Asset Management

Mirror, mirror on the wall, who’s the biggest disruptor of them all? – Why, the central banks of course!

This article is offered under “public access”.

The first time I remember hearing the term “disruption” in a business context was about 20 years ago, during my MBA studies. One of our professors called the direct delivery business model of Dell, the computer manufacturer, “disruptive”. He said: “Dell – or be Delled”, implying that businesses would be forced to cut out their traditional retailers in order to survive.

Today a “disruptor” is more often referring to a business that upsets the competitive balance by developing a new technology or by being the first among its competitors to apply this new technology. Companies like Netflix and SpaceX readily come to mind.

One salient feature of the current capital markets is the extreme valuation that some of these “disruptors” have attained. Take Uber for example. Uber went public early May of this year, raising $8bn from new investors for a post-IPO valuation of $82bn. For all of 2018, Uber posted a loss of about $1.8bn. Those losses have accelerated since the IPO.

Now what exactly is so disruptive about Uber’s business model?

Is it their use of GPS? Their smartphone app? Looking at companies like Lyft or locally available, it does not seem like Uber has any unique technology that could not be replicated by a global or even local competitor.

The phenomenal global growth of Uber is probably much more due to its lower prices than to its use of a novel technology. In traditional business economics you would expect a company to command a premium price for a more convenient service. Uber chose to sustain operating losses over long periods in a bid to become a “dominant platform”. The platform should then help them expand into new businesses such as Uber Eats, which in turn should make it harder for new competitors to enter the field, and then hopefully start turning a profit.

The main difference between Uber and traditional taxi companies is that Uber has access to massive amounts of investor capital, and is willing to use it to sustain losses over multiple years. A lot of “disruptive” companies could not have grown so fast and so large without access to capital.

And this is where the central banks come in!

Having reduced interest rates on savings to zero – or even below zero – the central banks have left people with savings before an uncomfortable choice: invest, or else sit back and watch your purchasing power erode slowly but surely. The central banks used the big financial crisis of 2008 to introduce new tools such as “quantitative easing”. This extraordinary injection of liquidity into financial markets was supposed to be a one-off measure to prevent the great financial crisis from spinning out of control.

Today, if your EUR or CHF savings are big enough, you have to pay for the privilege of keeping your money with the top-tier banks. The weaker banks are not yet able to pass the negative interest rates of their mandatory reserves with the central banks onto their customers. Today’s lofty valuations in most asset classes are explained in large part by investors gradually accepting a longer term and/or lower expected return on investment and/or a lower quality of issuer, for generally higher risk, in the hope of at least getting some return on savings.

Uber was able to attract equity investors in its loss-making business – first via private equity and then via its IPO – with a narrative of high growth and a promise that size would ultimately bring profits.

The equity market correction over the last quarter of 2018 seems to corroborate the thesis that central bank policy is having an impact that is more important than the economic cycle or profitability of individual companies. The correction came shortly after the US Fed stopped growing its balance sheet, not reinvesting bonds that came to maturity. Having raised short term interest rates from 0% to about 2.5%, markets were expecting the Fed to make a pause. When incoming Fed Chair James Powell announced that he would keep raising short term interest rates, the markets promptly corrected by 15%.

It also looked as if the Fed “caved” to the markets: they immediately stopped raising rates and have since reverted to lowering rates, bringing them back under 2.0%. It is perhaps not a coincidence that the equity markets started rallying in early October of this year, shortly after the Fed started expanding its balance sheet again, increasing its assets by over 250 billion USD since mid-September alone!

Central banks are quite aware that their policies are having undesirable side effects: asset price bubbles. Companies spend attracted capital on new jobs and development of products and services. Even if the company does not make a profit, at least it creates new jobs and contributes to the economy. Governments and politicians sure like that! But should central banks worry more about jobs than about asset bubbles? In one of her first public speeches since taking over from Mario Draghi, ECB president Christine Lagarde said that the population should prefer jobs over income on savings. Too bad for the pensioners and their life savings…

How do we at Vierny Partners SA adapt to this out-sized and “disruptive” effect of central bank policy on asset prices?

Historically, central bank policy has been more determinant for asset prices than trade wars or geopolitical crises. Even if we do not like current central bank policies, and have deep reservations as to how sound and sustainable it all is, we cannot change it and so we must accept it as a given.

On a first level, we exercise our right to hold onto cash. We are not obliged to give in to the “financial repression” from central bankers that we did not even get to vote for. A decision not to invest is also an investment decision! We can choose to keep considerable amounts of cash, and incur the negative interest on it, if at any given moment we cannot find an acceptable return for a given risk. We talked about this in a previous article.

The central banks sure seem poised to continue their current expansive policies. They have recently signaled that they won’t even stop at the first signs of more serious inflation. While central banks signal a steady policy, we cannot expect markets to always remain equally sanguine about it. Just remember last quarter of 2018! So on a second level we have started to rely more on market timing, as we explained in a follow-up article.

Chuck Prince, then CEO of Citibank, famously told the Financial Times in 2007: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing,” A couple of months later the subprime crisis burst and Chuck was forced into retirement. We are quite happy to sit out a dance now and then. And we are old enough to remember “slow dances”!

On a third and much more practical level, we see opportunities arising from poor allocation of the abundance of capital. You cannot blame companies for accepting the capital that investors are literally throwing at them without asking too many questions! Take the money while it is available, and think of what to do with it later.

Just think of the cannabis craze, resulting in spectacular IPOs and clear signs of bubble valuations during 2018. This year, despite equity indices making new highs, the air has been coming out of that bubble. Normal competitive forces are being reflected in the financial statements, and investors are already moving on to the next craze, be it Artificial Intelligence, Software as a Service or any of this year’s crop of IPOs.

These deflating bubbles can be profited from, using liquid and listed securities, in what is commonly referred to as “option strategies”. No need to resort to “short selling”, no need to wire your money to opaque and expensive hedge fund managers, or to pay for “structured products”. There is nothing new about these securities and strategies, but so far we see little evidence that traditional private banks and investment funds are using them to adapt to the changed market environment.

Central banks have made it harder for asset managers to find stable returns. On top of that, it has become a lot harder for individual investors to practice “do it yourself” investing.

In upcoming articles we will share more of how we deal with the impact of central bank policy, using our independence to adapt more quickly than traditional private banks.

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