Jeffrey Hutton: Since the beginning of the year most markets seem to be rallying, but is it a sign of return of confidence? Well, we put that to Satyajit Das. He is the author of Extreme Money and a financial commentator and he is here with us now.
Satyajit Das: Thank you for asking.
Hutton: Das, the S&P 500 is up about 12%, the ASX is up 7%, even the Nikkei is up 20%. Is confidence back?
Das: This is the Draghi rally. I call it the Draghi rally. Because Mario Draghi the head of the ECB pulled a rabbit out of the hat, because remember the tail end of last year in the last three months we were all looking ahead to the debt maturities in Europe going how in heavens name they were going to raise 1.9 trillion to finance sovereigns and the banks. Well, Draghi solved the problem very neatly. So, he couldn’t print money, but he came up with a very elaborate structure which is; he now lends money at 1% from the European Central Bank to the European banks, European banks then take the money and go buy government bonds, so simultaneously you’ve solved the funding problem of the banks and the sovereigns, and he has pumped trillion dollars in.
The way I think about it is it’s like a dead body, if you pump enough electricity through it you’ll see signs of life. And basically that structure is what is underpinning to a substantial degree the rally. So, it’s more a relief that the debt crunch we were expecting on the sovereign European front has been delayed. But people are getting a little carried away with themselves here because they are assuming this is a magic fix. It has bought time - it’s all it’s done. Now, if you use the time, which is three years because these facilities have maturities of three years, and you could do everything you needed to do you have some chance of maybe muddling your way through this.
But if I know European politicians and if I know politicians anyway, the chance of making all the right calls and doing all the right things is not high. So, we basically just bought some time and we are on a holding pattern, but we are going to run out of fuel at some point in time and the interesting thing is the market is starting to ask, well, Draghi, do this again, and Mario Draghi is now under a lot of pressure. He is on pressure from the Bundesbank not to do this because they’ve now belatedly started to worry about printing money which is, sort of, to Germans like Hell, you know, you don’t it or go there. But at the same time he knows markets expect him to keep the support going. So, he is in a very, very difficult balancing act. So, there are still tensions there.
Hutton: Do money managers need to rethink their fees?
Das: I think money management has grown up in a very strange environment over the last 30 or 40 years, which have been very benign and good to them. And in places like Australia where you have the superannuation flows of 9% going up to now 12% flowing into your coffers, it really has been more about gathering the funds and doing that right rather than what I would call investment excellence. And as I always jokingly say during this period, you know, you just needed to be long and patient and things would work out for you and the rising tides lifts all boats to varying degrees.
Now, what you've got is a very interesting inflection point for the fund management industry. The first point about the fund management industry is it's a very expensive process. For retail funds, you're looking at management and expense ratios of couple of percent. Even for wholesale funds, you know you are getting 0.5% or upwards depending on the asset class. Now, that's okay if you're making 10%, 15% a year. People are very forgiving of your 2%.
Now, if you're going to make 2% and charge 2%, I don't think you're going to have happy investors. So, as the return basically ratchets down, I think fundamentally returns are going to ratchet down, mainly because the leverage has gone out of system and under those circumstances, the fund managers need to think very, very carefully about how they do their businesses. Also, their business models are really quite deeply flawed. At a very basic level, let's look at some very simple things like benchmark driven investing. And the fundamental thing is they say, I've beaten the benchmark by 5%, but if the benchmark is down 20%, I've still lost 15% of my money and I think investors are going to get a lot less tolerant of that, particularly if it’s sustained. I think in the past people have sustained those losses and lived with that because they have more good years than bad years. Now, with the high volatility, it's going to become more tricky.
The second issues is the way the money is managed is you give it to specialist managers, somebody who is equity-only; and basically if you look at the equity-only guy, he's got to be fully invested all the times, and under those circumstances if the markets are not going to perform and equity is not the asset class to be in, they're trapped. So, all these problems are sort of starting to come up to fund managers, and to be honest, they are a bit like rabbits in headlights. They’re startled and they're frozen because they don't want to throw out 30 years of a business model because they believe it's the correct business model and they don't want to re-engineer that and then find the market goes back to normal, which is very difficult. So it becomes very difficult for them to actually adjust in that sort of environment and that's some of the challenges they face.
Hutton: So they should have flexibility to go to cash if they need to?
Das: Firstly, there have to be absolute returns. Secondly, there have to have the flexibility to buy whatever. I always joke that vintage cars in the last couple of years were better investments than most financial investments and there’s a very funny story about that around Bill Gross who obviously run PIMCO's Total Return Fund. He actually used to collect stamps and he basically sold his collection and basically gave the money to charity which is very nice of him, but somebody worked out the compounded return on the stamp portfolio and pointed out that it was far better than the total return fund. So perhaps his advice was Bill should have invested all the money in stamps not in real assets.
