Sunday, 18 September 2016

What Have We Got After 8 Years of Easy Money?

2 unusual events happened in July. The first was the Brexit referendum, in which Britons unexpectedly voted to leave the European Union, but the stock markets, equally unexpectedly, did not crash. Within 4 trading days, the Straits Times Index was back to where it was before the vote. It turned out that the markets had correctly predicted that central banks around the world would rush to loosen monetary conditions further to avoid a market crisis from developing because of Brexit. The second was the yields on 10-year Singapore Government Securities dipped below the interest rate of a 1-year fixed deposit that I had placed barely 3 months earlier in Apr. Granted that we are talking about different time periods (Apr vs Jul) and different credit risks (corporate vs government), but the fact that a 10-year government bond could not beat the yield on a 1-year fixed deposit simply amazes me. Is this a warning sign that the financial markets are close to a top?

Actually, both these 2 events are related. Because of a rush by central banks to loosen monetary conditions, which were already very loose, yields on government bonds dropped further, to the extent of going below that of a fixed deposit. Since the Global Financial Crisis (GFC) in 2008, central banks have kept interest rates at historically low levels. US interest rates are now only 0.25% to 0.5%. Several countries, such as Eurozone, Japan, Denmark, Sweden and Switzerland have even taken the unprecedented step of dropping interest rates to negative levels since Jun 2014! As if low/ negative interest rates are not sufficient, US and other central banks have carried out multiple rounds of Quantitative Easing (QE) to flood the markets with cash since Nov 2008!

Back in Nov 2008, if someone had told me that interest rates would remain at historically low levels for 8 years and central banks around the world would take turns to implement multiple rounds of QE, I would have predicted a booming global economy at risk of overheating and a raging bull run in the equities and bond markets!

Yet, 8 years later, what have we got? Sure, in the financial markets, we have a very long bull run in US equities and global government bonds. In Singapore, however, the STI did not even come close to breaching the level achieved prior to GFC, stopping at around 3,500 points versus the peak of around 3,800 points in Oct 2007.

In the real economy, the picture is even worse. Instead of a booming economy at risk of overheating, we have poor business and/or low margins in industries ranging from Oil & Gas, agriculture, commodities, shipping, shipbuilding, properties and banks. In the REIT space, almost every sector ranging from office, retail, hotel and industrial are facing challenges, due to either oversupply or changing demand. In some of the industries mentioned, some companies have even entered judicial management. Banks, being the barometer of the general health of the economy, are facing rising Non-Performing Loans. This is not a picture of a booming economy, but rather, a picture of an ailing economy.

Some people might argue that the reasons for the economic difficulties are OPEC countries flooding the crude oil market, property cooling measures and slowing global economies, especially that of China. These are valid reasons. However, aren't low/ negative interest rates and QE supposed to revive the slowing global economies? With the exception of the US economy, 8 years of low interest rates and multiple rounds of QE have not been able to add to the overall demand in the global economies. Instead, the flood of easy money have added to the overall supply by making it easy for companies to borrow money and build capacity. Ironically and in spite of the flood of easy money, what we have is not more money, but a fairly wide-ranging destruction of value across many industries. Investors who have lost money in stocks in the above-mentioned industries, despite a long-running US equities bull market, would understand best.

The value destruction described above affects companies and investors. Losses are, after all, part and parcel of investing. However, what is of major concern is that the same scenario seems to be playing out at the individual consumer level in the area of residential properties. On the one hand, we hear stories of a glut of completed properties and difficulty in finding tenants. At the same time, we also hear news of some new residential properties selling like hot cakes. Properties are not cheap these days. Without $1 million, you cannot buy a private property with enough space for a family of 4. Yet, there is no shortage of buyers for such properties. The situation is reminiscent of Offshore Support Vessel (OSV) companies which took on huge debts to expand their fleets of OSVs rapidly when oil price was high but are now having difficulties finding charterers to hire their OSVs. For these OSV companies, they will have to significantly tighten their belts and slowly pay down their debts for many years in order to stay afloat. If the same situation affects residential properties, many people will have to likewise tighten their belts and pay down debts. The local economy, which is predominantly services-based, will grow fairly slowly for several years.

The US Federal Reserves will meet to discuss interest rates in the coming week on 20 and 21 Sep. I doubt they will raise interest rates at this meeting. However, after witnessing the widespread destruction of value across multiple industries, I am in favour of raising interest rates.

Interestingly, despite 8 years of low and even negative interest rates, it requires the occurrence of an extraordinary event with economic significance, the Brexit referendum, and the equally extraordinary absence of an accompanying shock to the stock markets, for me to realise what is happening. Having said that, it does not mean that the financial markets will crash soon. It has been 3 years since the taper tantrum of Jun 2013 when then Fed chairman raised the possibility of scaling back its QE bond purchases, but the financial markets have gone on to achieve new heights. However, I have no wish to invest further in such an environment and will shore up my cash position when the opportunities arise.

If you wish to have a second opinion on the state of the global economies, you can refer to the writings of Rolf Suey.

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