Chasing Yield - Yields Bad Results
You've probably read about financial repression in which governments or their agents interfere in the market in an effort to reduce debt. The most obvious recent example is the Fed and other central banks interfering in bond markets and suppressing interest rates. While these central banks generally justify this act on the grounds that it will help the economy as a whole, the most obvious beneficiaries are governments issuing large amounts of debt to fund budget deficits. The support of the government bond market – and corresponding suppression of interest rates – lets governments run deficits beyond what a free market would allow. These deficits are seen by Keynesian economists as necessary to support aggregate demand until such time as the private market can take over and a self sustaining recovery commence.
In addition, the Fed justifies its bond and mortgage market support by pointing to the reduced cost of borrowing in the private sector. It is hard to argue that the policy hasn't been effective when household debt service payments as a percent of disposable income are sitting at 30 year lows. Corporations have used the low rate gift to go on an orgy of borrowing that has total corporate debt sitting at all time highs. The Fed believes that by keeping rates low, individuals and corporations will borrow and either fund new consumption or investment. This new consumption and investment will lead to more growth, at least in theory.
While financial repression is generally thought of in terms of interest rates, it can also take other forms. The capital controls introduced in Cyprus last week are a form of financial repression. The Chinese systematic manipulation of the Yuan exchange rate – in combination with capital controls – is a form of financial repression. The Chinese also set interest rates paid to depositors, rates paid by borrowers, lending standards for state owned banks and to whom money will be lent. The Chinese have financial repression down to an art. Taxes can also be a form of financial repression, the much cited proposed financial transactions tax in Europe being a prime example. Even tariffs are a form of financial repression. And as countries chase ebbing global demand, financial repression is likely to take the more extreme forms.
All of this financial repression has a cost, most of it imposed on savers and investors for the benefit of either the politically connected or the indebted. Savers face low interest rates on what were once safe investments and now, after Cyprus – at least in Europe – the prospect of waking up one morning to find a large percentage of their bank accounts confiscated. Savers and investors are being forced – impelled one might say – to take actions to protect their assets and their standard of living. In Europe that will likely mean deposit flight from the riskiest banks – if that can be determined in the opaque world of bank balance sheets – to the ones deemed safe. In addition, because the Cyprus solution makes the break up of the Euro more likely, it will mean a movement, possibly a stampede, from the risky south to the supposedly safer north. Don't be surprised if this leads to more stringent forms of repression to try and trap capital where it is most needed.
Here in the US, savers and investors have responded to financial repression just as Ben Bernanke hoped they would. They are abandoning safe havens such as CDs, savings accounts and Treasury securities for the higher yields of riskier investments. Bernanke calls this the portfolio balance channel of monetary policy. He believes that by forcing investors to take more risk than they otherwise would, it will raise asset prices and make them feel wealthier. This will lead to more spending and more growth. More growth will lead to more investment and more growth in a self reinforcing virtuous circle. The key variable is not asset prices themselves but rather how people feel about their supposedly new found wealth.
The problem with the theory is that investors and savers are not wealthier even if some of them feel that way. The Fed's act of taking some of the stock of Treasury bonds off the market does not create new wealth so much as move it around. Investors buying stocks from one another does not create new capital. Corporations borrowing money from one set of investors to buy back stock from another set does not create new wealth. Speculators borrowing on margin to buy stocks with higher dividend yields does not create wealth. Private equity firms borrowing to buy existing companies in leveraged buyouts does not create wealth. Hedge funds borrowing to buy up the existing housing stock does not create wealth. All the Fed is really creating with its newly manufactured money is inflation. It isn't inflation as the Fed would have us define it, but it is inflation nonetheless.
What bothers me – and should bother everyone – is that investors are not taking these risks voluntarily. They are being forced because of the Fed's financial repression to take risks they don't want to and in a free market would not have to take. More importantly, many investors do not understand or appreciate the level of risk they are taking and many likely cannot afford the potential losses that make risky investments deserve the name. Even the dividend darlings of the market that everyone seems to believe are a worthy substitute for safe income producing investments are not as safe as they seem.
Just to take one example, I recently took a look at a very well known consumer staples company. The stock trades for 22 times trailing earnings and 16 times the consensus estimate of this year's earnings (and at an all time high stock price). Earnings growth has averaged 5.35% per year for the last five years and is estimated to grow at 7.8% over the next five (as if anyone could see that far in the future). The company pays a dividend that at current prices equates to a yield of 3.3%. That 3.3% is what everyone buying the stock is concentrating on and this is a very well run company with a history of raising its dividend. Sounds good, right? What's the risk? Well, the amount the company spent last year on capital expenditures, dividends and stock buybacks exceeded its net income by a factor of 1.7 to 1 and as a result its debt load is rising. Unless earnings growth is about to accelerate – and this is a consumer staples company remember – the current situation may not be sustainable.
That same company's stock has in the past traded for an average trailing P/E of around 14. Even if they are able to generate sufficient cash flow to maintain the dividend (and in this case they probably can) merely returning to its historical average valuation would mean a loss of 36% for an investor buying the stock today. A 3.3% dividend yield for a company with limited growth prospects, a rising debt load and a valuation 36% higher than what prevailed in a more normal interest rate environment? That 3.3% dividend yield looks very expensive to me. I don't believe most investors do even this cursory analysis of the stocks they are buying. They are shopping for yield and a constantly rising stock market makes the risks seem remote. And by the way, this stock is not atypical for large consumer staples companies. Most of them are trading at multiples that make no sense except in the age of financial repression.
Investors are ignoring the obvious risks in the market in a desperate search for yield. How long that can continue driving stock prices higher is something I can't predict but it isn't different this time. Valuations matter and forcing people to overpay for stocks just because they pay a dividend higher than T Notes won't solve our economic problems. The side effect of the Fed's financial repression is the financial impulsion to take risk and it will have consequences.