There is a growing view that investment returns in financial markets are increasingly driven by central bank policy action rather than fundamentals (such as the macroeconomic outlook, business cycles and corporate earnings) prompting questions to be raised about the very nature of free market investing. We have already seen the impact of government policy play out in the major asset classes (equities, fixed income and currencies) and are now beginning to see this on real economy investments.
- Equities: Despite repeated downgrading of analyst 2012 EPS (reflecting downbeat corporate guidance) the S&P 500 registered a total return of 16% — reflecting a ~1.5pt. P/E multiple expansion (as a result of increased Fed liquidity via quantitative easing). In fact, prior to the onset of quantitative easing, S&P 500 had a 20% correlation with the size of the Fed’s balance sheet while it has increased to 85% since 2009 surpassing the correlation with company earnings, which ought to be the primary focus of investors. The size of the Fed’s balance sheet has increased more than 3x since the crisis and will increase by a further $1 trillion in 2013 as the Fed pursues accommodative monetary policy. Actions taken by the European Central Bank (see below) to alleviate financial stress in the Euro Area also played a significant role in the double digit returns delivered by the major European bourses in 2012. For example, the Greek, Irish and Italian equity markets delivered returns of ~15-35% in 2012, despite the recession in these countries (and the rest of the Euro periphery area) worsening.
- Fixed income: Policy action (Outright Monetary Transactions, Long Term Refinancing Operation) and rhetoric by the European Central Bank was instrumental in lowering sovereign bond yields in peripheral Euro Area countries despite no real improvement in economic fundamentals. Ever since Mario Draghi indicated in July 2012 that the ECB is ready to ‘do whatever it takes’ to protect the Euro Area, 10-year Spanish and Italian government bond yields have declined by over 200 basis points despite these economies sliding further into recession resulting in high levels of unemployment.
- Currencies: The recent depreciation of the Japanese Yen has been driven by the Bank of Japan (implementing the policies of the newly elected LDP government) targeting inflation of 2% by purchasing $140 billion of government securities per month commencing in January 2014. The Japanese Yen has depreciated by over 10% since the LDP was elected in December 2012.
Aggressive policy action was probably required during the credit crisis to halt the collapse of the financial system and prevent the recession from morphing into a depression.However, bailing out leveraged entities(arguably an unproductive use of government resources) has not only led to deterioration of sovereign balance sheets (OECD gross government debt-to-GDP is now in excess of 100% compared to ~70% before the crisis) but has also created significant moral hazard issues.Central banks and governments argued aggressive stimulus was necessary to restore orderly functioning of financial markets and to revive organic economic growth.
Despite an unprecedented amount of monetary and fiscal stimulus, deleveraging by the private sector has resulted in the recovery being very tepid, especially in the developed world. To counter weak domestic demand, a number of central banks such as the Fed, the Bank of Japan, the Bank of England and the Swiss National bank have continued with unconventional monetary policy to aid the export sector by devaluing their currency. Unfortunately, not all countries can depreciate their currencies at the same time. Recently, a number of countries including Russia, South Korea and Thailand have voiced concern over the ‘beggar thy neighbor’ policy adopted by developed countries. Essentially, with little or no room to further stimulate growth, countries are trying to steal market share by depreciating the value of their currency.
In addition, governments are beginning to exert increasing influence on real economy investments by using fiscal levers to onshore as much of the agriculture value chain as possible. Through judicious use of import and export tax rates, governments are able to alter unit economics across all sectors of the value chain. Altered unit economics as a result of exogenous government policy can potentially turn an investment thesis on its head, which in turn has significant consequences for the capital allocation process.
For example, Indonesia altered its palm oil export tax structure in September 2011 by increasing the export tax rate on Crude Palm Oil (CPO) while, at the same time, lowering the export tax rate on Processed Palm Oil. This was done with the intention of promoting local CPO value addition(e.g., the conversion of commodity CPO into Cocoa Butter Substitute, which is used as an ingredient in the global chocolate industry),thereby encouraging greater investment from the large palm oil players in the processing sector in Indonesia, thus creating employment opportunities for its large working age population.
As expected, the Indonesian government’s actions coupled with the private sector’s access to cheap capital has resulted in significant investment in the palm oil processing sector, as private sector participants pursued the ‘super-normal’ profits on offer as a result of the new tax regime. We estimate a pay-back period of ~3 years on a US$100 million investment, if the tax structure remains unchanged and there is no erosion in processed product margins
Despite the best intentions of the Indonesian government, we see a risk that the industry may soon suffer from chronic overcapacity – palm oil processing capacity is expected to reach ~40 million MT by 2014(from ~23 million MT in 2011) versus CPO output of ~27-28 million MT. Processors will be under pressure to purchase CPO (their raw material) to ensure maximum capacity utilization (to recover investment / operating overheads), which will invariably force them to bid up the price of CPO, thereby putting pressure on margins and affect the original investment thesis.
More importantly, in a levered scenario, the ability of processors to meet debt service obligations will be adversely impacted, leading to defaults among the smaller, independent processors. Larger companies with deeper pockets, access to their own raw material (via vertically integrated operations) and economies of scale will be better positioned to withstand this. Misallocation of capital leading to overcapacity, eventual bankruptcies and loss of jobs reflects one of the unintended consequences of government policy driving investment returns rather than project fundamentals.
Protectionist policies can lead to multiple rounds of retaliation as imports of one country are exports of another. In response to Indonesian’s tax structure, Malaysia recently scrapped all export taxes (previously at 23%) and removed an export quota (previously ~5 millionMT / year) on CPO in order to ease pressure of a rising stock build up and to provide a floor to prices that fell ~35% in the last quarter of 2012. In response to this response, the Indonesian government contemplated scrapping their export taxes on CPO barely a year after making such sweeping changes to encourage the processing industry. In the words of Gandhi, an eye for an eye may only succeed in making both countries blind.
Furthermore, in response to the recent Malaysian action – the Solvent Extractors’ Association of India has recently requested the Indian government to impose import duty on cheap CPO imports from Malaysia to protect its local oil seed industry. This haphazard nature of government policy will exaggerate the boom-bust investment cycle by leaving allocators of capital to second guess government action rather than focus on more important issues such as marketing, sourcing, operational efficiency and innovation that will enhance productivity over the long term. In our view, governments should focus on programs that increase the size of the food basket rather than aiming to control a larger share of the existing food basket.
History is rife with examples of government policy feeding asset bubbles, with the most pronounced being the recent credit crisis, only to end with disastrous consequences. Could the credit crisis have been prevented if the Clinton and Bush administration (via The National Home Ownership Strategy and Ownership Society respectively) not aggressively pushed homeownership among sub-prime borrowers by letting financial institutions lend recklessly to mask income inequality (for every dollar of real income growth that was generated between 1976 and 2007, 58 cents accrued to the top 1% of households) and if Chairman Greenspan had not held interest rates so low for so long which resulted in US household debt nearly doubling between 2000 and 2007 (household debt-to-disposable income increased from 92% to 126% over the same period)?
Governments should focus on the enablers of investment (e.g., skilled labor force, labor mobility, incentives for innovation, R&D initiatives) – not on altering investment theses that result in investment flow and asset price inflation. This may get politicians re-elected, but who will pick up the pieces once the bubble burst, which it invariably always does?
Try as you might, this time is no different – and unless free markets are allowed to function in the way they should, policy makers risk sowing the seeds of the next crisis at a time when the world can least afford it with the global economy extremely fragile and the policy cupboard almost empty.