INVESTMENT INSIGHTS
Risk-reward is an often-heard phrase
Originally Written in 2019 - still relevant today.
I get a reasonable amount of feedback from readers on this newsletter, some of it is even quite complimentary! When we started writing these letters, in some form over 17 years ago, it was seen as an addition to our fund management business to keep investors updated on our thoughts of the macro market-place. Since the introduction of the HindeSight Dividend portfolio, several years ago, there has been a a focus on trying to help any investor build a UK equity portfolio and understand the risks across other asset classes. We have written on property, bonds, precious metals, commodities and equities extensively in that time, but our overwhelming desire is to make investors, retail and professional alike, aware of the risks that we see around us, especially in these extraordinary times of free money and the ‘warping’ of the world as our Bloomberg ad earlier showed.
Risk-reward is an often-heard phrase, not just in the financial world. I can remember an old friend in our youth, who would use it, when he asked out as many pretty girls out as he could. The risk of rejection, or even a slap, could be outweighed by the reward of getting lucky once in a while!
With the valuations, as they are in many asset prices, I see so much risk for so little reward, it is truly frightening. Having long-dated bonds in my pension that trade at 200, which will be redeemed at 100, that could drop like a stone at any time or buying stocks with no earnings, or whose earnings you are paying 45x multiples for, seems to fit the all risk and small chance of reward scenario. Liquidity is also something we take for granted at times like these. ‘Getting our money back, quickly’. We already have Neil Woodford’s fund locked down, with no sight of redemption possibilities and the stock market is not even down much. Heaven help us when the balloon actually does go up.
My advice remains, to make sure that you have true liquidity with your monies, for the amount you may need when the system slips up again, like 2002 or 2008, and understand fully that stocks and bonds as a whole are very, very far from cheap at current levels. And like most people, I am sure you do not have enough portfolio insurance, like gold or T-bills, but there is still time.
Most readers will know the stocks that we have hated over the years, none more so than Metro bank, especially when it was at 4000 in 2018. It dropped over 90% this year since those heady days of craziness and I was recently asked if it could go out of business completely? In my experience, any stock – whether it is Metro or any other – that drops 90% in less than a few years has a very great chance of going to the wall, especially seeing as we haven’t even gone into an actual recession or banking crisis yet, or have we?
There has been a general belief that all is well with the banks, a decade on from the last crisis, but it is not obvious to me, especially in the stock prices of the UK and European banks.
I think it is worth republishing again something that I originally wrote in 2008, “Nothing New in Banking” and reposted in March 2016 & again here. Although readers may have seen it before, I believe the title speaks for itself. It is worth understanding that the ‘recessionary indicator’ of the inverted yield curve mentioned earlier has grave implications for banking profits as well.
In Medieval Europe which was predominately illiterate and constantly short of physical money, the split tally was a technique used to record bilateral exchange and debts. A stick (usually squared Hazelwood sticks were most common) was marked with a system of notches and then split lengthwise. This way the two halves both record the same notches and each party to the transaction received one half of the marked stick as proof. The technique was refined in various ways, one such way was to make the two halves of the stick of different length until it became virtually tamper proof. The longer part was called the stock and was given to the party which had advanced money. This is where “stockholder” derives from when we refer to modern day equity owners. The shorter half was called the foil and was retained by the party that had received the goods or funds as such that both parties had an identifiable and tamper proof record of the transaction.
In AD 1100, King Henry I came to the English throne and adopted the tally stick method of recording tax payments. By the time of Henry II, taxes were paid twice a year, and the tally sticks recording partial payment made at Easter soon began to circulate in a secondary discount market, being accepted as payment for goods and services at a discount since they could be later presented to the treasury as proof of taxes paid. It didn’t take long for the King and his treasurer to realise that they could actually issue tally sticks in advance, in order to finance war and other royal spending. The selling of these claims to future tax revenue created the market for government debt-an essential part of today’s fiat money system as well.
Medieval England also saw the emergence of the goldsmith banker. Since no actual banks existed at this time, merchants and noblemen who had received gold specie in exchange for goods and services rendered, entrusted their wealth with a London goldsmith. In exchange for each deposit of precious metal, the goldsmiths issued paper receipts certifying the quantity and purity of the metal held on deposit. The goldsmith receipts like the tally sticks soon began to circulate as a safe and convenient form of money backed by gold and silver in the goldsmiths’ vaults. Once again, it didn’t take long for the goldsmiths to realise that they could temporarily lend deposits out and collect interest on such loans. The temptation was too much and before long, they began issuing additional receipts for gold even if they were not backed by a deposit. This came to be known as ‘fractional reserves banking’ – lending out far more money than one actually has on deposit and the road to banking ruin was firmly in place.
The government and central bank of the day were still in the hands of the monarchy apart from a short Cromwellian experiment in the early 17th century. By 1660 Charles II was raising taxes although he did have to get parliament’s permission. He immediately went to cash in the future tax receipts by selling tally sticks to the goldsmiths at a discount. The introduction of making debt payable to the bearer allowed the goldsmiths to sell it in the secondary market to raise funds for more lending to the King. In order to attract more funds higher interest rates were paid to the depositors. At that stage of the game the goldsmiths had a good thing going for them, since the King was the equivalent of a triple A rated sovereign borrower, who could always be relied upon to cover his debt with future tax receipts. Despite the fact that the vaults soon contained more wooden sticks than gold and the King meanwhile had begun to issue tally sticks as he pleased, no-one thought it problematic especially as this increase in wooden stick production had started a seemingly prosperous credit boom. The natural limit to debt expansion is when your creditors are no longer willing to lend you more money despite of higher interest rates. By 1671 the annual discount on the King’s debt had reached 10% and new funds were barely enough to cover maturing loans. Time was running out. A cunning plan was called for and with some legal advice the ‘discovery’ that usury was still illegal; all interest rates in excess of 6% were not permissible. All the recent loans were now declared illegal and payment was stopped. Overnight the King’s tally sticks reverted back to their real worth –firewood. The King’s creditors, the goldsmiths and their customers had “drawn the short end of the stick” (the origin of a still used expression).
