The global credit shortage is over, according to European Central Bank council member Christian Noyer. Whew! Actually what Noyer said was that, “‘Globally, distribution of credit is not restricted unduly.”
It’s not exactly a ringing endorsement of central bank policies. But it does indicate that in at least some credit markets, there might be money to borrow if you can talk a bank into lending it to you. However, as Dr. Marc Faber told the Agora Wealth Symposium yesterday, “You cannot create prosperity through money printing and debt growth.”
It’s a fair point, isn’t it? You don’t get rich by spending money. Wealth cannot be achieved through a systematic attempt to impoverish the middle class through higher debt levels, lower asset values, higher taxes, and lower real wages.
That all sounds like common sense. So why are so few policy makers using their head? The people who hope the global economy can be revived through a resumption of credit growth seem to forget that it was massive credit growth that created the problem (massive global imbalances, huge debt levels, and mal-investments) in the first place. That problem now resides on bank balance sheets in the form of bad collateral and on household balance sheets in the form of credit card debt and a mortgage.
This sets up an interesting problem. How can you have inflation if impaired bank assets prevent the resumption of bank lending? Our old friend Dan Ferris says this about the issue, “Mass destruction of bank collateral certainly reduces lending capacity. Since our banking system is where the bulk of our money is created, deflation seems a rational expectation…Except,” Dan adds, “that the redwood seeds in the money-creation forest – excess bank reserves – have grown approximately 4,500% lately, to around $900 billion.”
“Multiply those reserves by 30 or so, as the banking system would over time, and you get more than double the entire GDP of the United States. But as long as the banking/lending apparatus is broken, it’s hard for the system to multiply new money into existence via loans and deposits.”
Dan makes some great points. Most money creation in the economy does come from the banks. Through the wonders of fractional reserve banking, the banks can turn each new dollar of deposits into ten dollars of new lending…and then lend on each of those ten dollars when they make their way back to the banks. This is why banks are the traditional engine of money supply growth in an economy, and thus the proximate cause of inflation (an increase in the money supply).
But if banks are still nervous about asset quality, they are much less likely to rev up the money creation engine with new lending. In fact they’re likely to do the opposite and stockpile cash. That’s what Dan has pointed out, showing that excess reserves held by banks at the Fed are rather large.
And if banks don’t have cash to stockpile against further losses, they’ll just go out and raise some. That’s exactly what NAB has done. “National Australia Bank Ltd., the nation’s biggest lender by assets, said it will raise A$2.75 billion selling shares to help weather rising bad loans and finance potential acquisitions,” reports Malcolm Scott at Bloomberg yesterday.
This is part of “Operation balance sheet repair through the equity markets.” NAB is not alone in using secondary offerings on the stock market to raise capital this year. Secondary offerings in the Australian stock market raised nearly $90 billion in fiscal year 2009. That was up 74% from the year before. Meanwhile, initial offerings (IPOs) raised just under $2 billion for FY 2009, an 83% decline from the year before (which itself was horrid).
That tells you there was hardly any new capital available for new businesses. Only 45 companies went public last year, compared to 236 the year before. That shows you how tight capital really has been. Of course, even listed companies have had trouble raising money in the secondary market.
So what does it all mean? It means Aussie investors (institutions and households) have provided Aussie companies with a capital cushion during the worst of the credit crisis. Will it be enough? What will the return on the capital be? Is it throwing good money after bad?
Those are all questions you have to look at on a stock by stock basis. Some companies are more efficient with capital than others. And a company that delivers a high return on net tangible assets without having large, recurrent capital expenditures is probably a company worth owning, or at least looking at-especially in this era where capital (and real capitalists, people who know how to put it to work) are so rare.
This, by the way, is why we’re still so bearish on financials. The capital infusions on to bank balance sheets are there merely to offset the decline in the value of bank collateral (mostly residential and commercial real estate, as Dan says, but also all sorts of other securitised loans). But when a company like Santos raises $1.2 billion in new capital, you can be pretty sure it’s not to offset losses from high-risk mortgage lending.
By the way, speaking of Santos and LNG, did you see that China’s biggest offshore oil and gas producer, the China National Offshore Oil Co. (or CNOOC) is going to drill three wells in the Northern Bonaparte Basin and look for natural gas? Yesterday’s West Australian Business News reported that, “The guaranteed first stage program, worth $80.8 million, will include up to five wells and 400 square kilometres in 3-D seismic work…The commencement of drilling will be a major milestone for CNOOC, which has been leading China’s global push to secure long-term energy supplies.”
Back to traditional capital for a moment. Does the fact that Aussie firms have raised so much equity capital mean the nation is not nearly as dependent on imported capital as we have feared in the past? The jury is still out on that one.
“Foreign banks are refining their lending activities in Australia rather than returning to their home bases,” reports yesterday’s Australian Financial Review. This means foreign lenders haven’t abandoned Australia entirely. “But the funding pressures on Australian companies remain intense. Data show an 80% fall in the amount of syndicated loans in Australia in the first six months of the year.”
Syndicated loans are loans where one or two banks organise an overall loan package in which multiple foreign banks are lenders. This reduces the risk (theoretically) of any one lender losing a lot on a loan. According to the AFR, “Global syndicated lending totalled $947 billion in the six months to June 30, a 49.2% fall from the year-earlier period. Australian loan volume fell an even steeper 80% to US$9.7 billion.”
