Relax, Mr Piketty, Inequality Will Be Reversed Big Time by Marathon Asset Management, dated Aug 2014. This is discussed in their new book Capital Returns: Investing Through the Capital Cycle: A Money Manager’s Reports 2002-15 we think – anyway read it below.
Ultra-low rates are enticing investors into risky assets with the prospect of future losses
Relax, Mr Piketty, Inequality Will Be Reversed Big Time
Thomas Piketty in his unlikely bestseller, Capital in the Twenty-First Century, opines that the growing gap between rich and poor should be closed through the imposition of a global wealth tax. The likelihood of such a coordinated assault on the rich must be slim. Nevertheless, Mr. Piketty can take heart from the recent behavior of many investors. Their hunger for yield, and accompanying disregard for safety, is set to reduce wealth disparities far more effectively than any new taxes. As J.K. Galbraith posited in The Age of Uncertainty: “The privileged have regularly invited their own destruction with their greed.”
Marathon recently hosted a meeting with a company, a constituent of the S&P 500, whose history might politely be described as chequered. The sum of its efforts over the last two decades has been a net loss. This was not the result of one exceptionally bad year. On the contrary, the business has been profitable in barely half of the last two decades. Long-term debt has quadrupled during the last ten years. Additional funding has been provided through a steadily rising share count (at the latest reading 70 per cent higher than a decade earlier.) Last May, this perennial underperformer issued an eight-year callable bond that is currently priced to yield just 4.7 per cent to maturity, a modest 2.3 per cent premium to US Treasuries. S&P rated the issuer BB-, indicating that the company “faces major ongoing uncertainties and exposure to adverse business, financial, or economic conditions, which could lead to the obligor’s inadequate capacity to meet its financial commitments.”
Nor is this an isolated example. Barclays High Yield Index shows the ten year noninvestment grade spread reaching an all-time low of 2.4 per cent at the end of the last quarter. This compares with an average spread of 5.2 per cent over the past two decades, and a peak spread of nearly 19 per cent in late 2008. Spreads have been following default rates lower. Moody’s calculates a trailing 12 month default rate of 2.3 per cent compared to a long-term average of 4.7 per cent.
Mr. Piketty identifies the “central contradiction of capitalism” in the fact that the average rate of return on capital has tended to exceed the pace of output growth. “Once constituted, capital reproduces itself faster than output increases.” In layman’s terms, the rich get richer.1 At the time of writing, the Federal Funds Target Rate is a mere 0.25 per cent, substantially below the nominal rate of US economic growth. In order to achieve high returns, investors must taken on a variety of additional risks. Treasuries with longer maturities come with interest rate and inflation risk. By shifting from Treasuries into higher-yielding corporate bonds, investor are also assuming credit risk. These risks are not independent as interest rates and credit spreads generally rise together.
True, investors can earn 4.7 per cent on “high yield” corporate bonds, roughly a percentage point above nominal US GDP growth, which might appear to support of the French economist’s argument. But this compares with an average historic yield on sub-investment grade issues of nearly 9 per cent. A return to “normal” conditions in the bond market would thus produce a capital loss in the region of 25 per cent. In the case of high inflation or particularly stressed market conditions, yields could rise to twice this level in which case the bonds would halve in value.
In addition, there are currency and liquidity risks to consider. Reports abound of investors enthusiastically leaping into the global carry trade, encouraged by new lows in foreign exchange volatility (which, as measured by JP Morgan, has been running at half the long-term average). As for liquidity, in less favorable market conditions the actual sale price would inevitably be below those quoted. This risk may be even more acute than in the past. Owing to stricter capital regulations, investment banks have considerably reduced the scope of their market-making. According to Federal Reserve data, primary dealers hold only $5bn net in high yield bonds, less than 0.5 per cent of the total market.
The wisdom of buying non-investment grade bonds at current yields can be gauged from the zeal of the issuers. Between 2003 and 2007, US high yield bond issuance totaled between $100bn and $150bn a year. In 2013, more than junk bonds with a face value of more than $300bn came to market, with a further $182bn issued in the first half of this year. Of the $2tn of debt included in Bank of America’s High Yield Index, nearly half has been listed in just the last 18 months. Recent low volatility in the bond market has fostered a feeling of security among investors. Last June, the Bank of America’s MOVE Index (a measure of Treasury option volatility) was close to record lows.
Banks have joined the party. US leveraged loan issuance, which peaked in 2007 just shy of $900bn, exceeded $1tn in 2013. According to the Bank for International Settlements (BIS), over 40 per cent of syndicated lending is now to non-investment grade borrowers, again above the 2007 peak. Bankers can also celebrate the return of the type of structured products that were so discredited during the 2008 crisis. Issuance of collateralised loan obligations (known by the acronym, CLOs) reached $82bn in 2013 and is forecast to rise above $100bn this year, beyond pre-crisis highs.
At the same time, covenants are weakening. Dealogic calculates that loans of the “cov-lite” variety – so-called because they lack the traditional covenants protecting creditors – rose 40 per cent in the year to June and now represent more than half of all lending. In another seemingly forgotten lesson from the crisis, bank loans are being purchased by mutual funds and even ETFs. According to Morningstar, bank-loan funds attracted a record $61bn in 2013. This poses the risk of future liquidity problems as funds can be sold faster than their underlying assets are redeemed.
In a doom-laden introduction to its latest annual report, the BIS warns that “a powerful and pervasive search for yield has gathered pace.” The central bankers’ central bank adds further words of caution: “The benefits of unusually easy monetary policies may appear quite tangible, especially if judged by the response of financial markets; the costs, unfortunately, will become apparent only over time and with hindsight.” In the US, the Federal Reserve Chair Janet Yellen recently noted that: “We’re seeing a deterioration in lending standards and we are attentive to risks that can develop in this environment.” The Fed offered assurance that it is working with other regulators to “enhance compliance with previous guidance on issuance, pricing and underwriting standards.”
These recent developments in the credit markets should not come as a complete surprise to Dr Yellen and colleagues. After all, the Fed has driven down rates with the intention of encouraging investors to take on more risk. Yet those who embrace low yields, poor credits, thin liquidity and even currency mismatches today may discover, when market conditions deteriorate, that the modest yield pick-up proves poor compensaiton for future losses. Mr. Piketty can rest easy. In an age when risk-free assets yield little or nothing, the determination of the wealthy to sustain a return on capital in excess of economic growth will, in due course, do more to restore equality than his proposed taxes. A free market solution to a political problem – who says capitalism is failing?
- There are numerous problems with Piketty’s argument. For a start, he assumes that the owners of capital reinvest their returns rather than consume them, an option which is not open everyone. Besides, as noted above (1.9 Growth Paradox), earnings-per-share growth for the US stock market has historically lagged GDP growth (this discrepancy being even more pronounced abroad.)
Capital Returns: Investing Through the Capital Cycle: A Money Manager’s Reports 2002-15 1st ed. 2015 Edition by Edward Chancellor
