Cash is King - Long Live the King
In the AFR I write that for better or worse, we live in a twilight zone spanning two worlds. First, there is the old world, where interest rates were to remain low-for-long, the cost of borrowing was the cheapest it had ever been, and central banks and fiscal treasuries could immediately alleviate every financial ill with ever more extreme forms of stimulus and money printing (aka quantitative easing) to bid up the value of all assets.
For years this column has argued that state interventions that manipulated financial market processes to adjust price signals so that capital and labour were allocated as the state (not the collective wisdom of the crowd) dictated undermined the very source of capitalism’s prosperity-producing machine – that is, creative destruction.
There is, of course, a role for governments to intervene temporarily when markets fail because of the asymmetric information induced by extreme shocks, like the one-in-100-year pandemic. But the elixir of zero rates, endless unfunded fiscal spending, and “QE-to-infinity” has been the ultimate panacea for both politicians and central banks desperate to satisfy the hedonistic masses.
All that changed when the inevitable inflation shock arrived. This brings us to the new world. The mother of all inflation pulses was unavoidable precisely because the aforementioned unconditional policy stimulus programs would be continuously rolled out to solve every conceivable economic problem, until they generated their own binding constraint in the form of unacceptably high consumer price pressures.
The pandemic was an unusually potent melting pot for the inflation shock because it precipitated both intense supply-side and demand-side influences. Goods and services suddenly became hard to access. Concurrently, global unemployment rates fell to the lowest levels in more than half a century. It was the perfect storm for nascent wage/price spirals.
Myopic politicians unleashed the inflation-fighting beast when they shifted the crosshairs onto their central bankers, whom they had legislated responsibility for vouchsafing price stability. Blame the monetary policy mavens.
After burying their heads in the sand throughout the post-GFC period, the putative high priests of “inflation-targeting” suddenly transformed from zero-rate QE junkies into uber hawks care of the political cover provided by prime ministers and presidents desperate to hold someone else accountable for the cost of living crises they had all been partly culpable for engineering.
It still feels like most people are oblivious to this new world and its far-reaching consequences. We face the spectre of high-interest rates for a potentially protracted period of time. Even when economies inevitably retreat into recessions, central banks will be reluctant to relieve too much pain by cutting rates to zero again and restarting QE given that these were some of the key causes of the demand-side inflationary problems in the first place.
Arguably the biggest concern has been the conditioning of businesses to rely on the low-rates-for-long paradigm. The last sub-prime crisis was triggered by vast volumes of high-risk, non-bank lending to residential property borrowers. The catalyst for this was the “Greenspan put” whereby the US Federal Reserve experimented with extreme monetary policy stimulus by slashing its policy interest rate from 6.5 percent in 2000 (just before the “tech wreck”) down to 1 percent by 2003 in response to the ensuing recession.
This crazy-cheap-money triggered an extreme housing boom, which encouraged unregulated non-bank lenders to furnish vast waves of asset-based (as opposed to income-based) finance to sub-prime borrowers that could only ever repay these loans on the assumption that house prices always appreciate, which everyone did assume.
When the Fed tried to normalise the price of money by lifting its policy rate from 1 percent to 5.25 percent in 2006, sub-prime arrears rates surged at the same time as US house prices started declining (they would ultimately crash about 25 percent). The eventual failure of many of these non-bank lenders as their access to finance evaporated – coupled with the enormous mark-to-market losses on once AAA-rated sub-prime mortgage portfolios as their underlying default rates rocketed – ignited a chain reaction across the global financial system that required most over-leveraged banks to be bailed out by taxpayers via equity injections, loans, and government guarantees.
The response to this global financial crisis was once again even cheaper money in the form of zero or negative interest rates and asset purchases by public central banks of many privately traded securities, including government bonds, corporate bonds, and equities. This playbook was extended even further to address the pandemic.
In the ashes of the GFC, regulators turned the screws on the banking system, forcing deposit-takers out of many riskier, non-core activities and massively enhancing the quality of their lending standards. The absence of any inflationary pressures in an increasingly indebted world also allowed policymakers to continuously lean on zero/negative rates and money printing to bid up the value of all assets at the first sight of adversity.
Near-zero bank deposit rates created the great “search for yield”, which central bankers actively encouraged. After most non-banks were killed off during the GFC, a new variety emerged in the form of a resurgent high-yield bond market, which was the non-bank lender of choice to companies that could not get similar terms from a now very conservative banking system. The high-yield market was further augmented by the advent of fund managers specialising in offering loans to small-to-medium-sized companies that were not being courted by conventional banks.
All this cheap money massively expanded the proportion of “zombie” companies that were listed on global stockmarkets. Coolabah’s systems track zombies across the US, UK, European and Australian exchanges. From 2010 to today, their numbers as a share of all listed firms have almost doubled. The definition of a zombie is a firm that does not have sufficient earnings before interest and tax to pay the interest bill on debt for three years in a row. Our research suggests that zombies account for about 15 percent of all listed companies in the US, UK, Europe, and Australia.
The zombies were protected by zero rates and QE-to-infinity. But many may now be torched by inflation and expensive money in what could become the next great sub-prime crisis. The more existential issue for all asset prices is that extremely low-risk and liquid investments are suddenly offering very high returns.
I’ve spent the last couple of weeks meeting global investment banks, and have been surprised to hear the same line trotted out by virtually every single one: why would you buy equities or high-yield loans when an A-rated, senior-ranking bank bond from a leading US or European bank is paying you interest rates of 7 percent or 8 percent annually? With risk-free cash deposit rates marching past 3 percenty, the minimum required returns on all assets must increase sharply. And the only way that can happen is via lower prices. Cash is once again king. Long live the king.
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Chris co-founded Coolabah in 2011, which today runs $7 billion with a team of 33 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...
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