Citi On Why QE Isn't Working
Authored by Robert Buckland, Head of Citi Global Equity:
QE Isn't Working: An Equity Perspective
The economics textbooks teach us that expansionary monetary policy, which lowers interest rates and eases credit, can be used to combat unemployment and economic recession. So, with inflationary pressures waning and the world economy slowing, policymakers around the globe have put this theory into practice and continued a "race to the bottom" for global interest rates. Many of those countries with policy rates still high enough to make it worth cutting have done so. Those where rates were already rock-bottom have resorted to increasingly creative means to lower borrowing costs even further.
Low interest rates should help to support consumer spending through reduced mortgage and credit card costs. In addition, by purchasing sovereign debt, QE policies help to reduce market pressures for governments to pursue growth-sapping austerity policies. But lower rates for overleveraged consumers and governments look more like damage limitation than growth promotion.
That leaves the corporate sector as policymakers' best hope for economic growth and especially job creation. Balance sheets are strong, profitability is high and the cash is piling up. Add ultra-low rates to the mix and surely CEOs will kick off a capex and hiring binge. But this has not really been happening, in the listed corporate sector at least. In fact, capex/sales ratios for publicly listed companies across the world have been heading downwards for much of the past decade even given a backdrop of progressively lower interest rates. Recent ultra-low rates have not noticeably reversed this trend.
Faults in the transmission mechanism
Such corporate caution is usually blamed on global economic uncertainties. Amongst these, the US fiscal cliff, China slowdown and the ongoing EMU crisis look most obvious. But we can't help feeling that there is something more fundamental going on here. The economic outlook is always uncertain at weak points in the cycle. Nevertheless, low interest rates usually prod CEOs into action.
We think one answer to this conundrum can be found in the equity market itself. As aggressive monetary policy has pushed interest rates to all-time lows, so the dividend yield available on equities becomes more attractive. The global equity market now consistently trades on a dividend yield above treasuries for the first time in over 50 years. Income-starved investors have noticed.
Turning textbooks on their head
If the global equity asset class has reinvented itself as an alternative bond market, this has profound implications for companies and, ultimately, policymakers. Textbooks suggest that investors should buy equities for growth and bonds for income. But low rates and QE have turned the traditional mantra on its head. Investors are increasingly looking to equities to fulfil their income requirements. And as the global equity market becomes dominated by these income-seeking investors, companies will become increasingly sensitive to their requirements.
Textbooks also say that the equity market exists to bring together those who capital and those who require it. Equity investors provide the riskiest capital to a company. They give up security of return in order to participate in the future growth of the business. Again, that looks less appropriate in current capital markets. Rather than providing new capital to companies, equity investors now seem more interested in extracting existing capital through share buybacks or dividends.
Another basic premise of financial theory — that lower discount rates should put a higher value in future corporate cashflows — is also being questioned by present circumstances. Low interest rates should encourage companies to invest more for the future because shareholders will value the resultant cashflows more highly. It is partly why policymakers have now set rates so low. But, again, these theoretical transmission mechanisms do not seem to be working. For the past ten years, a rising equity risk premium (ERP) has negated the supposedly positive impact of lower interest rates upon equity valuations. The ERP has now risen so far that equities have become an income asset, so increasingly attracting investors who are more interested in the next dividend than funding a new mine, drug or microchip.
It's all about the distribution
This brings us to a basic observation: companies remain reluctant to expand because increasingly income-obsessed shareholders don't want them to. If anything, ultra-low interest rates have exacerbated this theme. Policymakers should take note.
In 2011, US companies spent $650 billion on share buybacks and dividends compared to $580 billion on capex. While this is supportive of share prices, it does not help other stakeholders who would presumably prefer the capital to be spent on new investments and jobs. In markets where shareholder requirements have a greater influence upon companies, the suspicion of capex and preference for distributions is evident. In Europe, those sectors that invest the most are given lower valuations and in the US, share buyback and dividend ETFs have outperformed handsomely in recent years. It seems that the market is sending clear signals to companies "if you want your shares to outperform then distribute, don't invest."
What does this mean for policymakers?
If policymakers really do want to encourage stronger economic growth (and especially higher employment) then we would suggest that they take a closer look at the equity market's part in driving corporate behaviour. Despite high profitability, strong balance sheets and ultra-low interest rates, any stock market observer can see daily evidence of why the listed sector is unlikely to kick-start a meaningful acceleration in the global economy. A recent Reuters headline says it all: "P&G Plans to Cut More Jobs, Repurchasing More Shares".
If anything, low interest rates are increasingly part of the problem rather than the solution. Perversely, they may be turning the world's largest companies into capital distributors rather than investors. Perhaps rates should be allowed to rise back to more natural levels. This might be painful at first, but it could stop equity investors being so income-obsessed. Or maybe the real problem here is depressed equity valuations. Low PEs and high dividend yields reflect the long slow death of the equity cult. At the margin, current valuations encourage CEOs to distribute through buybacks or dividends. They discourage capex and job creation. Perhaps instead of buying government bonds, the next round of freshly minted QE cash should be used to buy the stock market instead.
Alternatively, and more menacingly for equity markets, policymakers might use the tax system to clamp down on capital returns to shareholders. "Investors are forcing companies to over-distribute and under-invest" has a certain populist ring to it. This was exactly the argument used to justify the removal of the dividend tax credit for UK investors back in 1997. Another, more equity-friendly, policy might be to give greater tax breaks to capex.
Even if economic uncertainties and shareholder constraints mean that listed companies are unlikely to embark on a capex binge soon, maybe low rates can have a more textbook impact upon unlisted companies. Having no stock listing could make them less aware of investor pressures and more willing to adopt expansive strategies. Perhaps these are the companies that offer the best hope for a pick-up in employment.
What does this mean for investors?
If policymakers hope that listed companies can help drive down current high levels of unemployment then it could be a long wait. Corporate expansion plans are likely to remain constrained by uncertainties about the global economy and a shareholder base that is more interested in share buybacks and dividends than capex and job creation. But despite our misgivings about their effectiveness, interest rates are likely to remain very low for some time.
What are the implications for investors?
- Equity markets are supported despite weak growth. Income-seeking capital should help to support global equities. Even if earnings growth is held back by weak economic growth, buybacks and accretive cash bids should help EPS expand.
- Inflation may come back sooner than expected. Just as equity market funded over- investment during the Tech bubble created deflationary excess capacity, so perhaps under-investment may now be creating the potential for future inflation. Bond investors should take note.
- Equity income and de-equitisation strategies are still key. Premium dividend yields relative to bonds should continue to attract income-seeking investors to the equity asset class. This will keep the appetite for equity income strategies strong. Those companies that offer progressive dividend policies should be rewarded with outperformance.
- Smaller growth stocks can trade at premiums. Despite the current circumstances, equity financing is still best suited to fund longer-term growth projects. But the limited amount of capital available to sponsor these projects means that growth premiums are likely to remain focused in companies down the market cap scale.
- Activism is here to stay. Expansionary strategies by corporates will continue to be treated with suspicion by the equity market and subsequent share price underperformance may attract the attention of activist shareholders. Those CEOs, particularly at the largest companies, who do not give this income-seeking market what it wants may find themselves replaced by a CEO who does.