Do valuations really matter?
The combined market value of Amazon, Alphabet, Microsoft and Intel stocks is around $2.1 trillion—a little short of India’s gross domestic product (GDP). A year ago, the market capitalization was around $1.55 trillion. That is a jump of $565 billion—36%. In contrast, their earnings for the three months ending September 2017 was higher by $3 billion over the third quarter of 2016. Irrational exuberance is back with a vengeance. Central banks around the world—principally China—can take credit. In the face of easy money, analyses based on fundamentals are of little value. They do not matter. The investment world is missing the child that called out the emperor’s nudity. But, one day, the child in investors will wake up and usually, it is too late.
A story in the South China Morning Post published on 14 October 2017 gives us some clues as to what has been driving the so-called global economic recovery that allegedly underpins the rally in all risk assets around the world. The story is about the government-owned Dongbei Special Steel Group Co. Ltd that was on the verge of closing down. The government in Beijing forced a bankruptcy through with creditors taking a 78% haircut on their dues, much against their wishes. What is interesting is that the story mentions glut conditions in the global steel market in 2014 and in 2015 that turned into a rally in steel prices in 2016. Usually, glut conditions do not disappear so quickly and their impact on prices lingers, with their effect receding only gradually. Global growth did not really pick up all of a sudden, spontaneously. What has been at work is an extraordinary jump in China’s liquidity and loans in 2016, similar to what was unleashed in 2009.
Assets held by the Chinese banking system—on and off balance sheet—continue to climb. Even if some of the explosive growth in off-balance sheet assets indicated by the People’s Bank of China in its Financial Stability Report 2017 was due to reclassification or double counting, the fact remains that the growth rate of on-balance sheet assets was 16.5% in 2016. Goldman Sachs had estimated that “Total Social Financing” (TSF) rose over 15% in 2015 and in 2016. TSF is the most comprehensive official measure of credit in the economy, and not just from banking sources. Nominal GDP growth in China in those two years was 6.9% and 10.0%, respectively. TSF had risen faster than nominal GDP.
In other words, the recovery in the prices of commodities and in the outlook for global growth can be traced to a massive infusion of liquidity by China over the years, continuing into 2017, the year of the Communist Party congress.
In September 2017, the TSF growth rate was 14.3%, according to Goldman estimates. We should not ignore the contributions being made by the Bank of Japan (BoJ), the European Central Bank (ECB) and smaller European central banks such as the Swiss National Bank. The ECB will decide in its meeting later this month if it should announce a timetable for ending its monthly asset purchases. It is a long way off from actually ceasing its asset purchases.
Macquarie Research wrote recently, “We maintain that the best explanation for investors’ perception that risks are low is that a combination of central banks’ liquidity (still running at about $1.5-2.0 trillion per annum), an assumption that central banks would swiftly reverse their policies at the slightest sign of volatility re-emerging, and China’s real estate and infrastructure investment, act as ‘risk buffers’.” They reckon that the global reflation set off by China in the second quarter of 2016 continues. Our analysis above confirms that. With China not slowing down its creation of debt—notwithstanding repeated protestations to the contrary—and with the ECB and BoJ not relenting either on their liquidity creation, the global reflation trade continues. On 25 July, in these pages, yours truly had expressed his misgivings about the so-called global economic recovery (“Is The Global Economic Recovery Statistical Or Real?”). It was only a hunch. Now, there is confirmation. China’s liquidity and leverage orgies explain the phantom recovery.
The analysts at Macquarie reckon that this has to continue lest the Ponzi arrangement of financial instruments backed up by “assets that are either worthless or declining in value” ends violently.
Liquidity and leverage maintain the charade that these financial instruments are worth something. They back the “perpetual doomsday machine” that global financial markets have become to continue humming, for that is the only way to keep the show going. The only risk, according to them, is if central banks and China actually misjudge that the recovery is self-sustaining and proceed to tighten policy. Or, if some investor actually asks the tough question about the intrinsic value of financial assets—whether technology stocks or emerging market bonds or euro high-yield (BB-rated bonds). If no one asked the question, the show can go on because it must—for there is no other way. There is no honourable or safe exit.
Bare Talk readily admits that it does not know when the party will end, when the lights will be turned off and when the last guest will stagger off the stage, not knowing what he was doing before and where he is headed next. But all parties do end. If you are not convinced, try asking Harvey Weinstein.
V. Anantha Nageswaran is an independent consultant based in Singapore. He blogs regularly at Thegoldstandardsite.wordpress.com. Read Anantha’s Mint columns at www.livemint.com/baretalk
Comments are welcome at firstname.lastname@example.org
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