Is it possible that from the ashes of the GFC and the resultant economic troubles, the human race has stumbled upon the elixir of wealth creation?
A scan across world equity, bond and asset prices might suggest so. Asset prices in Australia have recently begun to accelerate upwards as investors become increasingly ambivalent about the risks of inflation, credit problems, below trend economic growth, new or increased taxes and government charges, higher unemployment and a decline in national trade income. It appears that suddenly Australian investors (and savers) care little for risk because they perceive that such concerns will affect their ability to generate wealth. But is it real wealth creation they seek or the illusion of wealth? In any case, the investment landscape now confronting Australians is nothing compared with the predicament that confronts investors in overseas markets.
For instance, ponder the outlook for the owner of a five year German bond. As of today, their cherished bond is forecast to generate a negative internal rate of return (IRR) if they hold it to redemption. Had the owner bought the bond at face value, then they will have made an unrealised capital gain – the price has risen in the open market. As the price rises, the projected IRR falls from 1% to 2% per annum (at purchase date) to today’s negative. To make a further capital gain from now to any point approaching redemption, the owner must expect (or is it hope?) that a purchaser will buy the bond at a higher price. This means a buyer is prepared to accept an even larger negative IRR.
This leads to some intriguing questions:
- Why does an owner of this bond not sell it? And do so as a matter of urgency?
- But then again, why would any rational person buy that bond?
- Why is the market price for these bonds at a level where the purchaser who owns it is absolutely certain to lose capital if they hold it to redemption? Maybe that is the key – they do not intend to hold it to redemption, and maybe the current participants in the German bond market are not investors at all, but are traders and speculators.
Whatever the answers to the above questions, it is clear that the bond owner secures real wealth by selling it in the market for cash. The market price may be an illusion of wealth but the cash sale proceeds are real.
The illusion results from a belief that the European Central Bank (ECB) will ensure that private investors do not lose capital. This policy promotes the belief that private losses will not be felt by either primary subscribers or secondary purchasers. In our view, that was not what ECB President Mario Draghi meant in July 2012. He was actually saying that bonds would be repaid at face value at maturity. However, the European bond market has moved as if it is the market price that is guaranteed, and the result appears to be an historic price bubble.
Australia’s dilemma with interest rates
The Governor of the RBA noted recently that the recent cut in Australia’s cash rates will add to upward pressure on Australia’s house prices. He particularly noted the continual rise in Sydney residential prices that have lifted by over 30% in just three years. He suggested that a fiscal response was required to hold residential prices and improve affordability. In effect he was suggesting that governments had to act to increase supply to match demand. The demand for residential property was increasing as investors, both local and overseas, added to the demand from people who simply just want to live in their own home.
Figure 1. Rising home prices
Source: DB Global Markets Research, OECD
The above table from Deutsche Bank seems to support the RBA contention, and it is remarkable that the spiralling costs of dwellings is not a potent political issue in Australia. Scan the political debates across the country – Commonwealth and State – and you will hear nothing about the unaffordability of housing. Yet it is surely the most pressing issue confronting young families. As noted last week, it appears that the Australian political class has lost its connection with young people and young families. The result is the creation of massive and growing voter discontent that will become evident at election time.
Leverage returning to the US equity market
Low cash rates and low bond yields encourage debt and speculation. When leverage rises in the stock market, it adds to demand and pushes stock prices higher. When it is withdrawn, the opposite occurs. So where are we in terms of debt-funded speculation in the US stock market?
The chart below suggests that US “margin loans” have moved to a record level and exceed anything in recent history. The total amount of margin loans is higher than it was in either 2000 or 2007. However, that is not necessarily an issue as the US economy is larger than ever before and so are corporate profits and the value of the market. But the table does suggest that market corrections will follow a decline in margin loan activity. To some extent, this is another example of when leverage can create the illusion of high prices and therefore wealth.
Figure 2. NYSE investor credit and the market
The above chart also shows that price bubbles can have serious detrimental effects for investors. From the peak of the internet bubble, it took over 7 years for the S&P 500 to recoup its previous 2000 top. It did surge past the 2000 peak again in early 2013 when the US equity market reached an all-time high.
The key for investors is to be aware when they own an investment or an asset that is excessively priced against the likely returns it will generate. Often excessive pricing will continue for a period well after its original observation. Further, individual stocks can be buoyed by market conditions as broad based bubble markets appear. Comparative pricing is interesting but dangerous.
Today, some may say that an Italian bond or a low yielding property trust or a fast growing stock trading at 50 times PER are all relatively good value compared to a German bond. But everything looks good value compared to something that is ridiculously priced. That is the illusion of wealth.