So, essentially there have to have flexibility across asset classes, the portion of the assets and become absolute returns. That’s really difficult in the modern environment when we have created this cult of specialists, somebody looks at equities, somebody looks at bonds, somebody looks at this and somebody is the asset allocator. That becomes really, really difficult. And also, to some extent they have to be able to go short and from time to time it makes perfectly good sense to take leverage into your portfolio. So, all of that has to be factored in, but that is not a model that a traditional fund manager is, A, skilled for, B, mentally attuned to, and the entire system is designed for.
Hutton: So the party is over?
Das: The good times are gone and the party is over and they're going to have to adjust. People forget, in Japan I saw the destruction of the fund management industry in the 1990s. In Japan there was a lot of other things that went on, but there has been a destruction of the fund management industry because they just can't generate returns. And you see in the United States at the moment and countries with low interest rate money market funds are being destroyed, because it just doesn’t make any sense at this level, because you are losing money to basically invest money and nobody is going to tolerate that. That becomes kind of interesting. Also, one of the things that has happened in 2008 and 2009 that people perhaps would rather forget is there was an enormous destruction of confidence in financial advisors, in fund managers and so forth. And to some extend it takes time to rebuild the trust. Essentially, for them to go back and say well, it was just temporary arbitration and the model is fine and we'll do this, doesn’t really get you there.
I think people are becoming more discriminating, the investors are becoming more discriminating. I think for the first time in my life I see people becoming much more anxious to actually become financially literate. Previously it was, look I have money but I don’t have really the skills, I’ll hand it over to somebody. Now they are going; hang on, he is interested in mine and I am perfectly aligned necessarily. So I need to do this for myself. So all of that is playing into the fund management industry, but the good thing about the fund management industry is they have decided this is not a problem. So they have got their heads well and truly in the sand and they're just hoping that one day when they pull it out, the world will have returned to the way it was
Hutton: What's your view of housing prices?
Das: Look, Australian housing is one of those strange assets. Firstly, you can't have a rational discussion because it is like having a rational discussion about the existence of God, because you either believe it or you don’t. And essentially debating - there is no rational debate about it. But I think you go back to a fundamental thing about houses. Houses are not a financial investment. They are consumption good, because you need shelter. And essentially anybody who things that house is an asset is kind of diluting themselves, because they're going to always have to have shelter unless they have decided to become a street person or live al naturale in the wild somewhere. So basically, the asset class that we call housing is kind of a weird asset class anyway, because to me it is a consumption good, everybody else it's an investment.
The second issue is Australian housing is highly manipulated. It's a very manipulated market in terms of governments can control it by releasing land, changing zoning, changing the rules of what you can build - everything. Supply becomes constrained or unconstrained depending on what they do.
Secondly, the incentive structures that governments can apply through either things like the home - first homebuyer scheme, manipulating interest rates, stamp duties, capital gains tax, you name it, I mean basically it goes on, so highly manipulated market. So, to look at it in absolute terms of pure financial investment as some people want to do is kind of meaningless. However, there is some dynamics which are very evident and very difficult to deny.
If you actually look at what's happened in Australia is because of the tax benefits of capital gains and negative gearing, there is an over investment in housing and people have seen this as a long-term store of value, but the problem is an asset like housing is highly debt dependent. Because people have to be able to borrow to buy, because nobody can come out with a cheque of $500,000 and say I want to buy that. Here is my cheque. They don't do that.
So, supply of credit is fundamentally changing, though in Australia the government leans very heavily on the banks if you don't basically become a big housing lender. So, that's the first problem. So the question is whether the banks will be able to sustain the lending volumes, and we've seen the lending figures and they have slowed down quite dramatically. Part of it is them slowing down, part of it the demand isn't there.
Then the next problem is in the housing market, as you get these, what I call bubble effects, like in the mining towns and so forth where sudden influx of people, limited stock, puts that up, but then you get, what I call the cascade. So, one house goes up, then you can't buy that, so you buy the next house, so that goes up and that goes across the country to some degree, and we have benefitted from that.
So, if the commodity prices come off where we get that effect going down. If the financial market is tight, and interest rates go up, that part of it tightens and the rest of the economy where the bulk of people work has been weak all along. And you are looking at things like retail and services sectors, where the bulk of Australians work – manufacturing - they are all very weak or under real pressure.
So there is no income growth, and I keep saying to people there is no point looking at 5.2% unemployment. It's the incomes that people get, which are much, much more important. Are they earning? So, if you get that perfect storm for housing, which is the commodity boom drags itself to a conclusion, money tightening up, and income is not growing over a period of time or unemployment rising, then the combination is going to have a major effect on the - obviously the housing prices, but that coincides immediately with the problem in the banking sector because they are about 80% invested in housing directly or indirectly.
So, that loop starts to close and that's what you fear, and I think our politicians and central bankers probably every night say a prayer that that particular confluence of events doesn't take place.
Hutton: Das, thanks so much for joining us.
Das: It's my pleasure. It's nice to be with you.