We realise that this is a lot of scrutiny to pay the capital structure of a company. But that matters now as much as it ever has to individual investors, and probably more. A company (like a bank or non-traditional mortgage lender) whose assets are mostly made up of iffy loans can quickly see its equity wiped out on high loan losses. This wipes out common shareholders.
Also, as we’ve seen, companies with huge refinancing needs can hit the wall quickly if capital markets are not keen to reinvest in the business (and they might not be if the business is an inefficient user of capital). That raises the question of how the banking industry itself is allocating capital in the real economy, and where a nation’s accumulated savings are being productively invested (or unproductively squandered).
But let’s not go into national capital allocation strategies today. Let’s focus on two potential opportunities in this idea for Aussie investors. The first is that Aussie banks fill the lending gap and are able to do so at very favourable rates to themselves (and shareholders, via a rebound in dividends that were cut earlier this year). Their share of the syndicated loan market could increase if there is less foreign competition (although Chinese banks seem eager to loan some of their accumulated capital to Aussie businesses and consumers).
The second opportunity is something Kris Sayce has been looking at in his new publication, Australian Wealth Gameplan. We’re talking about the growing universe of fixed income and hybrid securities listed on the ASX-or really anything that produces more income for you as an investor. Of course the world of high-yield fixed interest investments is not exactly a risk-free place these days (property, managed investment schemes etc).
But the retail bond market-where you can buy a corporate or government bond as easy as you can buy a share of BHP or Rio Tinto-is developing quickly in Australia. Both AMP and Tabcorp issued bonds in April targeted to the retail investors. And if there is liquidity to be found among Australian investors looking for risk-free income, you can bet Australian companies will find a way to tap that liquidity, even if it means doing something new like selling bonds instead of new shares (which dilute existing shareholders).
Of course there is no such thing as “risk-free income.” Government bonds have that reputation (increasingly undeservedly). That’s why the ASX is working with the Australian Office of Financial Management to list government bonds on the local exchange. The government would love to tap retail funds in order to finance its deficits (which are large and growing).
But you could probably do better-at least in terms of yield AND capital gains-looking at corporate bonds. The nice thing about being a bond holder is that you rank the highest in a company’s capital structure. That means if the company does go bankrupt, you get paid first because you are a secured lender (unless you are GM or Chrysler bond-holder and you get strong-armed and ripped off by a socialist American president).
You could do even better buying distressed bonds. You look for companies that everyone thinks may go bankrupt. Then you just have to do a little balance sheet analysis. If the assets exceed the liabilities, you can almost guarantee that you’ll make money. At the very worst, as a secured creditor, you get your money back in a liquidation of the firm’s assets.
Or, if Christian Noyer is right and global credit conditions improve, you’d get a capital gain (if you bought the distressed bond at a discount to par) AND whatever yield the bond has (typically high the higher perception of risk). And that would be a mighty fine trade if that’s your game.
We’ll keep you posted on what Kris finds in the fixed income world. His solution is a lot simpler than the strategy we outlined above. Australian blue-chips, for whatever reason, have tended to pay higher average yields than their American counterparts. In fact the dividend yield on the S&P/ASX 200 tends to exceed the yield on the S&P 500.
That may reflect Australia’s traditional status as an importer of capital, and the need to offer higher yields for what are perceived as riskier assets. But Kris has already found one blue-chip with a great yield and a great return on net tangible assets (capital efficiency).
The good news is that we think the market should favour investors who can look at the capital structure of Aussie firms and capture yield from the ones that are not burdened by non- or under-performing loans. The better news is that Kris is doing the looking so you don’t have to!
Mind you we’re not implying that Noyer is right and everything is fine. Hardly! We think banks will continue to play it safe (and quake in their boots). Aussie banks continue to hold around $2 billion on reserve at the RBA. This is down from the double-digit overnight figures in the panic days of last year. But it still shows some reluctance to unleash a new credit boom via bank lending (or a lack of new, worth projects to lend to).
But we should probably be very thankful that Aussie banks haven’t gone whole hog back into the lending market. Though the RBA says inflation is tame, the amount of monetary reserves in the global financial system are just the sort of thing that could lead to a wildfire of inflation, including here in Australia. It’s just what the Fed wants to assure us it will NOT let happen. But the Fed may not be able to control the actions of the most profligate spenders of all: national governments.
We believe that in the absence of new bank lending to promote economic growth, governments are going to ramp up deficit spending even more this year and next. As Dr. Faber said in Vancouver, “I believe next year’s economy will face even larger deficits. Their deficit is attempting to stimulate credit growth. Unless real credit growth returns, they will have to put more and more money into the system to maintain the status quo. All polices target consumption. That is a mistake.”
So what’s this mean for the market? This is just one of the questions we’re taking up at next week’s debt summit in Melbourne. As for the U.S. Faber says, “The S&P 500 will not recover to 2007 highs. At the peak, 44% of the S&P was the financial sector. That is gone… not coming back.”
Does that mean the recovery in Aussie financial stocks is a fake out move too? More on that tomorrow. But just keep this in mind the meantime…this debt crisis doesn’t mean the world will end. It just means there’s going to be a big change in who owns global asset. That ownership is being transferred from debtors to creditors. That’s what worries us here in Australia…
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