Each year, there has been only one possible candidate for Chart of the Year. Last year it was the collapse of China’s shadow banking bubble; 2017 was Bitcoin’s stratospheric rise; 2016 the near-doubling in US 10-year interest rates; and 2015 the oil price fall.
This year, the ‘Chart of the Decade’ is in a league of its own. Produced by Goldman Sachs, it shows that the S&P 500 is in its longest-ever run without a 20% downturn.
The reason for this amazing performance is not hard to find. It has been caused by the US Federal Reserve’s adoption of Ben Bernanke’s concept that:
“Higher stock prices will boost consumer wealth and help increase confidence“.
Set out in 2010, it replaced the previous policy set out by William McChesney Martin that their job was:
“To take away the punchbowl as the party gets going”.
“Don’t fight the Fed” is one of the best short-term investment principles, but the Fed’s success is quite extraordinary when one looks back over the past decade. Each time the market has threatened to slide, they have rushed in with yet more support:
- In QE1, the Fed pumped out $1.3tn of support for financial markets, in addition to reducing interest rates to near-zero
- This free money mostly went straight into asset markets such as stocks, which weakened when the stimulus stopped
- QE2 came to the rescue with another $600bn of support – but again, stocks then weakened
- QE3 provided longer-term support, with $40bn/month then increasing to $85bn/month
President Trump’s tax cuts provided even further support when the Fed finally paused, as the Financial Times chart confirms, by encouraging a massive wave of share buybacks.
Remarkably, these buybacks came at a time when profits were actually falling as a percentage of GDP, as the third chart shows. Investors should really have been pulling out of shares, rather than buying more. But after so many years of Fed support, most asset managers had either forgotten how to read a Profit & Loss account and Balance Sheet – or had decided these were irrelevant to stock valuation.
Since September, we have been in a new Fed stimulus cycle. As I noted then, a $50bn hole had appeared in New York financial markets. Regulators and consensus commentators combined to explain this was only due to temporary factors. But since then, the support has reached $376bn, and the Fed has announced it will happily supply another $500bn of support to cover possible year-end problems, probably taking the total close to $1tn since September.
Behind this panic is the IMF’s warning that the $8.1tn of Treasury bonds available as collateral for the repo market, are in fact “owned” by an average of 2.2 different banks at the same time. Understandably, bank CFOs are pulling back, and trying to establish if “their” Treasury bonds in fact belong to someone else.
Regulators should never have allowed this to happen. They should also have focused long ago – as I suggested this time last year – on the implications of the decline in China’s shadow banking sector. Just as I expected, China is now exporting deflation around the world, with its PPI falling since June.
China’s slowdown also means an end to the flow of Chinese cash that flooded into New York financial markets, which hedge funds have then leveraged into outsize profits in financial markets.
The Fed turned a blind eye to this, just as it allowed BBB corporate debt to expand at a record rate, as the chart from S&P confirms. As we noted in June’s pH Report:
“US BBB grade debt, the lowest grade in which most funds are allowed to invest, is now more than $3tn, with 19% of this total ($579bn) in the very lowest BBB– grade. And this BBB– total jumps to $1tn if one includes financial sector debt. S&P also report that global BBB debt is now $7tn, with US companies accounting for 54% of the total.
“The problem is that BBB- debt becomes speculative debt if it is downgraded by just one notch to BB grade. And most investors are then forced by their mandate to sell their holding in a hurry, creating the potential for a vicious circle, as the most liquid bonds will inevitably be sold first. In turn, this creates the potential for a “waterfall effect” in the overall bond market – and to contagion in the stock market itself.”
The Fed’s focus on boosting the stock market is clearly going to end in a debt crisis. But when warning of this, the consensus responds as in 2006-8, when I was warning of a global financial crash, “That’s impossible”. And no doubt, once the debt crisis has occurred, it will again claim “nobody could have seen this coming”.
This is why the S&P 500 chart is my ‘chart of the decade’.
After the excitement of Wimbledon tennis and a cricket World Cup final, Londoners were back to their favourite conversation topic last week – house prices. But now the news has become bittersweet as the price decline starts to accelerate.
As the London Evening Standard headline confirms:
“The London property slump has dramatically accelerated with prices falling at their fastest rate in a decade, official figures reveal… The latest “punishing” downward lurch means that more than £21k ($26k) was wiped from the value of the average London house over the period, according to the Land Registry… The number of sales is still in decline with just 5947 recorded in March, down from 7350 a year previously.”
‘Reversion to the mean’ is always the most reliable of investment guides, and the chart shows prices could have some way to fall before they reach this level – and, of course, prices often over-correct after the type of sharp rise that has been seen over the past 20 years:
- Most people have to buy houses on a mortgage, where the ratio of price to income is the key factor
- As the chart shows, prices and ratios have seen 2 distinct periods since 1971 (when records began)
- Prices (inflation adjusted) have had an upward trend since 2000, with today’s 11% fall the worst
- 1971-1999 saw more violent swings – eg between 1983-1993 they doubled and then halved
- The average ratio since 2000 has been 9.3, which would bring prices down by a further 23%
- The average ratio between 1971-1999 was 4.8, which would bring prices down by a further 60%
WHY DID PRICES RISE?
