. It plans to build 20000 new homes in 39 developments at prices of up to £2200/sq ft. Yet 2/3rds of London buyers can only afford homes costing up to $450/sq ft – thus 43% of apartments for sale have already cut their price.
West End, Central London. This is the top end of the market, and was one of the first areas to see a decline. As buying agent Henry Pryor notes:
“Very few people want to buy or sell property in the few months leading up to our monumental political divorce from Europe next March, which is why 50% of homes on the market in Belgravia and Mayfair have been on the market for over a year. Yet there are people who have to sell, whether it be because of divorce, debt or death, so if you have money to spend I can’t remember a time since the credit crunch in 2007 when you could get a better deal.”
NW London. Foreign buyers flooded into this area as financial services boomed. Rising bonuses meant many didn’t need a mortgage and could afford to pay £1m – £2.5m in cash. But now, many banks are activating contingency plans to move some of their highly paid staff out of London ahead of Brexit. Thus Pryor reports buying a property recently for £1.7m, which had been on the market for £2.25m just 2 years ago.
W London. Also popular with foreign buyers, even areas such as Kew (with its world-famous Royal Botanic Gardens) have seen a dramatic sales volume decline. In Kew itself, volume is down 40% over the past 2 years. And, of course, volume always leads prices – up or down. Over half of the homes now on sale have cut prices by at least 5% – 10%, and the pace of decline seems to be rising. One home has cut its offer price by 17.5% since March.
Outer London. This is the one area bucking the trend, due to the support provided by the government’s ‘Help to Buy’ programme. This provides state-backed loans for up to £600k with a deposit of just 5%. As Molior comment, this is “the only game in town” for individual purchasers, given that prices in central London are out of reach for new buyers.
The key issue is highlighted in the charts above – affordability:
- The first chart shows how prices were very cyclical till 2000, due to interest rate changes. They doubled between 1983 – 1989, for example, and then almost halved by 1993. In turn, the ratio of prices to average earnings fluctuated between 4x – 6x
- But interest rates have been relatively low over the past 20 years, and new factors instead drove home prices
- The second chart shows the impact in terms of first-time buyer affordability and mortgage payments. Payments were 40% of take-home pay until 1998, but then rose steadily to above 100% during the Subprime Bubble. After a brief downturn, the Quantitative Easing (QE) bubble then took them back over 100% in 2016
The paradigm shift was driven by policy changes after the 2000 dot-com crash. As in the USA, the Bank of England decided to support house prices via lower interest rates to avoid a downturn, and then doubled down on the policy after the financial crash – despite the Governor’s warning in 2007 that:
“We knew that we had pushed consumption up to levels that could not possibly be sustained in the medium and longer term. But for the time being if we had not done that the UK economy would have gone into recession… That pushed up house prices and increased household debt. That problem has been a legacy to my successors; they have to sort it out.”
- The 2000 stock market collapse and subprime’s low interest rates led many to see property as safer than shares. They created the buy-to-let trend and decided property would instead become their pension pot for the future
- The 2008 financial crisis, and upheavals in the Middle East, Russia, and parts of the Eurozone led many foreign buyers to join the buying trend, seeing London property as a “safe place” in a more uncertain investment world
- Asian buyers also flooded in to buy new property “off-plan”. As I noted in 2015, agents were describing the Nine Elms development as: ” ‘Singapore-on-Thames’. Buying off-plan was the ultimate option play for a lot of the buyers [who are] Asian. You only need to put down 10% and then see how the market goes. A lot of buyers are effectively taking a financial position rather than buying a property”“
But now all these factors are unraveling, leaving prices to be set by local supply/demand factors again. Recent governments have taken away the tax incentives behind buy-to-let, and have raised taxes for foreign buyers. As the top chart shows, this leave prices looking very exposed:
- They averaged 4.8x earnings from 1971 – 2000, but have since averaged 8.7x and are currently 11.8x
- Based on average London earnings of £39.5k, a return to the 4.8x ratio would leave prices at £190k
- That compares with actual average prices of £468k today
And, of course, there is the issue of exchange rates. Older house-owners will remember that the Bank of England would regularly have to raise interest rates to protect the value of the pound. In 1992, they rose to 15% at the height of the ERM crisis. But policy since then has been entirely in the other direction.
Nobody knows whether what will happen next to the value of the pound. But if interest rates do become more volatile again, as in 1971-2000, cyclicality might also return to the London housing market.
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