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:
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 https://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:
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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