What the tally stick system and its application by Charles II shows us is that a fiat money system can work for many years where worthless pieces of wood or paper are deemed to have the same value as gold as long as there is complete faith in the government to not increase the supply of wood. Unfortunately in our history to date, no government has been able to resist the temptation to spend the future’s productivity for today’s consumption..
In most countries banking is seen as the life blood to the economy, its ability to lend to businesses or individuals is part of nearly every aspect of our lives, not just property and employment. Over the last year most bank stocks across the globe have suffered considerably with the Euro Stox banking index has fallen 35%. With high weightings in the main country indices such as the UK FTSE or the German DAX, this has been a key driver on the poor returns which has received far less attention than the dramatic decline in oil prices. As of today, Royal Dutch Shell is actually up 6% on the year versus Royal Bank of Scotland’s 25% loss. Is another banking crisis really possible after the last one?
In 2008, we wrote the basis of Fractural Reserve banking is simplicity itself. As a bank you receive deposits for which you pay X%, (these are your liabilities to be paid back), with which you make loans at X+% (these are your assets). The difference in the maturity of the deposits and loans, the spread (usually called the Net Interest margin) and the number of loans you make levered off the deposit base all factor into the equation of profitability. The correct analysis of risk and the diversification in determining the margin for potential defaults is key. Every bank failure in history has resulted from the incorrect analysis of the potential changes in these factors. While some seemingly conservative banks will fail at times as well as the more foolhardy; poor forecasting abilities are always at the fore front. In the pursuit of profits amid heavy competition, bankers will find new ways and hopes to avoid natural business cycle events. Not all are as stupid as others.
Our predictions from that time drew heavily from what had happened after the 1990 Japanese banking crisis showing that after the valuation bubble had burst, banking stocks collapsed by 70-80% before recovering to some degree and then spending the next 20 years going nowhere to drifting lower.
The reality is that the banking crisis of 2008 is still playing out. Despite all the new capital raises, the government bail outs, and the new regulations banks are still struggling to make enough money to cover the continual write downs of the loan book even with the economic recovery that every politician has been championing.
The largest factor in a bank’s profitability is the net interest margin, the money it can charge on its loans minus the money it has to pay to its depositors, the larger the spread difference the better. The premise of this is derived from the maturity yield curve in the specific country.
The yield curve is merely the different interest rates plotted against maturity. This curve will tend to fluctuate with the business cycle, flattening and steepening accordingly. In general, short rates are lower than longer rates because the risk for default increases over time but many factors change the shape. In ‘Nothing new in banking’, we wrote that banks’ profits had tended to track the shape of the yield curve as banks borrowed short term and lent long term for many years before the 2008 crisis. In the run up to the crisis, a strange phenomenon occurred, banks’ profits continued to rise despite the yield flattening. The economist J.K. Galbraith wrote in 1994, financial innovation is usually based on an extension of leverage. We now know that a major aspect of the 2008 crisis was that the new financial innovations of sub-prime securitisation were just this, more leverage and more risk. In the end, good old-fashioned poor risk management, little understanding of the business cycle and greed fuelled over leverage brought the house down.
Whether it is a banking crisis or a recession, the policy response is usually the same. Cut short term interest rates aggressively, steepening the yield curve. This immediately helps borrowers to maintain interest payments and not default as well as improving the NIM and increases the banks’ earning powers. These increased earnings can then be used to slowly write down the losses over time and recover. Generally speaking this has happened with much greater success in the US than the rest of the world. The challenges that the banks have faced, from increased regulation, fines for miss-selling products such as PPI as well as huge fines for ‘market abuse manipulation’ of Libor, FX to name a few have been considerable. However the greatest challenge that is threatening the entire business model is the adoption of negative interest rate policy (NIRP).
Japan has showed that the banking crisis after effects seem to last a lifetime. It is only 7-8 years since the GFC and we don’t have much to show for a recovery but maybe we shouldn’t be surprised. European banks have still not been able to write down enough of the debts from their increased earning power and now we have negative rates and very flat yield curves. If you thought it was hard to make money with a flat curve, try making it when half of the curve is in negative territory. Banks in generally have been reluctant to pass on negative interest rates that the central banks have instilled on them in Europe and Japan so far which means that unless they raise their loan rates they will just make less money (anecdotally, there are reports of Swiss mortgage rates rising because of this reason).
We are potentially on the crest of the business cycle in respect to low unemployment rates, often a precursor of a downturn. Monetary conditions are generally tightening in the world and valuations are hardly attractive with high P/E ratios and zero yielding bonds.
The story about the frog who doesn’t notice the water heating up, boiling to death before he realises to jump out, springs to mind. It is meant to demonstrate that if something happens gradually, then we might miss the disaster of what is happening.
We have negative interest rates in Switzerland, Europe, Scandinavia and recently Japan. It is probably going to eventually come to the UK and the US despite all good intentions. The academic lunatics will be fully in charge of the asylum as they take interest rates increasingly into negative territory and threaten the abolition of paper money starting with large denomination notes. Starting with disbelief, outrage, then rumours before it’s a fait accompli, many bad outcomes scatter our history.
Negative interest rates and even more excessive money printing in a last gasp but vain attempt to stimulate the economies to outgrow their debts may well be the straw that breaks the camel’s back and really brings the house down. As they say, I think I hear a rather large lady warming up her vocal cords in the dressing room.
Happy Investing!