2018-01-02
Keywords: Capital cases, Investment, Market analysis, Private investors, Strategy
Author: Martin Seppala
The next global financial crisis is around the corner. How should you prepare?
In a recent interview (TE 1.4.2016) MIT Professor Bengt Holmström said that nobody understands what is going on in the global economy right now. Neither he nor the presidents of the Federal Reserve nor ECB can tell you what the outcome of the current money-printing experiment will be. In an unprecedented situation, all major central bank interest rates are close to zero, and then a big part of the world is still struggling to get growth to pick up. At the same time money is printed to jump-start the inflation, with no or little visible effects. No matter how much they are pushed by free money, investors and executives refuse to start investing, fearing that the worst is yet to come. This worry is fed by a number of extremely worrying factors co-inciding on the world market. The Western world is aging fast and employment is dropping, which has caused a doubling in the dependency-ratio in both the EU and US over the last decades (World Bank). China, which held the world economy afloat after the last 2008-2009 financial crisis, is now starting to feel the effects of western demand falling. It has so far managed to keep its GDP growth above 5-6% with a strong financial stimulation, but this has led to an debt-burden which is very high for a developing country and to over-investment into domestic real-estate and infastructure.
“The western world is aging fast and employment is dropping, which has caused a doubling in the dependency-ratio in both the EU and US over the last decades (World Bank).”
It is estimated (BOF 2016) that China’s government debt now amounts to 250% of GDP, while there may still be substantial hidden off-balance liabilities on top of this through e.g. state backed companies. China’s struggle is in its turn hitting the demand for raw material (oil, minerals etc) very hard, causing the GDPs of countries like Russia and Brazil to fall rapidly. The social problems and unrest caused by the macro economic struggles, causes the leaders to act irrationally (China to crack further down on freedom of speech and social media, Russia going to war(s) to keep focus elsewhere, Western leaders avoiding inevitable structural reforms in fear of loss of mandate to populistic peers etc), which further postpones and grows the problems.
All in all the recipes for a “perfect storm” (i.e. financial crisis) are there. In addition, all the central bank and government ammunition to tackle the storm has been used during the last 7-8 years. In addition US, Chinese and European consumers are heavily indebted. When the next wave hits, it is going to be without any possibility for shelter. As, however, pragmatic executives and investors cannot just “roll over and play dead”, the real question is not if the situation is bad, but what strategies to deploy in this situation?
In the author’s opinion, there are two main scenarios for how the global financial situation will develop next.
The first, more positive scenario is that the coming years show that the USA’s 3,5 trillion USD (Bloomberg 16.9.2015) quantitative easing program really worked and the country returns to a normal GDP-growth and positive inflation scenario (possibly even hyperinflation). In this scenario, the effect US economy is strong enough to handle slightly higher interest and currency exchange rates without it hurting its trade balance too much. Such a scenario could give confidence to the ECB to keep maintaining and possibly growing its own QE-program (so far 1,2 trillion EUR) until the same cycle is started in the EU. A growing inflation in the world’s two largest consumer markets would start spending and investments, which in turn would restart the Chinese global factory and it demands for oil and raw materials. In their newly found wisdom the politicians would then use this opportunity provided by growth to reform old and rigid structure, adjust government spending to levels sustainable with an older population (esp. EU) and to slowly but surely deleverage (EU, China and US) and return to a normal, less debt-driven cycle.
The problem with this positive scenario is the amount of debt cumulated to many countries’ public sectors. The regressive left in many developed countries likes to claim that the amount of debt isn’t a problem. But what they then overlook is the problem of the rising debt-service costs as interest rates rise and as refinancing gets more expensive. When combining this with aging populations with high expected benefits, high household debt levels and deteriorating dependency-ratios, this so called positive scenario is unlikely to play out very well for a wealth of countries. An interesting twist is also that automatization and robotization will paralelly first hit these countries through major structural unemployments, which further narrows down their politicians room to make necessary reforms. Recent evidence also suggests, the US economy is not ready to handle significantly higher interest rates, causing the Federal Resereve to postpone its planned interest rate hikes.
The more likely scenario, however and unfortunately, is that the mistrust in a controlled turnaround is too big to start any major investment or spending boom. In fact one could argue that the QE and interest rate decreases have already caused the hyperinflation scenario to take place. It is just very unevenly spread and not showing up in traditional price index baskets due to significant decrease in the price of energy and raw materials. Up until the end of last year, most major stock indeces were at – or close to – their all-time highs. Even though very little improvement in the world economy had been made since the last crash. At the same time investors have been pouring in money into perceived real estate safe havens such as London (up 50% from the last 2007-2008 peak. Source: Business Insider/Savills 2015) or Stockholm (up 100% from the last peak. Economist 2016). Not to mention cities like Shanghai, New York or e.g. Vancouver.
