We have had eight, nearly nine years of zero interest rates and negative real interest rates. You don’t have to be a convinced Austrian economist to believe that in this length of time an extraordinary amount of “malinvestment” – investment that is not justified by economic reality – has grown up. Now that interest rates seem to be rising, that malinvestment will collapse, losing lenders’ and investors’ money. This column therefore surveys the various forms that malinvestment may have taken, and where the greatest value traps lie.
It is amusing to examine the antics of Janet Yellen and the current Fed Governors, all of them appointed by President Obama (the Presidents of regional Fed banks, appointed partly by local bankers, are a different story.) They spent the whole of 2016 finding excuses to renege on their intention to raise interest rates four times that year, which had been announced in December 2015. Then within the space of two of the eight-per-year Fed meetings, they completely reversed themselves. Not only are they determined to raise interest rates at least three times in 2017, but the first of the three rises will almost certainly come as soon as March 15.
In this area, as in many others, the unexpected election of President Donald Trump has revolutionized the Fed’s thinking. Suddenly an economy that had been thought too fragile to bear the burden of interest rate rises is thought strong enough to bear them at a rapid clip. Nothing has changed, other than a stock market boom that to Obama-followers is totally irrational and unexplained.
For devotees of the policies of the last decade, there is no reason to suppose the abysmal global productivity performance is about to change, or that businesses, free from the blight of endless new regulations, are about to embark on a bout of capital investment – after all, the regulations were carefully designed by the finest minds; they cannot possibly have had any blighting effect on the economy, right?
One is left with the suspicion that the Fed’s inner circle, who believe their decade of “funny money” revived the economy, now want to normalize interest rates to crash it on Trump’s watch. By so doing, they believe they can instill in the electorate a deep regret for ever having elected another Republican after the follies of President George W. Bush.
Whatever the Fed’s motivations, their core belief that the decade of “funny money” was beneficial for the economy is mistaken. It has destroyed productivity growth, in the U.S. and around the world. It has also left us with a massive overhang of investment that was encouraged by the endlessly available cheap money, but is hopelessly uneconomic once interest rates return to a market level. Thus, even though the Fed cynics are wrong about what higher interest rates will do to the economy, they have left us a gigantic booby-trap of malinvestment that will collapse in value once interest rates are restored, inevitably causing economic disruption as it does so.
The largest reservoir of malinvestment, because promoted most enthusiastically in the last decade, is in the tech sector. The taxi service Uber, for example, is not worth anything like its “private market” valuation of $68 billion. It has a clever piece of software, but the taxi business is cursed both with low barriers to entry and a high degree of regulation. There is also very little synergy between taxi markets in different cities. With Uber both subject to competitor attack by the likes of Lyft and blocked by local regulators controlled by local taxi monopolies, and losing $2 billion annually, it is worth very little more than Joe’s taxi service, if as much – Joe has MUCH lower overhead and no sexual harassment lawsuits.
Similar examples abound all over the tech space. Tesla Motors (Nasdaq:TSLA) has relied for the last years on superb political connections that have just been voted out of office. It is making losses, has just bought another loss-maker, Solar City, that is probably not viable in the long term, and depends on projections for production and sales that look very aggressive indeed, particularly if some of its excessive subsidies fall away.
Alphabet Inc. (Nasdaq:GOOG) was overpriced at its IPO price of $85 per share in 2004, as I wrote at the time; it is more overpriced at its current level of around $830 (yes, I admit it, some of my predictions of doom are just a teensy bit early!) It and Facebook (NYSE:FB) still depend on an online advertising market that is riddled with click fraud, provides few measurable benefits to business users and is being progressively sliced into smaller pieces by new entrants. (Also, social media has always seemed to me a singularly pointless human enterprise, though I quite grant you the lower orders appear to enjoy pointless activities.)
