From 2008 to 2017, many central banks expanded their balance sheets by printing huge amounts of money. This money was used to purchase government bonds to drive down interest rates. As interest rates for safe government bonds fall to record lows, many investors were forced to buy riskier assets like junk bonds, stocks and property to get better investment returns.
However, just like Newton's third law, every action in the economy will have a reaction. Initially, the bond buying program by central banks were going well up to 2012 - 2013. Then, suddenly things changed. First, gold prices started to drop very significantly after a very strong run as inflation did not materialised. Next, in 2014, oil prices dropped very significantly. In 2015-2016, there was a small stock market shock in the U.S. When central banks print money, there is a marginal cost and marginal benefit to the economy. Ideally, the optimal point is to stop printing money when marginal cost equals marginal benefit. Most central banks use inflation to measure whether they are overdoing it. When inflation is high, central banks will stop money printing and raise interest rates. However, in the U.S. and Europe high inflation did not materialised. This signals that we are entering a dangerous age of central banking because the models that central banks use to make decisions are likely not accurate.
So what really happened? What was broken?
How Central Banks Affect Fundamentals
One major theory that I have been considering relates to destructive competition. The main difference between normal competition and destructive competition is that in normal competition, competitors will stop competing if they incur losses for more than 3 years. In destructive competition, cheap loans allow loss making competitors to survive and start price wars to drag everyone down. This is based on observations of real life corporate behaviour and investor reactions to low interest rates.
When interest rates are low, many corporations borrowed money especially in the technology sector, to compete in price. For example, when interest rate are low, many shale oil company issued junk bonds to finance their exploration efforts. This resulted in a strong oversupply in the oil market and when prices drop all players suffered. Since shale oil companies have a lower cost of production than offshore oil companies, many offshore oil companies got into financial trouble. The latest casualty in 2017 is Seadrill.
Likewise, due to low interest rates, many pension funds decided to allocate more of their money into alternative assets like venture capital and private equity to get more returns. This resulted in a sea of funding for new technology start-ups. Many start-ups with no profits like Uber managed to get funding to grow their business to a large scale. Taxi owners who paid for expensive taxi medallions in New York City suffered as they struggle to pay of the debt they incurred to buy the medallions.
Another example will be how Amazon borrows money to acquire Whole Foods and start price wars with offline retailers. Amazon’s strategy has affected the retailing sector very significantly and many retailers are closing down. Similarly, Netflix borrowed money to fund their cash flow investment into new content. This had dealt a great blow to traditional cable television companies.
In China, things are no different. Loans fuelled an over investment in steel factories. As such, they overproduce steel products which cause prices to drop very significantly. In their desperation, these steel factories decide to export their steel below cost overseas and the world wide steel market suffered very significant losses. Some countries decided to enact tariffs to prevent dumping of cheap steel into their country.
Some think that the banking sector is the greatest beneficiary of money printing. While US banks may have benefited by being able to lower leverage, European banks still have high leverage. Low interest rates results in lower net interest margins for banks. Loan defaults from destructive competition further reduce profits. The European banks won't go burst, neither could they generate enough profits to reduce leverage on their balance sheet fast enough.
The consumer and household suffered very greatly in this age of central banks. Low savings interest rates hurt consumers who save and inflation reduces the value of their savings. Destructive competition results in a loss of jobs and low growth in wages. When wages remain the same for last 8 years, while housing prices go up, many consumers took out loans to buy houses. Low wages and loan repayments significantly reduce the spending power of consumers. As such, many consumer goods companies witness low growth for the last few years as the consumer is squeezed. For non-essential goods like entertainment, consumers have been substituting expensive goods for cheaper options. This drive for cheaper options is partly the reason why Internet companies are doing well.
How New Fundamentals Affect Investment Decisions
As a result of the above, the consumer had chosen to invest in Exchange Traded Funds or property markets. This is because the consumer believes that ETFs and property can provide higher returns than saving rates. This belief is further strengthened by historical trends that ETFs and property have higher returns than the current saving rates. At the same time, encouragement from the financial community that ETFs are the safest way to invest in the stock market solidify the position of ETFs as a must have investment in many consumer’s investment portfolio. This irrational rush caused stock market indices to run up very high despite already high valuations.
Corporations are no better. Low interest rates encourage corporations to do share buy backs. Share buy backs essentially delays the current year’s dividends to increase future dividends and increase ownership. Thus, there is a trade of between current dividends versus share buy backs. When interest rates are on a strong down trend, future dividends in the next one or two years do not decrease much from interest rate discounting but increase more from increase ownership. Furthermore, share buy backs will have a market impact on share prices and will push share prices higher. As such, low interest rates incentivise companies to buy back shares. Many companies aggressively bought back shares during the last 5 years. Some of these share buy backs are funded by debt. Imagine what happens if future interest rates embark on an increasing trend. In that case, the current share buyback spree will stop and stock prices will lose support from share buybacks.
As consumers pile into ETFs, fund managers started to lose out to their benchmarks. This encourage high net worth investors to invest more into ETFs because they are convinced that fund managers are unable to outperform benchmarks. Desperate fund managers start to buy top performers in ETFs which are generally technology companies. Despite that, the bubble in the stock market is small compared to the bubble in the bond market and the bubble in certain property markets like Canada, Australia and Hong Kong. Capital seeks returns. When desperate, capital will pile into asset bubbles to seek return from other capital holders. When desperate, capital will leverage up multiple times to amplify small return into a big return.
Leverage is another way capital take advantage of other capital holders to gain more returns in the short term. The end game is a zero sum game because people that sell takes wealth from people that hold the assets when bubbles burst. Before bubbles burst, buyers look like geniuses.
In early 2017, the U.S. central bank, the Fed, had started to raise interest rates 3 times in light of higher inflation. This started a race among global central banks to tighten credit markets around the world. China quickly entered the race by imposing capital restrictions on foreign acquisitions and deleveraging the corporate sector. While the Fed had stop increasing rates in the second half of 2017, the damage in the economy is done by the previous three rate increases. More defaults will likely appear just like the recent bankruptcy of Toy R' Us. Expect slower growth or even negative growth. Low inflation is a sign that price wars are rampant in the economy.
The key to identifying the turning point in the stock market may be to observe loan defaults. I suspect more and more industries will face losses as destructive competition is amp up to the next level. Subsequently, more loan defaults will happen when players in the industry are unable to service their debts due to losses. The last time this happened was during year 2015 to 2016 when many Oil & Gas companies finally defaulted after few years of trying to survive low oil prices. What happened to the Oil & Gas companies will likely be repeated across other industries. As such, many industries will suffer long and protracted survival periods before defaults hit hard when people realise that the price war will never end.
As loan defaults spread slowly across the different sectors, the stock market may drop slowly first as investors slowly accumulate losses from junk bonds and liquidate their shares slowly. But the defaults in each sector will not be completed as some companies will be saved by excess liquidity in the financial system. However, when sufficient liquidity has been withdrawn from the system due to higher interest rates, all the companies that were able to delay defaulting, will suddenly be unable delay their defaults anymore. In one go, these companies in different sectors will default together which will cause a dry up in liquidity. A shortage of liquidity will result in a sudden steep drop in global share prices.
After the stock market crashes and many companies go burst, it is expected that oversupply in many industries will be pull out of the market. This will allow many industry players to set prices back to normal levels because the price war has ended. A simultaneous increase in price levels due to multiple price wars ending will likely cause strong inflation. This may force central banks to raise interest rates despite strong defaults. When that time arrives, a new article will appear here.