Global Equities Research: An Annoying Fairy Spoils My Commute

 

Let’s just assume some passing fairy waved her magic wand one morning as you stumbled out of bed cursing that blasted alarm. Rather than the usual bleary-eyed commute, this fairy has the power to transform you, body and soul into the Eurozone economy. Once you had recovered from this interesting turn of events, what would the different parts of your body stand in for? Let’s say the brain would stand in for the government, the limbs for all those factories and offices keeping you constantly on the move, whilst all the veins stood in for the banking system irrigating the whole body with money being pumped round. In this analogy, the blood would be the money and the heart that regulates it all would be the central bank.

Let’s continue the analogy and assume that just over 10 years ago, following a multi-decade long feast on rich and sticky food (build-up in debt pre-crisis) which you failed to burn off with exercise, you were unfit and in need of a diet. But instead of cutting out the custard donuts as Doctor Doom Roubini suggests (remember him?) you carried on regardless. Cardiac arrest follows (the global financial crisis), and you were only kept alive in intensive care by an impressive array of multi-coloured pills (low interest rates and Quantitative Easing, QE). The trouble is that over a decade on you are still hooked on this treatment and at the merest sign of a palpitation you gobble down some more pills (yet more QE and low rates).

What are the side effects? To start, your blood increasingly tends to clot up (deteriorating quality of loans discussed in our August edition of this newsletter), your arteries thicken (increasing difficulty of banks to make any profits), you pick up dangerous infections (the “doom-loop” temptation of Italian banks to have a growing percentage of deposits invested in their own sovereign debt) and you start to develop strange rashes if you ever dare ease off on the pills.

These strange rashes came in the form of some very odd movements in the “Repo” market in September, normal rates for overnight lending spiking from 2% to 10%. A “Repo” is a way of borrowing money against the security of something you own. In financial markets the “thing you own” is typically ultra-safe investments such as short dated US Treasuries. Once you repay your loan, your lender hands you back your treasury bond. Now QE involves the Fed creating money out of thin air and buying up lots of assets such as these very same treasuries from banks. The net result is that the whole banking system ends up with lots of cash in exchange for their treasuries. So, what happens when the Fed reverses QE? As you would expect, the exact opposite: cash drains out of the banking system. If you mix in some global financial crisis era regulation which forces banks to keep much more of the cash as reserves at the Fed, then all of a sudden there is not enough cash to go round. Borrowing this scarce commodity leads to sudden squeeze up in rates in the Repo market.

So, is this “Human Body as Economy” analogy too gloomy? I fear not. For none of this is in question. Much of the lending in the world economy is of stunningly bad quality. Just look at the US$2tn cov-lite loan market or the sea of corporate loans on the lowest possible investment grade. Bank profits coming from simply lending is well down on pre-crisis levels, Italian banks hold near record levels of their own country’s debt and the recent Repo rash is not very comforting.

Source: Bloomberg

Extrapolating this trend into the future is highly plausible but continued addiction to those coloured pills will just make these side effects increasingly severe. What is the alternative? Let us say a good bit of inflation would be like a doctor recommending you spent a bit of time on the treadmill. A few years of sweat and tears later, you notice you have got considerably trimmer as those debt pounds have melted away. The trouble though is that this exercise regime has to be cranked up very gently. Anything more strenuous could trigger another cardiac arrest as exercise (inflation) bumped against a system with much of the blood in the system tending to clot up (all those cov-lite loans, loans to zombie companies and poorly rated bonds coming home to roost).

What does this all mean for Canada Life Investments’ equity funds? In a world where the financial plumbing is so subject to blockages, we have a strong preference for companies which have, as it were, their own wells and springs and do not have to rely too heavily on the public utility function of the banks. When you have got your own strong free cash-flow and low debt you can relax and look at that strange troubled man with delusions of being the EU economy walk by as he hurries on his way to the gym.

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CLI01507 Expiry 31/12/2019

 

 

Daniel White

Daniel White

Senior Research and Strategy Manager

LF Canlife Global Equity Fund

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