London prices have been boosted by 4 main factors since 1971:
Demographics. Most fundamentally, the BabyBoomers (born between 1946-1970) began to move into their house-buying years. This dramatically increased demand (as I discussed last week), whilst supply was slow to respond due to planning restrictions etc.
In addition, women began to go back to work after having children, creating the phenomenon of 2-income families for the first time in history. The younger Boomers saw the benefit of this as affordability rose; those who followed them paid the price in terms of higher prices.
Buy to let. London became the capital of ‘Buy-to-let’. UK tenancy law changed in 1988 and by the mid-1990s, parents realised it would be cheaper and better to buy apartments for their student children, rather than paying high rents for shoddy lodgings. Others followed in the belief that property was “safer” than stock markets”.
Falling interest rates (they were 15% during the 1992 ERM crisis) made the mortgage payment very affordable – particularly with tax relief as well. But since 2017, tax relief has been reducing, and disappears next year. And today’s ageing UK population, where nearly 1 in 5 people are now aged 65+, means the Boomers no longer have spare cash to spend on buying property.
The global city. After the financial crisis, London property appeared an oasis of calm as the Bank of England supported house prices by cutting interest rates to near-zero, dramatically boosting affordability. Everyone knew by then that “house prices only increased”, as memories of the 1970-1980s were forgotten, and so capital gains seemed assured.
This made London, along with other “global cities” such as New York, very attractive to Russians, Arabs, Asians and anyone else who was worried that their government might try to grab their money. Europeans also bought as the eurozone crisis developed. And then the success of the 2012 London Olympics made it the city where everyone wanted to live, especially as its financial sector was booming due to central bank stimulus programmes.
WHAT WILL HAPPEN NEXT?
The question now is whether these drivers will continue. Brexit, of course, has already cast a shadow over the idea of the UK as an island of stability in a troubled world. And whilst the collapse of the currency since the referendum makes property more affordable for foreign buyers, it means that those who bought at the peak are nursing even larger losses.
And, of course, the fall in the actual volume of sales is another worrying sign. Volume usually leads price, up or down. And housing markets aren’t like stock markets, where you can usually trade very quickly if you want to sell. Instead you have to wait for a buyer to appear – and even then, the UK’s property laws make it possible for them to pull out until the very last moment.
All in all, it would therefore be surprising if prices didn’t continue falling, back to the average house price/earnings ratio of the past 20 years. A temporary over-correction, where they went even lower, would also be normal after such a long period without a major fall.
Whether they go lower than this, and return to the 1971-99 ratio, probably depends on what happens with Brexit. If those who believe it will open up a new ‘golden age’ for the UK economy are right, then prices might well stabilise and could even rise again, after the initial disruption. But if it proves an economic disaster, then a return to the troubled period of the 1970s would be no surprise at all.
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.
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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As promised last week, today’s post looks at the impact of the ageing of the BabyBoomers on the prospects for economic growth.
The fact that people are living up to a third longer than in 1950 should be something to celebrate. But as I noted in my Financial Times letter, policymakers are in denial about the importance of demographic changes for the economy.
Instead, their thinking remains stuck in the past, with the focus on economists such as Franco Modigliani, who won a Nobel Prize for “The Life Cycle Hypothesis of Savings”, published in 1966. This argued there was no real difference in spending patterns at different age groups.
Today, it is clear that his Hypothesis was wrong. He can’t be blamed for this, as he could only work with the data that was available in the post-War period. But policymakers should certainly have released his theories were out of date.
The chart highlights the key issue, by comparing average US and UK household spending in 2000 v 2017:
- In 2000, there were 65m US households headed by someone in the Wealth Creator 25-54 cohort, and 12.5m in the UK. They spent an average of $62k and £33.5k each ($2017/£2017)
- There were 36m US households headed by someone in the 55-plus New Older cohort, and 12.4m in the UK, who spent an average of $45k and £22.8k each
- In 2017, the number of Wealth Creator households was almost unchanged at 66m in the US and 11.9m in the UK. Their average spend was also very similar at $64k and £31.9k each
- But the number of New Older householders had risen by 55% in the US, and by 24% in the UK, and their average spend was still well below that of the Wealth Creators at $51k and £26.4k respectively
Amazingly, despite this data, many policymakers still only see the impact of today’s ageing Western populations in terms of likely increases in pension and health spending. They appear unaware of the fact that ageing populations also impact economic growth, and that they need to abandon Modigliani’s Hypothesis.
As a result, they have spent trillions of dollars on stimulus policies in the belief that Modigliani was right. Effectively, of course, this means they have been trying to “print babies” to return to SuperCycle levels of growth. The policy could never work, and did not work. Sadly, therefore, for all of us, the debt they have created can never be repaid.
This will likely have major consequences for financial markets.
As the chart from Ed Yardeni shows, company earnings estimates by financial analysts have become absurdly optimistic since the US tax cut was passed.
The analysts have also completely ignored the likely impact of China’s deleveraging, discussed last month.
And they have been blind to potential for a global trade war, once President Trump began to introduce the populist trade policies he had promised in the election. Last week’s moves on steel and aluminium are likely only the start.
Policymakers’ misguided faith in Modigliani’s Hypothesis and stimulus has instead fed the growth of populism, as the middle classes worry their interests are being ignored. This is why the return of volatility is the key market risk for 2018.
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