How is an investor to survive “post QE”?

1. Capacity risks of investments in a QE world

This commentary ponders Capacity risks in a world where investment is being encouraged by subsidised borrowing. In the main part of the commentary, I analyse prospects of over-capacity within some asset classes, and of scarcity in others. In the Appendix, I set out a brief case study of capacity risks within row crop vs. permanent crop farmland investments.

2. Avoiding investor euthanasia!

Keynes and his intellectual heirs – the current practitioners of quantitative easing – may have missed an important second order effect of QE. That rising asset prices may lead investors to build more productive capacity than is needed. Which in turn will supply more goods, services and real estate space than is demanded, putting downward pressure on prices. Hence I argued in my last Commentary that “Quantitative Easing is Causing Deflation”.

Keynes concluded in his 1935 “General Theory” by advocating:

“the euthanasia of the rentier, and, consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity value of capital.” (Chapter 24, Section II).

What might an investor do to try to avoid this fate?

3. The “free lunch” phase of quantitative easing

Quantitative Easing is the subsidisation of borrowing (investment if you prefer) by central banks. All QE programmes seek to lower interest rates along the term structure i.e. to lower interest rates on 5 and 10 year bonds as well as on short term bank and government instruments.

This creates an almost immediate one-off wealth effect in the financial sector (as bond portfolios and bank asset books become more valuable). As discussed last month, leveraged sectors of the economy such as real estate and corporates also benefit because these players are now able to issue cheap debt, so can now compete with each other for assets – leading to a one-off increase in asset prices. And therefore to a wealth effect for investors in real-estate and corporates.

The initial phase of QE tends to “lift all financial boats” together. But it particularly boosts those in the bottom row of the below table, i.e. the (typically leveraged) “Financial Capital” and “Big Business” investments:

The “Free Lunch” Phase of QE – lifting all boats but especially Financials and Big Business

It is true that savers’ incomes are negatively impacted by QE. However at first the positive wealth effect outweighs this as asset prices are buoyed up. That many years of lower income will now follow is more than offset in investors’ minds (although it should probably not be) by this upfront wealth effect. For all these reasons the early phase of QE appears to be a “free lunch”, at least at the macro level.

4. The capacity expansion phase of QE

Although there has been a feel good factor in the period 2010 to 2015, the impacts of QE may be less positive going forward.

While investors experienced a one-off wealth effect in the early years, over time, as interest rates approach the zero bound, there is no more room for asset price increases i.e. the “wealth effect cow” begins to run dry.

New sources of savings (and reinvestments of maturing old capital) are going to receive a near zero return going forward. Rentiers, as Keynes predicted and wished, are being quietly euthanised. Meanwhile, this is a real boon to those governments who are borrowing to excess (most of the world nowadays), as they pay off their old coupon debt and refinance at near zero interest rates. This is a disincentive for politicians to get their respective houses in order.

To preserve wealth, investors now need to either spend precisely zero each year, or alternatively, as Keynes points out, they need to take more risk with their capital. This is likely to lead them to make investments into new buildings or equipment, i.e. to capacity expansion. Especially in the leveraged industries that were the early darlings of QE, viz. Financialised Capital and Big Business. A dramatic example has been investment in shale oil drilling, where technological advances and massive capacity expansion financed at low interest rates created a perfect storm of over-production.

5. An eventual shift out of bonds and financialised assets

A shift of wealth out of bonds and equivalent instruments now yielding close to zero percent will eventually occur. It will either happen because of a sudden crash in the bond and/or associated leveraged markets (e.g. property and/or credit organisations). Or (as happened in the Japanese bond market – whose inevitable euthanasia is only now being achieved via monetary debasement) it will happen slowly as the self-satisfaction of the early years of QE slowly turn to gloom and depression as capital owners wake up to the fact they are being euthanised.

6. Which sectors will prosper in the “medium” and “late” stages of QE?

The less-leveraged Entrepreneurial Capital and Old Money sectors (the top row of the below table) often did not perform as strongly in the first phase of QE i.e. they are currently less over-priced. Further, the net rate of annual capacity growth in these sectors (close to zero anyway for capacity inelastic Old Money investments) is likely to be lower than the growth in demand for their services. It follows that it is in this second period of QE, prices of Entrepreneurial Capital and Old Money investments should outperform.

