Wednesday, December 29, 2021

Pilkington et al.: "Credit-Driven Asset Price Inflation"

As part of the know your customer checklist, after the "As your financial counselor, I need to determine you risk tolerance, wanna cut the cards for $10,000?" question I asked one very wealthy gentleman if he had any margin accounts and his answer stuck with me: "no, I can get an uncollateralized signature loan cheaper than the money the brokers are offering."

Among the truths that can be teased out of that answer - and there are many - is a premier source of wealth inequality. Jus' sayin'.

From Verdad Advisers (verdad is the Spanish word for truth):

How cheap money is driving overvaluation risk in public equity, PE, and housing

By: Philip Pilkington with Daniel Rasmussen & Greg Obenshain

Credit is the lifeblood of our economy. From consumer purchases financed on credit cards to home purchases funded by mortgages to equity investments made on margin and private equity funded by private credit, credit is a key driver of both prices and volumes. When debt is cheap and easily available, asset prices tend to rise; rising asset prices in turn make loans look safer, fueling yet more credit availability and more purchases.

Today, credit is extremely cheap and extremely accessible, and that is driving rising asset prices in three key markets: public equity markets, private equity markets, and housing markets. In each of these markets, rising asset prices are accompanied by decreasing loan-to-value ratios, falling debt costs relative to income, and, most strikingly, asset prices that look extremely high relative to history.

The Scylla and Charybdis of investing are bankruptcy risk and overvaluation risk, and when credit fuels rising valuations, investors should be doubly concerned. To navigate between these two dangers, investors need to be fully cognizant of the risks posed by rising asset prices and monitor credit markets avidly to look for signs of any change in credit conditions that might lead to a reversal.

In what follows, our goal is not to predict the next crash in any of these markets, or even to highlight definite bubble activity. Rather, we aim to highlight risks that we believe investors should be mindful of and understand that, by being invested in current markets, they are implicitly underwriting.

Public Equity Markets

The extremely low cost of borrowing has three primary impacts on equity markets.

First, companies issue more and more debt, swapping equity for debt and leveraging up corporate balance sheets.

Figure 1: Corporate Debt and Equity Issuance
Source: Federal Reserve, GMO

Second, unable to earn returns in credit markets or on cash balances, investors shift a larger portion of their investable assets into stocks.

Figure 2: Aggregate Financial Asset Allocation Among Household, Mutual Funds, Pension Funds, and Foreign Investors....

Some people don't like Pilkington but we find him to be interesting, even provocative. Some previous links:
Economics: "The Miracle of General Equilibrium"
The writer, Philip Pilkington, is one of the sharper knives in the econ drawer.
As long-suffering readers know, I don't have time for a lot of the public intellectual economists, life's too short for political and policy preferences gussied up in fancy-dress math. There are a handful of names I make time for, Nordhaus and Shiller among the heavyweights and Timothy Taylor* and Pilkington among the lesser (but brighter than I) lights.

Pilkington's book The Reformation in Economics, aims directly at the heart of the question, "How much of economics is ideological?" He hangs his academic hat at Kingston University and grubs his living as a member of the Grantham Mayo Van Otterloo Asset Allocation team....

"Social Structure And The Determination Of Interest Rates"
GMO: The Deep Causes of Secular Stagnation and the Rise of Populism

Here's a snippet from one of his papers, "How Far Can We Push This Thing":

....The other way that inflation might get caught in the system is if workers bid up their wages to maintain their purchasing power in the face of inflation. Imagine that wages and inflation are both growing at 2% a year and so real wages are constant. Now imagine that, due to an increase in the fiscal deficit, inflation rises to 4% in a given year. If workers then try to raise their wages to 4% growth in that year then it is conceivable that businesses will raise their prices in order to pay these new higher wages. This could result in a wage-price spiral where the higher rate of inflation gets caught in the system.

For this to happen, however, workers must have sufficient bargaining power to demand that
businesses raise their wages. If they do not have enough bargaining power, then they will not be able to defend their real wages against the price increases and so will have to just accept the real wage cut that they receive5. While such a system is not ideal for workers, it does entail very low risk that once-off price increases will translate into permanently higher rates of inflation.....

He basically argues that, barring wage-price spirals, inflation is a one-off, which of course is a tautology but it is interesting to see how he develops his thesis. 

And it will be interesting to see if the new-found worker autonomy and power is real, or at least real enough to demand wage increases in excess of inflation.