This week’s CPI report for the September quarter must have been very dispiriting for the honest toilers at the Reserve Bank.
They have been cutting interest rates since November 2011 and this year embarked on one of the world’s biggest quantitative easing programs, yet underlying inflation is stuck at 1.2 per cent, half what they want. Next week rates will be cut again, along with making their quantitative easing the world’s largest — a final, futile, throw of the dice.
They might be telling each other it’s just the coronavirus, that it’ll be right when there’s a vaccine, but in their hearts, they must know it’s not only that: in the past five years, trimmed mean underlying inflation has averaged 0.4 per cent per quarter; in the five years before that, 0.6 per cent; and in the five years before that 0.8 per cent. It has been a long, inexorable decline.
Of course, this year’s sharp recession and unemployment hasn’t helped, even though aggregate income has increased because of government transfers and has been saved, not spent. Next Tuesday governor Philip Lowe will be forced to announce something he said he wouldn’t do: take the official cash rate below 0.25 per cent, which he said was equivalent to zero in Australia.
But it will be little more than symbolic. The market cash rate is already near enough to 0.1 per cent because of the liquidity the RBA has been flooding the system with, deliberately using cash as the rate cut you have before you have a rate cut.
Inflation has been declining because of the deflationary impact of technology, digitisation and disruption. The volume and price of money might once have been effective in moving consumer prices, but not any more.
And the refusal of central banks to just roll with inflation that’s lower than their made-up target has led to unprecedented distortions: global debt is now more than three times GDP and financial assets five times.
This is not an accident: debt and asset prices are the central banks’ tools of trade. It’s by inflating these that they hope to achieve their goal of 2 per cent inflation.
The most obvious result of this, coupled with the digital revolution, is that the sharemarket is in chaos, where no one knows how to value companies any more.
Price/earnings ratios are no longer any help in sensibly valuing the technology companies that are driving the market, mainly because most of them don’t have any earnings yet, or if they do they are deliberately held down by investing for growth. And that includes the miners digging for battery minerals.
Most of the technology and battery metals CEOs I speak to explain that they could make a profit if they wanted to, but are too busy grabbing market share.
The companies that are growing don’t make a profit, and the companies that make a profit aren’t growing, and in fact they are mostly going backwards right now because of the coronavirus recession, so the profit forecasts are not only down, they’re rubbish.
In any case, a price-earnings ratio, the traditional valuation tool, only describes the short term — next year — while the paradox of the technology stocks is that while they may be the playthings of speculators, their marginal pricing is being set by long-term professional investors who are taking a 10-year view, or longer.
So fund managers are increasingly using discounted cash flow (DCF) to value stocks, since PE and “price to enterprise value” simply don’t capture the long-term nature of what they are doing and certainly doesn’t capture the growth that they can clearly see.
In fact, some fund managers are giving up on valuation itself. Mark Schmehl, portfolio manager at Fidelity Investments, told the Globe and Mail this week: “Valuation, I find, is a useless tool. If you base your investment decisions on valuation, you are never going to make money.”
It’s true that the long-term cash flow forecasts required for a DCF calculation are no more than an educated guess, and then there’s the problem of deciding on a discount rate when the long-term bond rate is under 1 per cent.
Normally you’d stick an equity risk premium (of 3-6 per cent) on the bond yield (which used to be 5 per cent) and there’s your percentage number for discounting future cashflows to the present.
But that doesn’t work any more because inflation is so low … as a direct result of the activities of the very digital businesses that the fund managers are trying to value.
Monik Kotecha of Insync Funds Management, a Sydney-based investor in global technology and disruption stocks, told me this week he uses a discount rate of 9-10 per cent, which is very conservative, implying a huge equity risk premium of 9 per cent.
Yet he is fully invested and finding no shortage of things to buy — because the growth in future cashflows that he can see for the companies that are disrupting the existing order is so phenomenal that a 10 per cent discount rate still leaves plenty of them looking cheap at current prices.
Many fund managers are going with “normal” discount rates of half that, which can make even the bubbliest of stocks look cheap.
So the world is in the grip of a vicious or virtuous circle, and we won’t know which it is until after the bubble bursts — or doesn’t.
Technological disruption is leading to persistent low inflation, which is leading to zero interest rates, which are leading to inflated asset values and debt.
In the meantime, the result is decidedly unvirtuous, and potentially vicious: record debt, inequality and disgruntlement.
EDITOR-AT-LARGE, THE AUSTRALIAN BUSINESS REVIEW
Alan Kohler is one of Australia’s most experienced commentators and journalists. Alan is the founder of Eureka Report, Australia’s most successful investment newsletter, and Business Spectator.
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