This is a complex area. It would be good to hear your views and ideas. Please add them via the comments box below this blog.
I was chatting on the phone (I don’t do many physical meetings at present but it does not seem to slow my work down. In fact I suspect my productivity might be improving.) with Peter Parry (UKSA Policy Director) about the current impact of COVID-19 on the economy, the stockmarket and investing.
Peter reminded me that the foundations for World War II were laid by the Treaty of Versailles. Were the foundations of today’s financial crisis laid in the response to the 2008 Financial Crisis? Banks were not allowed to go bust. They were bailed out by Governments around the world. Lessons were not learnt. Governments and central banks flooded the markets with cheap money. Interest rates were kept low, by and because of the excess supply of money. Debt soared. Governments and the men and women on the street spent money they did not have and instead borrowed more and more, with wishful thinking that it would come good in the end. The rules for stress tests were designed to show the banks were safe. Some of the above is true, some may be the stuff of conspiracy theorists. You must judge.
Governments around the world prioritised and encouraged/incentivised debt over equity. Interest on debt was/is tax deductible but profits are subject to corporation tax and dividends have to be paid out of after tax profits. Companies with “inefficient balance sheets” were ridiculed and subject to corporate raiders and attacks by activists. Private equity backed companies had far higher debt to equity ratios than public quoted companies and became the role models for quoted companies to try to aspire to.
Share buy backs were encouraged, despite very strong evidence that companies tended to buy back their shares at high prices, to the detriment of long term shareholders.
Institutional shareholders railed against any company that had lots of cash in its balance sheet.
Company valuations rose to frothy levels. Some felt a correction was in order.
So we entered 2020 in a dangerous situation. Many were aware of the above problems. But with the market reaching new highs, anyone who failed to follow the herd would underperform; and be vilified. Worse still, the pressures on short term performance meant that “underperforming fund managers” would lose their mandates or lose their jobs and be replaced with those who promised to perform, ie follow the herd.
So what do we do about it? I think “the system” should encourage companies to retain a reserve of cash. This will give them flexibility in difficult times. The problem with running a tight ship is that when times get tough you either have to do a rights issue/fund raise or issue new debt or borrow from the bank. The experience of 2007-2009 taught us that banks don’t/can’t provide new/extra loans when they have to de-leverage themselves. At the very time when you need them they cannot provide the basics service they are meant to provide. They are useless at lending when you really need the money.
Just at exactly the wrong time, we have a new accounting standard IFRS9, which requires banks to recognise losses as soon as they see them appearing, rather than over the expected life of the loan. In today’s environment this will result in huge provisions, the announcement not of profits but huge losses and a huge reduction in the capital ratios of banks. Bank shares have halved, but could easily half again or require new government cash injections to keep them solvent.
China productivity dropped about 40% initially when the Wuhan crisis measures were implemented and are are now running at about 30% below 2019 levels. Absent other factors, we can expect the same.
Examine carefully balance sheets and debt and how sensitive a company is to big reductions in turnover and how it might cope if that continued for several weeks/months. Many companies will not survive: e.g. the airlines are now lobbying hard for bailouts from government. The 50% reduction in the crude oil price will (if it becomes the new norm) hugely impact the oil companies and those who serve them. Restaurants and shops are empty and closing. Homeworking when possible is the norm and many offices are operating on minimum physical staffing levels. For myself it is almost business as usual as I can conduct most meetings by video conference or phone conference (not as good, but adequate) and this saves me hours of time travelling to London, which I have suddenly realised was not really necessary.
So where does this leave us?
This is titled as a white paper, so needs to float some ideas for discussion. I suggest:
- Remove the tax deductibility of interest on debt.
- Reduce the short term focus of shareholders. Individual shareholders have a longer term focus (well the majority do), but are disempowered by the current structure of the market which gives too much power to the fund managers and not to the asset owners and ultimate investors. If the providers of capital can show their preference for long term considerations, then company management will change their modus operandi from the short term (satisfying what they think fund managers say is important) to longer term considerations (which is what the asset owners want, but the current power system prevents).
- Government to move towards higher interest rates over time towards the more historic normal rates of 3 to 5%.
- Governments to normalise the supply of money over time and remove the distortions creates by QE.