Frank Gelber examines whether we should invest in equity and property markets right now, or wait until the pack moves in.
The GFC correction isn’t over. We’ve had the yield correction. Next comes the recovery in incomes; but we need to differentiate between financial equity investment and real investment (construction, equipment et cetera) in capital stock.
Real investment needs to be funded, through equity investment and/or debt. That’s why financial investment cycles tend to lead real investment, both in upswing and downturn. But the incomes that drive investment returns rely on the real economy, and they’re driven by demand for and supply of services related to capital stock. Superimposed on that are fluctuations in capital returns (prices or yields associated with inflows and outflows of equity funds). Investment markets, both financial and real, are enormously cyclical, and this cycle was a beauty. The financial engineering boom drove an inflow of debt funding, augmented by increased equity funding which underwrote strong growth in real investment.
Real investment is a key driver of the economy. Investment in the financial engineering boom drove strong economic growth and profitability, boosting financial returns (both yields and capital growth) and encouraging more investment and gearing. Over the past 30 years we’ve only seen two major phases of investment. In both episodes, debt played a key role. During the 1980s, aggressive banks – looking to build their books – forgot about risk. In the last episode, driven by the logic of financial engineering, we were going to make all of our money by structuring product rather than by returns to real investment. The logic of financial engineering was to generate a cash return, with income greater than interest, and gear it up to improve return on equity.
The equity analysts were all in on this party and would castigate anyone with the hubris to stick to old-fashioned, low-geared returns, accusing them of having lazy balance sheets. The weight of money associated with the resultant inflow of both debt and equity funds drove yields too low. Markets were overvalued. The GFC triggered a correction in yields, cleaning out the over-valuation. In overseas markets, where the financial engineering boom held more sway for a longer period, oversupply in some real investment markets caused a more significant downturn -affecting cashflows, compounding the impact on equity prices and causing the banks to write off substantial bad debts.
Much of the developed western world had a financial crisis in the banking system. For them, real investment won’t recover until excess capacity created during the boom is absorbed. It’ll be a long, hard haul. Just like it was for Australia in the 1990s. But that didn’t happen in Australia this time. Certainly, in some property markets demand fell in the downturn. But real investment hadn’t time to build into significant oversupply. That’s why we had a downturn, not a recession. Asset values corrected, but didn’t fall enough to cause significant debt write-offs. Incomes weakened in some markets but were unaffected in others. Meanwhile, the GFC pulled the rug out from under new investment, while the blowout in yields meant that increased returns were required to underwrite financial feasibility.
Now, incomes will start to recover as the economy continues to strengthen, with demand running ahead of capacity. And that’s the next step. Given low investment, it won’t take long to absorb any excess capacity. So the next upswing isn’t far away. That’s true for property and mining markets and the general business sector. Meanwhile the financial markets are still recovering from shock. Heightened awareness of risk has caused a flight to secure assets, particularly fixed interest, and a flight away from perceived risky investment. Likewise, debt funding has dried up and is now only tentatively starting to return. Very tentatively! That’s looking at risk through the rear vision mirror. Most of the risk is gone.
The correction knocked over-valuation out of the system. Risk is now low, not high. But debt remains risk averse and equity is shy. We think real investment will be slow to recover. The equity investors and debt funding required to finance it will be slow to let go of the purse strings. We’re a lot more cautious now. We won’t see aggressive investment driving growth. Rather, income, underwritten by demand in a recovering economy, will be the first to pick up, thereby driving rising prices. Only later will investors return in force. This is the stage of the cycle when people ask where the money will come from to finance the next round of investment.
My stock answer is that there will be no shortage of funding when the financial feasibilities work. And that will require increased returns. What will drive returns? Shortages of stock, that’s what. This is one of those rare times when we know returns have to rise to underwrite financial feasibilities. And, given risk-averse debt and equity markets, we’re unlikely to see premature investment underwriting future returns. I’m not sure of returns over the next one or two quarters. But I’m pretty sure of returns two, three and four years from now, and that’s where my investment horizon lies. It may not please the short-term performance analysts that set the investment agenda. But, to me, it’s a more sensible investment approach.
This is the time to get set in undervalued equity investments – not on a short horizon, but to set up returns two to five years from now. It’s not the time to sit on the sidelines avoiding perceived risk. The GFC correction took care of over-valuation. And we’ll need the capital stock as the recovery proceeds – and quite soon in the scheme of things. Not all sectors have the same prospects, but around me I see a world littered with low-risk, high-return equity investment opportunities on a medium-term horizon.