Part I
Whipsawed! That's the only way to describe last week's stock market action. For the first time in history, the United States stock market moved by more than 3.5 per cent from peak to trough on six consecutive trading days. It was near impossible to trade in that type of market and such volatility could lead to many silly decisions as investors try to tame the rollercoaster. Investors could easily find themselves acting just for the sake of it and, at times like these, the more appropriate phrase is "don't just do something, stand there." There were many factors that contributed to last week's market action. For that refer to last week's article, for even though it was written before the main market movements, the reasons were still correctly identified.
Where we go from here is not quite clear although my bias is to the downside. The problem is that regulators and politicians are constantly changing the rules of the game and this is creating unprecedented and uncertain outcomes. From the study of physics, appreciate that at very high or very low temperatures, matter acts in ways that are not consistent with the norm. What we are experiencing now is a market version of the phenomenon found in the physical world. We can, however, discuss how exactly did we get here, why has it come to this and what is the most likely end game. It should be clear to all that this is a debt crisis that has gone on for four years, yet the fundamental basis of the crisis is hardly discussed. Instead, there seems to be an eagerness to do more of the same hence my bearish stance since this crisis has started four years ago.
Capital problems
In simple terms, the problem is not so much the use of debt but the misallocation of capital inclusive of debt. Let me now explain. Start with a basic concept of return on capital. If one were to use capital (money) to engage a project, one would expect to earn a rate of return on that project that is higher than the cost of capital. Assume that the project is financed by a combination of debt and equity so that its average cost of capital is 15 per cent. If the project is for one year, then it should generate a rate of return of at least 15 per cent, otherwise it would not be able to pay back the suppliers of capital (debt and equity investors). If the return is less than 15 per cent, then capital is being misallocated as it being used in a sub-optimal manner.
If every project is productive enough such that it earns a positive return on capital, then cash flows will always be positive, debt will always be repaid and the cumulative impact of these activities is that economies will grow and people will prosper. Appreciate that if debt is used for non-productive purposes, then the opposite is likely to occur. Therein lies the problem. In the debate of austerity versus stimulus everyone is calling for the Keynesian solution, which is to pump out more stimulus. Even here at home, the call from business, trade unions and politicians is the same, spend more, run a deficit: it will cause economic activity and then everything will be okay. It will not and we will simply be digging a bigger hole for ourselves unless behaviours change and there are mechanisms in place to ensure that capital is more efficiently allocated. These measures are likely to be unpopular, so they will not be implemented.
Those who are glibly arguing for stimulus should read the 1919 work of the same John Maynard Keynes, The Economic Consequences of Peace. Keynes suggested that the inequity between rich and poor was at the time actually beneficial to the overall society since the concentration of wealth made it easier to mobilise capital. He argued that the balance came from the virtues of the wealthy who "were not brought to large expenditures," but instead sought to save and invest their accumulated wealth in such a manner that the whole community benefited. According to Keynes, if the wealthy had sought their own wants and enjoyments and spend on themselves in a conspicuous manner, the masses would have found that status quo intolerable. This environment speaks to a culture of savings driven economic growth.
Culture change
Over time, especially after the Second World War, the culture of savings vanished and a culture of consumerism took over. Maybe it was because of the advent of real time media where people could be more easily enticed, but regardless, savers shifted to consumers. Those less well-off sought to mimic the spending of the wealthy. As Keynes suggested, in such an environment, something had to give. If workers were paid a higher wage so they could better afford, that would result in less profitability for corporations and, by extension, the wealthy. Easier access to credit seemed the most palatable solution, which effectively meant the use of bank credit to subsidise corporate profitability.
Credit became the substitute for higher wages and, of course, the bank would also make a profit from the interest charged on the credit. This all came at the expense of the average worker. So it went in the developed world where credit moved from a privilege to an entitlement. All of this may sound anti-business, but, up to this point, there is really no issue if, as explained above, the credit is put into an activity where the return on that activity is greater than the cost of the credit. Choices had to be made. Do I borrow for items that are going to increase my wealth or do I borrow to consume and keep up with the Jones? Even if individuals were inclined to be responsible and adopt the former approach, in came a new participant in the Ponzi finance game.
Government intervention
Enter the government to provide incentives to borrow as opposed to save. Every student of finance knows that according to Modigliani and Miller, a corporation will be indifferent to the use of debt or equity in their capital structure. The eventual preference for debt comes from the ability to deduct the interest cost associated with the debt from taxable income. Did you know that in the United States up to 1986, it was possible for individuals to deduct the interest cost associated with credit cards and car loans from taxable income? All of these are strong incentives to utilise debt. At the same time, there are taxes on interest income, dividends and capital gains, in other words, forms of income associated with investing and further investing in equities.
Can you imagine allowing a tax deduction on credit cards, which essentially means not paying your bills on time, but, at the same time taxing the propensity to save? Appreciate the behavioural changes that emerged from these incentives, behaviours that T&T and much of the Western world have mimicked.
Before the current crisis, these incentives seemed like a win-win situation as, for example, a tax deduction on the interest associated with a car makes it easier for people to buy a car, which makes them happy and, in turn, keeps the politician in office. It also creates loan demand and profits for the bank, which is good for the stock market. There is, of course, demand for motor vehicles, which supports the manufacturing sector, leading to more jobs, more consumption, more taxes, and life is good.
Now assume that a car loses value by 15 per cent per year and the interest cost on the vehicle is 15 per cent per year. Given these hurdles, would you consider most cars to be generating a positive return on capital for their owners?
The only way it would make sense to purchase cars, household appliances and other durable goods on credit is if the convenience provided by these items are such that it allows you to increase your earning power over the life of these assets. Further that increase in earnings must be sufficient to offset the interest cost, otherwise you are likely to be worse off in the end. Yet, most people are salaried on a fixed income that increases only marginally in relation to overall gross domestic product growth in an economy. In the end, the satisfaction that comes from owning something (utility) thumps the financial discipline that the return on a asset must exceed the cost of the asset leading to an illusion of wealth. That illusion is now being exposed. To be continued next week.
Ian Narine is a broker registered with the Securities and Industries Commission.
