Sound Money

This is the transcript of a talk I gave at Sakelige in Pretoria on Business Cycles and Capital Structure in October 2019. Video recording here.

Good afternoon. Great to be here with you, a group of real risk-takers who are advancing society one risk at a time. Honour to share the stage with a mentor of mine, George Glynos. As Piet has said, I work in asset allocation, but I’m not here to provide investment advice. I appreciate that the talk is a little sobering but it’ll enlighten you on business cycles (1), the influence of central authorities on these business cycles (2), the purpose of each stage of the cycle (3) difficulties we find ourselves in at present (4) and how we can respond as individuals, business owners and society (5).

1. Cycles are a natural phenomenon

Cycles are as natural as night and day. Historically people centred life on seasons, crop cycles and the various seasons of life; from youth, adulthood and old-age. Cycles are useful, allowing us to plan, act appropriately in each phase and contend against the natural challenges that life is bound to throw at us. It’s unwise to ignore cycles as they’re the rhythm of life.

Each cycle provides a different opportunity and risk. It’s prudent to get an education in childhood and there are lots of opportunities offered to get one during the low pressure period of adolescence. It’s risky to go outdoors and build during winter but it’s also an opportunity to spend time indoors, restrategise and conduct internal development. Acting appropriately allows us to grow and benefit through the cycle, smoothing out the highs and lows.

Debt is the instrument used by humans to exacerbate or smooth the cycle. We can buy a house in our youth to smooth future income into an asset today. But we can exacerbate the cycle, by pretending that they don’t exist, leading us to think that the good times will continue infinitum. For example, using debt to buy fancy clothes and alcohol, leading to a party during youth and a hangover in adulthood.

2. Central banks are meant to smooth cycles, prevent recessions and avoid bank runs

Historically central banks were used to finance wars but the US Fed was founded in 1913 after a series of bank runs, which set the stage for a new age of central banks. The founders of the Fed sold the narrative to the public that CBs are meant to smooth cycles, prevent recessions and avoid bank runs.

Conceptually the goal makes a lot of sense. Central banks can lower rates in tough times to ease economic pressure by allowing debt growth. And they can tighten rates in good times to dampen debt growth and reduce economic exuberance. But in reality it doesn’t really work this way.

Humans are prone to desire the good times now and avoid the bad times, or at least prolong the troubles into the future. Politicians, in particular suffer from impatience – they want results during their term in power and care little about the longer term consequences that they could lump onto future regimes.

Impatience and short-termism are distinct features of global economic policy. Reflecting back on George’s presentation for a moment. Higher rates encourage delayed gratification, savings and greater preference for the future. By contrast, lower rates tell society to prefer today more relative to tomorrow and spend money today.

Well the average central bank interest rate between the US, UK, Japan and Germany has fallen from 10% in 1990 to below 1% today. A falling interest rate trajectory tells that we’ve been told to focus significantly more on the present than the future. Interest rates fall lower in each business cycle downturn and during the next upturn they don’t rise back to the peaks of the previous upturn because we’re consistently trying to improve our short-term outcomes will little appreciation of the consequences for the future.

Instead of smoothing out business cycles, in reality central banks have become the creator of the modern business cycle where interest rate and credit cycles are the predominant driver of the cycle. Cycles are less related to seasons and crop cycles but are integrally related to the credit cycle. Economies have settled into these cycles which average 5-10 years, driven by numerous factors but dominated by credit. Booms are associated with looser central bank policy and busts are associated with tighter central bank policy.

Each country has it’s own cycle but we’re all integrally interlinked by global finance, which implies that there is a lot of overlap between the local cycle and the global. The importance of the USD and the US economy implies that the US Fed is the most important and the driver of the global cycle. No surprise then that business people, economists and investors the world over hang on each and every world from the US Federal Reserve, SA Reserve Bank, etc, they are the central feature of modern business cycles.

Just as each season serves it’s purpose, so does each phase of the business cycle serves its purpose, including recessions.

3. Purpose of recessions: economic healing process

Linear thinking leads many to conclude that recession = unemployment = bad = must be avoided. But what are we missing here? If we can appreciate that seasonal winter serves its purpose, what is the economic purpose of recession?

