Familiar voices are alarmed

Roger Montgomery


July 18, 2018

Synchronised advancement across all technology disciplines, and synchronised real-estate appreciation across all geographies, suggest a common fuel source that sits above local and discrete factors. What is this source and what if it is pulled away?

As we are all well aware, central banks have been, through quantitative easing, suppressing interest rates since the GFC. Consequently, monetary policy has fueled unprecedented flows of institutional and private capital into real estate, private equity and stocks.

Now, with quantitative easing turning into quantitative tightening, several observers are rightly warning investors to hold more cash.

Private equity stretch

Stand back and take a look at the technology advancement of the last few years; in every field from artificial intelligence, virtual reality robotics and drones, to telecommunications, autonomous vehicles, electric vehicles, renewable energy, the sharing economy (Airbnb, Uber), digital advertising and 3D printing – the list goes on – technical advancement has accelerated across all fields simultaneously.

Meanwhile, investors have become enamoured with the possibility of profiting from the ability of technology to ‘change the world’ and disrupt legacy business models.

The multilateral advancement across technical and business fields is not a coincidence. It is simply a function of abundant and cheap money, which has concurrently provided funding to ‘blue sky’ projects, while fuelling a fear of missing out amongst investors.

Do you believe investors would have chased a private equity ‘opportunity’ and put US$29.9 billion ($40.8 billion) into a venture that has not turned a dollar of profit since it was founded in 2009 – and continue do so even as regulators clamp down on its aspirations – if interest rates on cash were 7 per cent or 8 per cent? That company, Uber, has a selfascribed ‘valuation’ of US$60 billion.

One cannot help but conclude that Uber would not exist to disrupt legacy business models and change the world if returns on cash were more attractive. It is simply the punitive returns on cash that have prompted investors to pursue and fuel risky ventures.

Tesla, even after its recent sell-off, sits on a market capitalisation of US$60 billion. In 2017, the company delivered just 100,000 vehicles. Ford Motor Company sits on a market capitalisation of US$47 billion and last year sold 6 million vehicles. Clearly, returns from buying the stock today, even as production ramps, are not going to be great.

I’ve heard Airbnb executives wax lyrical about various metrics that demonstrate their company’s superiority over legacy operators. But the metric that matters is profit, and in 2017 Airbnb reported a US$93 million profit on revenue of US$2.6 billion – a 3.5 per cent margin. The Marriott Hotel Group generated US$1.4 billion in profit on US$22.9 billion in revenue in 2017, for a 6.1 per cent margin.

At least Airbnb is profitable. Many of its highly promoted peers and rivals aren’t. And there is little doubt that many ventures now requiring ongoing funding will collapse as interest rates continue to climb and offer improving risk-adjusted returns. It is worth noting that on June 13, the US Federal Reserve raised its overnight lending rate to a range of 1.75 per cent to 2.0 per cent. And it anticipates two more hikes within the next six months.

Bloated listed equities

History holds valuable lessons. The consequences the last time the world attempted economic recovery through the suppression of interest rates are explained in the classic book, Lords of Finance: The Bankers Who Broke the World. Its author, Liaquat Ahamed, offers us the following reminder:

“The quartet of central bankers did in fact succeed in keeping the world economy going but they were only able to do so by holding US interest rates down and by keeping Germany afloat on borrowed money,” Ahamed wrote. “It was a system that was bound to come to a crashing end. Indeed, it held the seeds of its own destruction. Eventually, in the last week of October 1929, the bubble burst, plunging the United States into its own recession. The US stock market bubble thus had a double effect. On the way up, it created a squeeze in international credit that drove Germany and other parts of the world into recession. And on the way down, it shook the US economy.”

Elsewhere, the world’s largest hedge fund, Bridgewater Associates, has stated: “We are bearish on financial assets as the US economy progresses toward the late cycle, liquidity has been removed, and the markets are pricing in a continuation of recent conditions despite the changing backdrop.”

I have previously written that the majority of the debt accumulated since 2010 by US non-financial corporations has been used for unproductive purposes, specifically financial engineering such as earnings-per-share-boosting stock buybacks, special dividends and mergers and acquisitions (at inflated prices).

Swapping equity for debt through buybacks has, almost without doubt, inflated the equity market while simultaneously misdirecting capital away from productive purposes. By way of example, US banks collectively returned 99 per cent of net earnings to shareholders via buybacks and dividends. In other words, the jaws between prices and reality have widened.

Bridgewater again: “2019 is setting up to be a dangerous year, as the fiscal stimulus rolls off while the impact of the Fed’s tightening will be peaking,” and “…since asset markets lead the economy, for investors the danger is already here.”

Finally, Warren Buffett’s Berkshire Hathaway is now holding US$116 billion in cash, a quarter of the company’s market capitalisation. Why? In the latest annual report, Buffett wrote that an attractive price is “a requirement that proved to be a barrier to virtually all deals we reviewed in 2017”.

As one commentator noted, Buffett has enough cash on hand to acquire 450 of the S&P 500 companies outright. Yet he did not buy any of them. Nor did he reduce the cash position to expose himself to more shares of any S&P 500 components. He has chosen cash in the form of short-term Treasuries.

History, the world’s biggest hedge fund and the portfolio of the world’s most successful investor are all telling us something. Stay tuned.

Real estate bubble

Accommodative monetary policy since the GFC has also driven an unprecedented flood of money into real estate, with cross-border flows concentrating in capital cities. But again, the jaws have widened, with property prices divorced from the primary economic fundamentals – namely the spending power of households.

Cities including Auckland, Sydney, Shanghai and London have grown by more than 10 per cent a year, on average, every year since 2013. In Vancouver, prices are up roughly 60 per cent in just the last three years. In Sydney, house prices jumped more than 80 per cent between the end of 2009 and the peak last September. Munich, London, and Hong Kong have all seen house prices rise by 50 per cent on average since 2011.

As with tech companies, the synchronised appreciation of real estate across all geographies hints at influences beyond local factors and it has the International Monetary Fund concerned.

The IMF has noted: “In recent years, the simultaneous growth in house prices in many countries and cities located in advanced and emerging market economies parallels the coordinated run-up seen before the crisis.”

When dollars concentrate around particular stocks or technologies, or real estate in particular types of cities, pushing prices to disengage with their economic drivers, and when debt is at record highs, it is time to be cautious. Of course, the IMF, Bridgewater and Warren Buffett could all be wrong. But it’s worth paying attention to them.

Roger Montgomery is chairman and chief investment officer of his own investment firm, Montgomery Investment Management.

TOPICS:   Airbnb,  Bridgewater,  IMF,  International Monetary Fund,  private equity,  real estate,  TECHNOLOGY,  Tesla,  Warren Buffett

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