Lose the Battle, But Win the War / Who are The Gatekeepers? / by Adam Howard

Prior to last week I have been talking a lot about how much capital is apparently out there, looking for a home.  Once again, working on the assumption that everyone reads what I have written religiously, the title of an Update a couple of weeks ago was actually about all our homeless money.

Well, I spoke to an old mate from my halcyon days as a tennis player who has done quite well in the finance game.  We will call him The Competitor.  The Competitor and I were very close as younger blokes, until both our competitive streaks got in the way.

The Competitor tells me there is currently $2 Trillion USD invested globally in negative yield government bonds.  I will write that again in terms that don't involve finance speak.

Around the world at the moment there is money equal to 125% of the total value of the Australian economy, or 125% of the value of the entire Australian stock market, invested in government bonds that are actually losing money.  And the investors who put the money there were aware this was a loss making investment when they made the purchase.

 Doesn't make sense, does it???

Of course not, unless you put yourself in the minds of those making these kinds of decisions and ask "Why?"  The only real reason you could come up with is "safety."

As an investor you were worried that if you put that money anywhere else you might be exposing yourself to the risk of an even bigger potential loss.

Now, to be fair, the losses aren't big in percentage terms.  Most negative yields are smaller than -1%.  But 1% of $2 Trillion is $20 Billion.

So, in summary, fund managers around the world are prepared to lose $20 Billion of their customers' money each year in return for the perceived safety of owning sovereign debt.  

That's not to say investors will actually lose any money, as those bonds will form only a part of a funds's portfolio.  Here is a nice, simple pie chart that I found that shows one potential mix of assets in a portfolio.

On the basis of this asset mix, about 20% of the assets are fixed income, or bonds.  And not all of the bonds held will be loss making.

But the decision to hold loss making assets is obviously made to balance out the much higher risk of loss associated with other assets. I wonder what those assets are?

I am no expert, but it seems that the US stock market has bounced back remarkably well from the GFC.  But it also seems like the index is fairly volatile.  Might be a good idea, if you were an investor, or fund manager, to find a place to put some money that balanced out that volatility and risk.

The funny thing is a lot of the money that has been spent on these equities that has pushed up the index has actually come from the US central bank, the Fed, via it's 3 programs of Quantitative Easing (QE).

How?  Well, for those interested in a boring read, here is an explanation of QE:

QE - An explanation

The Fed has pumped about $2 Trillion into financial markets, first by buying US Treasuries (US Gov't Bonds) with long maturities and finally by buying mortgage backed securities.

What this means is the Fed has basically exchanged hard-to-sell assets, (what a finance "expert" might call an illiquid asset) for easier to sell assets (which you might call more liquid assets).

The people on the other side of these deals with the Fed haven't been Mum and Dad investors, or even rich individuals; they have been large funds or institutions (an institution might be an insurance company or a municipal government or a superannuation/pension fund).

Any what have they done with their new found liquidity?  Check out the graph of the S&P 500 Index above.  I don't want to jump to conclusions, but it looks like they have bought up a lot of shares, and pushed up the index by doing so.

But, what does this mean for us here in Australia?  Why talk about it?  Well, almost half of our share market is owned by overseas investors and almost half of the other half is owned by super funds, and  both groups have probably got some cash in the till that has come from the QE programs.  

These investors, or fund managers, are seeking yield, not really capital gain a lot of the time, but yield.  Dividends.  Income paid by the companies to shareholders to say thanks for sticking with us.  

How do I know this?  Well, I don't for sure, but I speak to Super fund managers as well as superannuants (like my Mum and Dad) and they say that's whats most important: income.

Yield, or a good dividend, is usually paid by a mature, profitable company. Blue chip companies who are seen as solid corporate citizens, like Commonwealth Bank, BHP Billiton and Wesfarmers.

But the catch is the whole point of QE was to stimulate a US and hopefully global economic recovery by pumping liquidity into financial markets, and that that liquidity would then go to productive uses.  

