Marcellus: The Fed’s Accommodation of Wall Street: Endgame

Published on: 3 May, 2019

The renewed easing of monetary policy by the Fed is unsustainable. Therefore, we believe it is prudent to prepare for the end of accommodative monetary policy in the US. For India, such a regime change, would increase the cost of capital, hurt Indian real estate and those who finance the same. It could however help shore up India’s flagging household savings rate even as it depresses discretionary consumption in India.

“If the Federal Reserve were to signal…the withdrawal of the Federal Reserve put on stock markets, much of the problems associated with financial capitalism – poor returns to labour, excessive…executive compensations, short-term investment horizons, preference to financial over real investments, investor indifference to risk, build-up of public and private debt and systemic risk – would begin to sort themselves out…The rise of finance has been too steep and has crossed the peak usefulness for many societies.” ― V.Anantha Nageswaran & Gulzar Natarajan in ‘The Rise of Finance: Causes, Consequences and Cures’ (2019)

What the Fed is doing is scary
Over 50 years ago, Hyman Minsky famously said that “Stability leads to instability. The more stable things becomes and the longer things are stable, the more unstable they will be when the crisis hits.”

We can’t think of a better demonstration of Minsky’s theory than what the Federal Reserve has been upto since 21st December 2018. Spooked by the correction witnessed in US equity markets in December 2018, the Fed did an abrupt turnaround in monetary policy (from hiking rates to not hiking, from shrinking its balance sheet to not shrinking it any more). In fact, if the US media is to be believed, the Fed is about to announce a new variant of QE: https://www.cnbc.com/2019/04/29/fed-looking-at-a-program-that-could-be-version-of-quantitative-easing.html . The Fed doesn’t seem to care that unemployment in America is at 20-year low or that equity and residential real estate valuations in America (as measured by P/E multiples and rental yields respectively) are higher than they were prior to the Lehman crisis.

The Fed’s behaviour is compounded by a US President who wants monetary policy to be relaxed further and by central bankers across the world who are falling over each other in trying to follow the Fed. Thanks to these central bankers, we are seeing IPOs at wonderful valuations eg. USD3 billion for a coffee company in China: https://in.reuters.com/article/us-luckin-coffee-ipo-breakingviews/breakingviews-chinas-wannabe-starbucks-brews-a-muddy-ipo-idINKCN1RZ0ET

Financialisation creates significant political risk for the West
This sort of accommodation of financial markets further enriches the American elite and further taxes the ordinary Jane Doe (through more expensive real estate and more generally through the higher cost of living). In a hard hitting new book, Anantha Nageswaran and Gulzar Natarajan lay out some sobering facts with regards to the United States:

• 1. “Credit market debt and the market value of equities in America were 212% of GDP in 1981 and 514% of GDP in 2014.
• 2. The balance sheet of the Federal Reserve exploded from USD 200 billion to USD 4.5 trillion. Call that 23x gain…
• 3. During the same years, the value of non-financial US corporate equities rose from USD 2.3 trillion to USD 23.6 trillion. Call it 10.3x…
• 4. The median nominal income of US families increased from USD 31,000 to USD 71,000 over the over the period. Call it 2.3x….
• 5. The average weekly wage of full-time workers in constant 1982 dollars was USD 330 per week in 1987 and is currently USD 340. Call it 1.03x.” (Source: ‘The Rise of Finance: Causes, Consequences and Cures’ – V.Anantha Nageswaran & Gulzar Natarajan (2019)

As Western monetary policies continue to exacerbate pronounced inequalities, it feels like a matter of time before populist pressures force a withdrawal of such monetary policies (labelled the ‘Greenspan Put’ to celebrate the man who led America down the garden path). Whilst it is not possible for us to guess when such a policy reversal will take place, it is incumbent upon us to prepare for it.

Focusing on downside risk
The most likely consequence of the withdrawal of the Federal Reserve/Greenspan Put will be a sustained rise in the cost of capital globally. The US 10-year Government bond yield is the world’s risk free rate. As shown by this link ( https://www.macrotrends.net/2016/10-year-treasury-bond-rate-yield-chart) for nearly forty years this rate has been falling. It bottomed out at 1.5% in August 2016 (down from 15.4% in September 1981). To quote from our 19th November 2018 piece: “This epic downward trend in the world’s risk free rate has defined most of our careers. Had it not been for this downward trend, it is doubtful whether Emerging Market equities or Private Equity or Real Estate for that matter would be as big an asset class today as it has become.” (See http://marcellus.in/blogs/have-we-hit-peak-finance/)

From 1.5% in August 2016, the US 10-year Government bond yield has risen to 2.5% in April 2019. If one looks forward, there is good reason to believe that the US 10-year bond yield will rise towards 5% (which is where it was before the Lehman crisis struck) if the political consensus in America shifts against the accommodation of Wall Street at the expense of Jane Doe.

Such a rise in US interest rates will almost certainly have a corresponding impact on the cost of money in India. Assuming a similar rise in the cost of money in India will take the Government of India ten year bond yield nearer to 9-10% (compared to the current 7-8%). How will that impact the Indian stockmarket?

We see three layers of impact playing out:

1. 1. The immediate consequence looks likely to be a shift in lending market share from the NBFCs to private sector banks (especially private banks with strong CASA franchises). Given the issues already plaguing the wholesale money market in India (IL&FS, Essel, Debt mutual funds’ challenges, etc) this shift in market share in favour of private banks is already underway. A sustained rise in the US 10-year bond yield could make this shift more long lasting.
2. 2. The medium term consequence looks likely to be a rise in household financial savings (India’s household savings rate has fallen sharply from 25% in FY10 to 17% in FY17) and a drop in discretionary consumption (which has boomed over the last decade). Such a shift could create further issues for sectors like residential real estate and auto. The challenge could also extend to next rung down of discretionary consumption eg. electricals, consumer durables. On the other hand, the rise in household financial savings should help India’s banks (most of whom are struggling to attract deposits).
3. 3. The longer term consequence looks likely to be a drop in the price of land, real estate and fixed assets as the world and India gets accustomed to more expensive capital. (On this issue, my colleague, Salil Desai has written an interesting piece: https://marcellus.in/blogs/marcellus-three-degrees-of-disruption-in-home-buying-in-india/) It is hard to  gauge the full consequences of such a readjustment in fixed asset prices. Perhaps it will lead to a renewal of interest of gold as a safeharbour asset. Alternatively, it could lead to greater household financial savings as highlighted in the preceding bullet.

Investment implications
Our straightforward style of investing in companies which consistently generate double digit revenue growth alongside delivering Return of Capital consistently in excess of cost of capital typically pushes us away from the sorts of companies which seem likely to suffer if the world readjusts to a permanently higher cost of capital.

As shown in the Appendices of both of my bestselling books “The Unusual Billionaires” (2016) and “Coffee Can Investing: the Low Risk Route to Stupendous Wealth” (2018), our portfolios tend to: (a) correct much less than the broader market in the wake of a financial upheaval; and (b) recover more quickly than the broader market once the upheaval has subsided. Worrying comes naturally to risk averse investors like us as we seek to ascertain when this extraordinary accommodation of financial markets by Western central bankers will end.

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Saurabh Mukherjea is the author of “The Unusual Billionaires” and “Coffee Can Investing: the Low Risk Route to Stupendous Wealth”.

Note: the above material is neither investment research, nor investment advice. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India as a provider of Portfolio Management Services and as an Investment Advisor.

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