“The more likely scenario, however and unfortunately, is that the mistrust in a controlled turnaround is too big to start any major investment or spending boom.”
This is the hyperinflation happening right in front of our eyes. When QE (i.e. printing money) and kicking the can down the road doesn’t convince anyone to buy or invest more, the markets start to shake regardless of the central banks’ and governments’ opposite efforts. In this type of environment the only way to return to normal is through a significant market correction, i.e. through bursting bubbles and lower asset prices that will re-create the interest of investors and consumers. Most likely we have seen the beginning of this in Q12016. In January alone US stocks dropped almost 2 trillion USD in value (Washington Post 1/2016) and in China the losses year-to-date in end of February were almost 25% (CNN Money 2/2016). Whether the final blow to the global markets comes instantly over rapid developments over a few weeks like in 2008-2009 or as a series of downward spiraling corrections, the major correction and market clean-up will come sooner or later. This will momentarily cause even more turbulence and unrest in the developing world, and leaders in countries like China and Russia will have an increasingly hard time to control their populations, no longer bribed from demanding basic freedoms with improvements in living standard.
As an investor, where should you be in this type of market situation? The voices suggesting a strategy based on high leverage and waiting for the hyperinflation to eat up that debt has fortunately died out the last year. But should you then just be holding cash and gold waiting for the crash?
While some analyst now actually advocate this type of approach, it is very unlikely to be able to predict the exact timing of the major correction. And while sitting there waiting, you may miss out on good opportunities. Yes, you should make sure you are liquid and not heavily leveraged. In the shorter term secure cash-flow is king. Any utility stocks with stable customer bases paying out dividends, are likely to be good investments in this environment. Also diversification internationally and across sectors is advisable. Investment properties, especially on the residential side (everyone always needs a home) offer good opportunities even just before the upcoming storm. The good part here is that while London, New York and Stockholm never really crashed and are instead continuing to build their bubbles, there are several other markets that already had their correction (such as Spain, parts of Germany, parts of the US), and which are unlikely to be as much affected by any further downward corrections. When combining such investment-cycle timed opportunities with rigid analysis of underlying long-term demand and purchasing power, a savvy investor can have his money working for him while waiting for the inevitable global correction.
As a company executive, you should be equally concerned about a secure liquidity position and keeping leverage moderate as your investors peers. In terms of short-term, payback-oriented market expansion, developed markets with strong purchase powers and especially e.g. Germany, UK, Scandinavia and the US show potential. These markets have solid infatstructurs and stable, relatively high-earning consumer pools and are hence attractive expansion targets. Developing your (any, also traditional) business model to enable more automation, long-term service contracts and geographically diversified customer portfolios is also smart in a volatile global market situation. As all business in the end is consumer business, companies with risk appetite and a long-term view, should also keep looking at areas with the biggest long-term population growth i.e. India, Turkey, Africa, South-East Asia etc. This, however, is only for companies with a cool head and a strong equity ratio; if your perspective and patience is 5-10 years or more, the upcoming turbulence during the next 5 years should not set you off from developing this part of a growth portfolio as well.
“Start strengthening your balance sheet and create long-term cash flows and business models that are likely to survive the crash.”
Success is what happens when opportunity meets preparation. In the economic history it has many times been proven that more money can be made in a crash than in a steady upswing (from George Soros benefiting from currency crashes to companies like Ebay and Amazon getting ahead of competition after the burst of the dot.com bubble). Preparation in this situation is not get paralyzed by the seemingly mixed signals and constant worrying news. Start strengthening your balance sheet and create long-term cash flows and business models that are likely to survive the crash. As the markets inevitably correct themselves, you will be in a great position to enter new positions with very attractive valuations. As you will be sitting on a comfortable equity and cash-flow position timing that opportunity will also be easier for you. The mother of all market opportunities will reward the prepared after markets have cleared unviable competitors and practices.
Excedea is the one-stop shop for companies and investors who want to grow internationally. We have a long history in international growth, having delivered over 250 consulting projects in over 40 countries in Europe and Asia. We support our clients in planning, financing and executing international growth projects. We have raised tens of millions of euros in equity for our clients, and have successfully delivered over 250 public funding projects, enabling our clients to leverage their existing resources to execute their growth projects with less risk and higher returns.
Martin Seppala Ph.D. (Econ.) is Partner and Chairman of the Board at Excedea, with over 17 years of experience in creating successful international growth for client companies and investors. Whatever spare time Martin has between managing the company and taking care of his three sons, he likes to spend either sailing, golfing of engaged in any team/social sports.
Should you have any comments or questions related to capital investment, please contact Martin at martin@excedeacapital.com or +358 44 077 1976 / +372 53 439 398
