ASSET PRICING CHALLENGES
Traditional economics has been turned on its head, escalating the challenge of pricing assets. Here are four perspectives.
More jam tomorrow – Our activities are broadly predicated upon assumptions of steady to rising prices. Our trove of knowledge and experience with falling prices is limited. Were deflation to ensue, it could unleash menacing dynamics that spiral the world into economic darkness.
A world of falling prices is worrisome because it spurs us to delay consumption and investment. We wait because we can buy more “jam” tomorrow; it will be cheaper then. For companies, it infers more ill-timed crimping of capital investment, in favour of capital deployment for share buybacks.
While central banks have been active to the point that interest rates have breached zero in Europe and Japan, investors are slow to respond. Savers may be lethargic, feeling they lack alternatives, or simply risk averse. Nevertheless, it seems almost a conceptual paradox that savers are willing to pay others to hold their money (due to the negative rate), rather than move it to other positively yielding assets.
For markets, with zero clearly no longer the floor for interest rates, further rounds of sizable quantitative easing can herald in fresh lows. Additionally, a more expansive list of eligible securities for central bank purchase can induce an even broader set of credit spreads to narrow.
In a normal inflationary environment, such low interest rates entice lofty equity valuations; bonds look a meagre alternative, and future earnings are hardly discounted. Matters get trickier if a whiff of deflation permeates the air. Suddenly, forecasts of a rising earnings trajectory are doubted, hastening equity markets to recalibrate notches lower. The seeds of volatility are sown. Dramatic equity market recoveries can also be expected; after all, we have an inherent bias towards higher earnings, and low interest rates inevitably rekindle notions that equities are comparatively cheap.
A second troublesome feature of deflation is that indebtedness increases in value over time, rather than being whittled down by inflation. In an inflationary environment, high borrowing at historically low interest rates seems savvy; but the debt becomes a lodestone in a deflationary one. If global growth slows much from here, tighter monetary policy by the Fed risks increasing indebtedness at an inappropriate time.
Beggar thy neighbour – The efficacy of ultra-low interest rates upon lending to bolster economic activity may be waning. Foreign exchange is moving centre stage as a mechanism to stimulate business activity.
By encouraging a weaker currency, a country resets its “competitiveness” with the stroke of a pen, beggaring it neighbours through better terms of trade.
Canada calls it it’s “shock absorber” solution to economic weakness. It is far more expeditious than arduously earning competitiveness through innovation and investment in productivity improvements.
The two big neighbours everyone has been beggaring are China and the US. The music stops when they no longer agree to play. The Chinese have recently decided to reduce being a mark, by pegging the yuan to a basket of currencies. That not only unhitches it partially from the powerhouse greenback, but also stunts the effectiveness of beggaring by its trading partners.
The existence of foreign exchange and for the most part, freely trading markets, means there is no vacuum in which to price assets. An asset here is priced relative to an asset elsewhere. So conceptually, one can view the central banks as encouraging currency market dis-equilibriums, which underpins a volatile state of affairs for pricing assets. Large currency fluctuations bounce around the value of both risk-free and risky international assets when measured in one’s base currency.
For example, AUTHENTIC’s observation that European equities appear inexpensive relative to US equities, is currency dependent. It could be an investment game-changer for the dollar, and thereby relative equity market valuations, if the Fed were to cease bucking the global easing trend and stall their monetary policy tightening plans.
Winner-take-all – The global reach and immediacy of delivery offered by the digital world, has enabled winner-take-all companies to come into existence. The tech industry produces “unicorns” when they become the networked “eco-system” of choice for a global market of users.
With the notion that the marginal cost of adding another online user seems close to costless, and the allure of an addressable market the size of an ocean, companies brought under the mantra of winner-take-all typically sport lofty valuations. That is how a successful software company can challenge traditional economic assumptions of diminishing returns to scale. In the digital world, a mindset of increasing returns to scale can flourish, and so can the profits – at least for a period of time.