We’ve established that falling interest rates reduce the cost of capital, encourage debt growth and people tend to conduct more business activity for a period of time. But what else takes place below the surface and what are the consequences? Well some of these businesses are great ideas, producing sustainable businesses but some are bad ideas masquerading as good ideas because the cost of capital, the interest rate, has been reduced. At the extreme, Pets.com and WorldCom were massively bad investment during the dot.com bubble. In South Africa, DiData got caught up in the ’08 bubble. Some companies (like DiData) get caught up in the hype and some (like Pets.com) would never have existed if interest rates weren’t lowered to the degree they were in the preceding years. Today, what about Tesla, or the tech unicorns? Uber, Lyft, Twitter, WeWork… Would these businesses survive if the cost of capital was normalised? I’m not an equity analyst and I don’t have specific company forecasts but clearly some of them would come under pressure under higher interest rates. It’s not just technology businesses, new tech is just exciting and prone towards exuberance.

When interest rates are finally increased, unhealthy, unproductive ventures go out of business. They are found out as bad investments (malinvestments) because they aren’t sustainable at a higher cost of capital. This is a wonderfully good outcome for society because of the capital and resources being allocated towards the unproductive investment can be shifted into more productive ventures that are sustainable. Yes, the frictions are painful for the people involved but its good for society at large to shift towards more productive and sustainable ventures. It’s also good for the individual to take the consequences of their bad business decision and use their lessons elsewhere, rather than living an economic lie for so long that a change in economic direction becomes impossible. Real growth and learning come through mistakes, not through paternalistic molly coddling.

Conclusion: recessions are an economic healing process, are required and should not be avoided tooth and nail.

4. Current business cycle positioning

During a “normal cycle” where interest rates were normalised during each cycle, there would be fluctuations in the capital structure during each cycle but they would normalise from cycle to cycle. Spring in the cycle would be associated with low levels of debt, high interest rates, low inflation, and investment into long-term capital intensive projects that still make sense at high rates of interest. The summer of the cycle would be associated with falling interest rates, rising debt and boom times in the economy. The autumn of the cycle is associated with rising interest rates, strong performance in consumer sectors like retail, good employment numbers but uneven economic growth as long-term investors become increasingly sceptical about the sustainability of the cycle. Winter would be associated with recession, high unemployment, delinquencies, liquidation and central bank support as they try to soften the consequences of previous economic errors.

And during a normal cycle, I would try and identify where we are in the cycle, seasonal capital structure and advise you on the appropriate positioning for the forthcoming cycle. If only things were so easy!  The signs aren’t very clear out there. I contend that we’ve moved into extended autumn because central banks have tried to remove economic cyclicality altogether and banish recessions from our economic lexicon.

The economic consequences of extended autumn are increasingly clear. Cycles should be a natural phenomenon but impatience, omnipotence and paternalistic thinking has tried to banish recessions from our lexicon. Interest rates across the developed world have fallen for the last 30 years because authorities resort to lower rates at any sign of economic distress in the hope of avoiding recessions. We’ve now entered a period of extended economic autumn where Economic spring doesn’t arrive. Debt levels continue to rise because there are no write-downs. Business people don’t truly feel the discipline of the market forces so there isn’t an appropriate reallocation of capital.

5. Implications for Capital Allocation

So what does this imply for capital structure and capital allocation?

5.1. Interest rates are never increased enough to truly liquidate all the malinvestments across the globe. In South Africa we know the consequences of SAA, Eskom, etal bailouts but there’s a similar trend globally. In the US, government provided massive funding for banks during the Global Financial Crisis (GFC) and failed to solve the inherent problem with banks, reducing economic productivity across the globe in the subsequent cycle. European banks have been dodos in recent years, waiting for more fiscal support.

Society becomes increasingly unproductive as we prop up bad investments. Measurement is faulty but just so that I provide you with a focal point; Developed Economy growth in GDP/hour worked fell from 5/6% in the 1960’s to below 1% in recent years.

5.2. Instead of saving and investing in our future, we’re encouraged to continue to dis-save, consume capital and reduce productivity. Global debt levels are at record highs.

Economic growth won’t return to normal levels or where we hope it might be until society breaks out of the low rate and rising debt cycle. But there are only 3 ways out of the low rate, high debt, weak growth trap: growth, debt-write-downs or inflation. I’ve explained why growth is unlikely. Debt write-downs are completely unpalatable to economic and political authorities. So central banks continue to try and monetise debt through inflation, and they’ll turn to increasingly unorthodox measures in an attempt to achieve their outcome.