The Mature phase of QE – expansion of capacity in response to low interest rates

Financialised Capital is the most worrying sector in the “post QE” period.  Incentives to both new capacity and leverage make for a dangerous mix. Capacity in lending and real estate markets will often have grown quite fast (after a lag for the capacity to be built). Demand is unlikely to keep up. The terms of trade of these sectors are likely, at some point, to follow the “shale oil” spiral down once it becomes apparent that capacity is increasing faster than demand. This realisation may be accompanied by a “Minsky” debt deflation (such as that witnessed in 2008). Central banks are likely at that point to combat financial collapse with further aggressive government purchasing of assets. However at some point they will discover limits (political and/or relating to the debasement of their currency and/or to a need for positive interest rates) to the attempt at a perpetual motion machine that is QE. For example, political resistance may at some point grow to unelected central bankers progressively nationalising financialised sectors like real estate. This will occur despite the urgings of “Keynesians” encouraged by the financial sector, who will argue for this.

The other sector in the bottom row, Big Business, which probably out-performed in the early years of QE, will have mixed fortunes. Some mature companies will do fine. Others may be impacted by the next de-leveraging. Others may struggle to grow their revenues (amidst possibly deflationary conditions). Big Business in general may struggle to maintain the lofty valuations created in the early period of QE through debt-financed stock buybacks. However, to be fair, a lot of this will depend on whether the world continues on a deflationary path (which is bad for corporates). Or whether governments manage to stimulate inflation, which could make “inflation proof” stock markets perform quite well.

7. Conclusion – a life-cycle approach to investing during QE periods of history

After World War One, and with the benefit of hindsight, the perfect strategy for an investor in Germany during the initial deflation and subsequent inflation was to have no debt and be long cash during the early asset price deflation, then to buy assets when they became cheap, and to allow the subsequent currency debasement to compound one’s returns (at that point using debt to further leverage returns). As recalled in When Money Dies (Adam Fergusson, 1975), farmers did extremely well in this period, accumulating many of the city luxuries of the time from their previous – and now broke – urban rivals, such as grand pianos, and prospering greatly. At least when they managed  to avoid subsequent looting and farm raids by angry – and impoverished – urban people!

One may need to adopt the opposite strategy during a QE. In hindsight, taking on debt and buying commercial property and bank shares and other Financialised Investments in the early phase of QE produced great results. Repaying debt as the asset markets start to peak (which if the Free Lunch phase of QE lasts five years should happen in the US and UK in 2015 or 2016, and in Europe rather later) may then make sense.

In the “mature-to-late QE” phase it may be wise to invest in defensive Old Money assets. Their scarcity should protect them in asset markets that are likely to be awash with too much of everything (including, quite possibly, nominal currencies which governments are likely to resume aggressively debasing).

In conclusion a nimble investor may elect to manage exposures to the QE cycle by moving from the lower left to the upper right of this table as the QE programme matures.

A Life Cycle Approach to Investing in QE periods

On the other hand  investors who do not want the risks of Financialised Assets, or the low cash flow returns of Old Money investment may prefer the operational risks of the Entrepreneurial sector or the systemic risks of Big Business. I believe these two sectors are likely to face returns dispersion: some components will do well (one may own the next Facebook or Google, or some Big Business shares that may further increase its pricing power over time through branding or regulation) while some components (many?) may perform poorly, due to the current high valuations.

In truth a diversified portfolio should have elements of all four. The arguments advanced here about Capacity Risks following a period of subsidised interest rates suggest that the late stages of QE years could be a time that the Old Money risks could particularly shine.

With warm regards as always,

Forbes Elworthy

8. Appendix – How do farmers discount farm investments?

The reason for preparing this Appendix is I developed the concept of Capacity Elasticity in order to explain different levels of operating return normally expected for different types of farming risk. Adjusting for the Capacity Risks of different types of farming helps one to compare returns, in a fair way, across farming systems. I set out those arguments here as a worked example of a Capacity Elasticity analysis. This may help shed light on the concept, and help the reader to think about the levels of extra return (relative to less elastic asset classes) an investor might need in order to take the risk of assets prone to over-capacity, such as Commercial Real Estate.

Typical returns of bare land vs. farm improvements

In farming circles in most countries unspecialised or “bare” farmland is considered a “good buy” at cash-flow yields above 2.5% to 5%. Europe is an exception with (trended pre-tax, unlevered, post-subsidy) Bare Land returns typically capitalised at 1% to 2.5% (not necessarily irrational given the population densities of Europe and therefore embedded development values).

In contrast to these low rates, farmers typically require pay-backs of 5 to 10 years, i.e. expected IRRs of 8% to 15% per annum in order to invest in improvements to their land.

Prices of going-concern farms are consistent. To illustrate, let us assume the value of unimproved “Bare Land” within an unspecialised row-crop farm is 75% of the total farm enterprise value, and that a further 15% is contributed by Fixed Improvements (soil improvements, drainage, housing, lanes, fences, irrigation), and that  total assets are completed by 10% Working Capital & Machinery.