New businesses would potentially create new products which would then be in demand.  Increased consumer and business demand would mean companies would have to make more stuff.  That would create jobs.  Things would begin to get moving again.

I know that's a bit idealistic but let me have it...just this time.

What has really happened is most of that money has been re-invested in safe places.  And those safe places are safe because the people in charge don't take risks; calculated or blind.

So, now we have on one hand a global search for the best yield, and balancing that, a global search for the safest asset.

The best yielding Blue Chip equity worldwide?  HSBC at 6%.

Safest asset worldwide?  Either a Swiss or Danish 2 year government bond at between -0.65% and -0.77% yield.

But did all this liquidity actually do much to improve economic conditions?  Not really...

What really appeared to happen was the extra liquidity pushed the value of the USD down quite a bit against the currencies of the US' major trading partners, and all of a sudden US-made goods were a lot cheaper.

Lower prices meant more orders and purchases, which meant more demand.  Demand lead to a need for greater supply and a need for more jobs.

In addition, the US had had its base set very low by the GFC.  Now? Well, the US is in tip top shape.

Unemployment of 5.5%; a 7 year low.  Business investment up 8.5% for the year to December 2014.  An end to QE in sight and talk of a possible increase in the federal funds rate soon (at 0.25% the only way was up).

And that's why the RBA is keen to drop the cash rate further; not to make it easier to access debt, but to potentially force the value of the AUD down, which would make our exports much cheaper.  The problem the Board of the RBA has is juggling the desire to bring the value of the AUD down with the risk of creating a debt-fuelled housing bubble.

Some say we are already sitting on a debt-fuelled housing bubble....but I am not one of those "some."

So, my point is Global Markets and the QE program didn't actually do much to improve the wisdom, health or quality of life of the human species, or even improve economic conditions much.  It did, however, help those heavily leveraged (love that term, "leveraged) to financial markets.

This leads onto my final point for this week, which is about a breed of financial animal I have spent a bit of time observing over the past few months; the Gatekeeper.

The Gatekeeper is usually a 35-55 year old white male who  has spent time working in the US or UK in finance; preferably stock broking, funds management or investment banking.

He returns to his home city, with a kit bag full of experience and a well developed network, and sets up shop helping wealthy people invest the fruits of their labour.

For the most part, these blokes do well and mean well.  They seek to educate and provide access to markets that investors might not even know about, let alone consider as an investment opportunity.

There is, however, a small subset within this group that it appears may be abusing their position.  

Here is an example.  If someone has a good idea; a patented product, some new technology, and wants to access capital markets by means other than a direct float on a share market, the Gatekeeper can provide access, but at a price.

Why would someone want to access capital markets?  To get prototypes made; for working capital to keep the doors open until sales build to a level where business is sustainable; for further research and development.

The rule of thumb for that price is 10% equity for access.  So, you, the owner of the business and idea/technology, "sell" 10% of your company in return for access.  But I use the term "sell" loosely as there is no payment in return.

That seems a little steep to me.  Even for naked capitalism, it seems like someone is having a laugh.  Here is a TED talk given by US billionaire Nick Hanauer, famous for being one of the providers of seed capital for Amazon.com and writing a scathing open letter to his fellow billionaires titled "The Pitch Forks Are Coming" on who actually creates jobs:

A lot of good new ideas never see the light of day because the Gatekeepers do not facilitate the bringing together of the capital and the idea, or will do so only for exorbitant fees.

This made me think about the role of the company in the 21st Century.  

The old role of the corporation was to bring together a community of like-minded people to pool their capital in order to try to achieve something not possible on their own.

Or, in the case of something like The Ford Motor Company, to organise and structure a business to such a degree to make it possible to mass produce something as complex as an automobile.

But these days the role of the corporation seems to be to protect one from liability while providing access to profits.  Everyone takes a clip.

Food for thought....