Moving away from the tech sector to its victims, the shopping center business has certainly not enjoyed an excessive level of investment over the last decade. Indeed, there were no major shopping centers completed in 2007-12, compared with an annual average of 140 in the 1990s. However, those who claim that the major shopping centers that are currently trading on 30 times earnings have avoided problems by focusing on the top of the market are like analysts around 1908 extolling the superior quality of a particular manufacturer’s buggy whips. The venerable age of existing shopping centers is not a help to their survival; while still carried at a high cost in their inadequately depreciated owners’ books, aged shopping centers are a positive deterrent to customers. As the retail business moves online, individual retailers disappear, including the “big box” stores, and credit conditions tighten over the next few years, so will the dinosaur shopping malls head down the inevitable track towards extinction.
Hotels are at the opposite end of real estate from shopping centers; they have enjoyed enormous investment in recent years, in this case all over the world. Moreover, unlike the shopping center business, the hotel business does not appear to be doomed, although tighter immigration controls and protectionism could cause it to downsize. Nevertheless, ultra-low interest rates have caused massive over-building, resulting in numerous empty catacombs with no visitors. These will disappear, and their lenders will lose money. So will mortgage lenders against fashionable and overpriced big-city housing, whose price has also been inflated to excessive proportions by funny money.
Regulation causes malinvestment just as does funny money. The most egregious example of this is in the green energy sector. Hundreds of billions of dollars have been wasted worldwide preparing for a global warming that appears unlikely to happen to anything like the extent predicted by its enthusiasts. Power brownouts are likely not only in Germany, but in most of the rest of the EU, as anti-carbon prejudice has combined with anti-nuclear prejudice to leave countries dangerously reliant on power sources that don’t operate on a calm, cloudy day. While solar power is viable in hot, dry climates, much of the solar investment in Europe and the temperate parts of the United States has been wasted, and will have to be written off, as will almost all of the wind power investment (absent perpetual subsidies). Emergency power stations, small and inefficient and powered by cheap natural gas, will be built to assuage Europe’s popular outrage at levels of power and light provision similar to those of a Syrian war zone.
Banks in the last decade have been subject to both regulation and funny money. This has caused their profitability to become entirely skewed, with speculative trading desk and derivatives operations profiting excessively while lending to small business has been at best marginally profitable. The “quantitative easing” of the Fed, the ECB and the Bank of Japan and the zero-rating of government debt for capital calculations has clogged up bank balance sheets with unproductive detritus and arbitrage games, and taken their focus away from productive activity. Regulators has imposed huge and arbitrary fines, the proceeds of which have to a surprising extent gone to leftist slush funds. As interest rates normalize and regulation is loosened, many banks will find themselves in the position of Deutsche, facing large, unquantifiable losses and an absence of profitable business opportunities. The result will inevitably be defaults, and equally inevitably bailouts by unfortunate taxpayers.
Funny money has also caused corporate managements to engage in corporate strategies and practices that would not be tolerated in an environment where financing was less easy to come by. They have paid themselves excessive remuneration, sometimes spectacularly so even in the case of abject corporate value destruction, as at Yahoo. They have indulged in excessive share buybacks, which benefit only their own stock option schemes, while cutting research and investment to the bone They have issued shares with no voting rights, which would be unsaleable in a well-run capital market. They have outsourced businesses to low-skill, inefficient and unreliable emerging markets, and have cut back training budgets, preferring to hire peon labor in the form of immigrants on restricted work visas, while condemning Millennials to unemployment. They have devised self-defeating short-termist corporate strategies, like the pharmaceutical companies cutting back on research and jacking up drug prices arbitrarily. As interest rates rise, the worst-run companies will suddenly find themselves overleveraged, out of cash and without a viable business, causing new bankruptcies.
Through deregulation and returning monetary policy to a market-based system, the Trump administration, if it governs wisely, has every chance of restoring productivity growth to its historic levels, and making the U.S. economy Great again. Regrettably, even if it succeeds in doing so, it will have to suffer a major and very unpleasant recession in the early stages of this. That recession will however be entirely the result of past economic idiocies, and blame for it should be put on the past administrations and Fed officials where it belongs.
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)