A farmer purchasing that farm might then discount the Bare Land at 4%, the Fixed Improvements at 12% and the Working Capital at 10%:

As per the table this farm as a whole would trade at a blended “capitalisation rate” of 5.8%. This is actually a little below the average 6.4% rate at which US Maize farm profits were capitalised over the 10 years to 2012:

Operational Returns for United States Maize: Average = 6.4%

Source: USDA and MOA Analysis

Extending analysis to permanent crops

Now let us assume the neighbouring equivalent land has been planted with a long-life “permanent” crop. Vines and orchids are expensive to establish so the Bare Land might now contribute only 30% of this (much more valuable) enterprise.

As you can see from the table, applying the same discount rates to each element, this farm is capitalised at 9.5%. Again this is not wildly different from observed “cap rates” for permanent crop farms:

Operational Returns for California Almonds: Average 9.4%

Source: Almond Board of California and MOA Analysis

A capacity elasticity theory of farm investments

The reason Bare Land is discounted at lower discount rates than farm improvements and specialisations is, of course, that farmers expect farmland will outperform investment in crops and/or working capital. Land is more versatile than a specialised business (it can grow many different types of crop – lowering risk) and is also the “scarce” factor which should capitalise future gains in the sector.

The comparison is especially true for long-cycle “permanent crops”; where capacity can take years to build, has far higher rates of depreciation (both physical and economic – as a result of varietal change) and with high risks of synchronised industry capacity increases (plus high switching costs).

Bare Land will never have a Capacity boom and it does not depreciate. You cannot make a meaningful amount more, no matter how high the price. The nearest effect to a Capacity boom is a productivity boom, but this lifts the production per hectare often offsetting the resultant fall in commodity prices. Therefore, farmland has a Capacity Elasticity of close to zero.

Farmland capacity response to returns

So why bother with specialist crops at all? Well, wine grapes, pip-fruit, stone-fruit, citrus, currants and other cane crops including kiwi, almonds, coffee, cocoa, palm oil, coffee and rubber all typically generate much higher revenues per hectare than more extensive land uses (such as “row crop” or “grazing” farming systems). However they also have far higher costs (especially capital costs) per hectare. When the revenues of these sectors exceed their costs then they can exhibit markedly higher profitability than more extensive farms.

As noted this distinction may become  particularly relevant in a time of subsidised interest rates. “Discretionary investment” sectors of the economy, like permanent crops, are likely to be quite challenged by Quantitative Easing for two reasons. Firstly capital has got cheaper. No amount of capital can change the quantity of Bare Land. So QE cannot change the equilibrium profitability of extensive farming systems. However cheap capital applied to a permanent crop sector can spread the crops across former unspecialised land and massively increase its capacity, boost sector-wide supply, and undermine returns for individual farms (a form of economic depreciation).

The second challenge posed by QE is “new entrants” to the farming sector. Financial fund managers who have not grown up in the farming industry may not have heard the horror stories of apple and peach and wine grape industries that grew too much capacity and saw these farmers forced to sell these fruits at their marginal cost of production, making significant annual losses when taking into account overheads and their cost of capital. These new entrants are also often less fussy than established players about marginal costs of production. They may just want to make the numbers add up at the average historic cost and price ratios. Indeed, in contrast to experienced farmers who normally only want quality land, these new entrants (as discussed in previous Commentaries) tend to obsess about buying “cheap land”. I.e. land that makes the ratios in an Excel spreadsheet look good. It is exactly these new entrants that will be found out the next time there is a capacity-driven commodity price cycle in their “new” industry. Unless meeting a co-incident expansion in demand for their goods or unless expansion is brought to an end by climatic or industry structure, these specialist forms of farming tend to “blow themselves up” periodically.

Permanent crop capacity response to returns

Price performance is not the same as total return

It is important to note that “relative asset price performance” is not the same as “investment total return”. One pays a price for the defensive qualities of investments like gold, collectables and Bare Land in that these sectors have low running yields. It follows that some sectors with high and therefore risky Capacity Elasticity (such as Permanent Crops) may well have a sufficiently high expected cash-flow return that this more than compensates for the likely lower capital gains of their sector. This is exactly the point of the “Capacity Elasticity” model. One estimates the cash-flow yield premium that investments with more capacity risks should earn in order to justify investment.

Our capacity elasticity model compared to the capital asset pricing model

The Capital Asset Pricing Model estimates the extra basis points of discount rate an investor should need for a volatile investment. Similarly we hope the “Capacity Elasticity Model” may help investors estimate the risk premium a high Capacity Elasticity asset class will require, relative to lower risk investments.