Unfortunately, the stock price of the moment is just a pinpoint for a very large dispersion of potential actual outcomes. Tweaks to market penetration forecasts and fee-paying subscriber adoption rates, for example, can cause dramatic share repricing. So one has to be careful in assessing who can truly enjoy a monopolistic position with no marginal costs. The hard reality is that few companies operate independently of the economic cycle, and without having to step up investment, sooner or later to remain competitive. There are numerous variable costs associated with product upgrades, global branding, market access, logistics, infrastructure, legal and client service, which are at risk of being underestimated.
Game of chicken – To some surprise, oil producers continue to maintain maximum production as best they can without blinking.
Why? Because they are engaged in a virtual game of chicken. Check it out on Wikipedia: “The name "chicken" has its origins in a game in which two drivers drive towards each other on a collision course: one must swerve, or both may die in the crash, but if one driver swerves and the other does not, the one who swerved will be called a “chicken”, meaning a coward.”
The troubling aspect of chicken is that it is structured as an anti-coordination game. Consider the payoff matrix for the drivers:
Swerve Tie, Tie Lose, Win
Straight Win, Lose Crash, Crash
Now consider the major oil producers as the drivers. Envisage Russian President Vladimir Putin as behind the wheel of one.
They are all continuing to gush oil at full throttle (driving “Straight”) as best they can, driving down the price of oil towards the point at which they all “Crash, Crash”.
Consider that rather than crashing, if they were all to cut production (“Swerve”), they would then all “Tie”. So why do they do it?
They do it because they have high sunk costs already, and the costs associated with shuttering wells now and re-opening them at higher prices, are also not negligible. If only they could be assured that if they cut back production, that everyone else would follow…But that is not what they see on the road ahead; quite to the contrary.
The oil producers see their competitors, especially the low cost producers, driving on, pumping oil unflinchingly, like in a game of chicken. They are striving to be on the “Win” side of the “Win, Lose” payoff. Those who swerve by cutting production, “Lose”.
The conundrum of this game is that there are multiple feasible outcomes, none of which is apparent. They depend on the responses of the particular players. Furthermore, the immediacy of the digital economy in collecting and transmitting true and false intentions, can intensify the game. It enables a virtual game of chicken in real time amongst producers, inflaming volatility in the oil price and related share prices.
In terms of global growth, it is not clear that the oil price slump is actually the harbinger of an economic slowdown the way some make it out to be. Chicken is the name of the game on the oil supply side. Interestingly, global demand still seems ok.
Rather, what is worrying is the observation that consumer savings from lower gas prices are not yet being funnelled into other consumption. Presumably, some of it is being used to pay off debt. While that is wise in a deflationary environment, we don’t want to create one! We also observe that industries enjoying cheaper energy inputs have not been announcing capital spending plan increases. Spillovers from a potential energy sector crash into the financial sector are also beginning to cast a taller shadow.
Summation: Up for the challenge – With price always a relative concept, an asset can only be cheap or dear relative to something else.
This quarter, we highlight four AUTHENTIC perspectives of particular relevance for asset pricing in the challenging year ahead:
1. In a deflationary environment, there is more jam tomorrow, meaning assets are expected to be cheaper then, than today.
2. When countries are beggaring their neighbours through foreign exchange depreciation, the price of the asset in foreign currency terms is changed in an instant. That change affects the perception of cheapness of other assets in relation to it.
3. Does a company’s share price enjoy a winner-take-all valuation relative to other companies, or is this status in doubt? Asset price adjustments can be dramatic.
4. Oil producers are deep into a game of chicken with multiple potential outcomes for oil prices. It is not entirely related to economic fundamentals, but it affects them.
These perspectives portend an excitable, more volatile year ahead. For AUTHENTIC, an active investment stance of taking risks tentatively, and being prepared to pull them off decisively, should help us serve our Clients their investment returns.
At AUTHENTIC, we are sensitive to global asset class valuations and trends, and keep a watchful eye on foreign exchange activity and opportunities. We believe that idea generation and perspectives are critical for successful investing. They enable us, at times, to foretell asset price direction. Furthermore, by developing and pursuing multiple investment themes, we have the context and scope to evolve portfolios according to market conditions.
We believe that our investment themes and active style are conducive to coping with the speed and magnitude of asset price changes expected in dynamic year 2016.