5.3. Further monetary unorthodoxy. Left-leaning economic thinkers are spit-balling MMT (Modern Monetary Theory). They are justifiably critical of Quantitative Easing because of the negative impact it has had on wealth gaps. When you explicitly target rising asset prices, you shouldn’t be surprised that the rich benefit more than the poor… But rather than do away with QE, new age economic thinkers want a piece of it for themselves and their constituents. MMT is essentially “QE for the people” trying to divert capital towards those who didn’t receive it during the previous phases of QE. In reality MMT is still QE; low rates, debt and short-term focus. I don’t think it’ll work but I think it’s coming…

5.4. Socioeconomic/political uncertainty

It goes without saying, that perpetual economic autumn is not good to the masses around the globe. Economic growth and employment opportunities dwindle. Social mobility – the real societal equalizer and harmonizer – is severely limited. Demands for social welfare will rise but government isn’t able to provide the same level of support as they could previously because they’re heavily indebted. Educated and richer people also suffer economically but they are able to protect their wealth in financial markets and they have the ingenuity to spot economic opportunities, which still exist. The more educated, richer and bigger businesses are also able to contend against increasingly burdensome economic regulation. The apparent divergence between rich and poor widens and social friction rises as a result.

6. What do we do about it?

6.1. Pays to be aware of the trends and have a less emotive response to them, particularly the social-political trends. Trump, Brexit, the EFF, etc. Of course, there are more specific micro-explanations for each, but they are all signs of people being frustrated by perpetual economic autumn, capital consumption and a lack of economic opportunities. No need to lose sleep over each Trump/Malema tweet. Pull back the lens and understand the context.

6.2. Where growth and expansion paid great returns over the past couple of decades of perpetual summer, we’re not going to be in spring for a while. Broad-based growth is no longer the name of the game. Businesses with expectations of a dramatic recovery in conditions for the average man on the street are going to be wrong.

6.2. Complacency / risk taking shifts from Orthodox to unorthodox. Low rates and debt have provided life-support for years but these won’t have the same impact over the coming decade. Conditions are changing. What worked over the past 30 years just isn’t going to cut it. My parents’ generation went to university, got a career job, bought a house and invested into the stock market. These strategies worked so well that we almost don’t think it’s a very risky strategy any more. I’m not saying that none of these strategies will work in the future but we have to understand the fundamental drivers of these trends, appreciate which ones are linked to the unsustainable trends we’ve discussed here and where alterative risks could emerge.

6.3. This doesn’t imply that we shouldn’t take on risk. Risk is a critical component to human development and it should be welcomed. From an investment perspective, we’re having to challenge our thinking but it’s tough when there is so much linear thinking around the globe. The safe options aren’t quite as safe as they seemed previously. This actually enhances the attractiveness of the historically less safe options because the risk-reward balance has been altered. Difficult to know each individuals conditions but where am I taking risk: asset classes that can specifically benefit from volatility, like hedge funds. Assets which are undervalued but have underlying physical value.

6.4. If growth strategies aren’t going to work as effectively as they have in the past, we need to have conserving strategies. Storing value, in liquid assets than cannot be expropriated is wise. I won’t go into all the investment implications but there are a number of interesting options available in the liquid physical asset space. Store of value crypto currencies like bitcoin are very interesting as a digital alternative, which are even more liquid and difficult to expropriate (obviously everyone needs to conduct their own due diligence on this volatile asset class). Perhaps an even more important option than actual investment capital is the investment into intellectual capital, which is incredibly liquid and impossible to expropriate. I often tell new crypto enthusiasts that learning about the concepts and tech is far more important than the monetary investment. Investments into people are also another different way to think about returns.

6.4. Cycle will turn but hope is not a strategy. It’s a time for conservation of wealth and energy. Perhaps MMT will be the catalyst, pushing CPI higher and forcing central banks to raise interest rates. It’s at times like these where the world is trying to force-feed us to think that savings, investing in the future, family, culture and long-term planning strategies are useless that these will become most valuable. There are incredible opportunities available for those who are willing to buck the trend and stand out of the crowd at take calculated risks in bucking the trends. And the opportunities will become increasingly clear over the coming quarters.

7. Concluding remarks: Constructive and less emotive lens to response

Economic cycles are as natural as night and day. Central authorities have powerful abilities to intervene and linear thinking has pushed us to a point where these authorities are dangerously and paternalistically toying with our economic future, trying to avoid the economic healing process of recession. The cycle will eventually turn, but until such time as we take the real pain, broad economic prospects are weak and society will continue to consume capital. But we don’t have to succumb to these trends.

Despite the difficulties the future poses, the conclusion is not doomsday-esque. I’m merely laying out the conditions, the trends and the consequences so that we can respond appropriately. It’s the people who understand the conditions and respond constructively towards them who will have a positive outlook on the world and constructively influence others. The cycle will eventually shift and those who have positioned their capital, education and businesses appropriately will stand to benefit. I hope that we’ll be able to subtly educate family, friends and colleagues about the economic, political and social trends to empower ourselves during this stage of the perpetual economic autumn.