Taking Stock 16 January 2025

JANE Fraser, the CEO of one of America’s biggest banks (Citi, formerly Citigroup), has explained why she and her bank are so optimistic about the American sharemarket’s prospects in 2025.

She bases her hopes on “American exceptionalism”, a relatively modern concept which acknowledges America’s entrepreneurialism, innovation, and technological leadership.

Implicitly it points to the funding of research and development of America’s Magnificent Seven (MS). The MS spend this year will exceed US$250 billion, three times what they spent in 2020.

Fraser sees equity markets rising inexorably, based on the growing profits of these giant companies which she and many believe will address and conquer the challenges of global pollution, labour and skills shortages, unimaginably high sovereign, corporate, and household debt, healthcare and education.

She does not offer a view on how a structurally inadequate US tax system will address social spending.

Like most American banks, Citi is recording enormous profits, perhaps disposing of doubtful loans to private credit funds.

American exceptionalism is now a widely-cited concept, overtaking Trump’s catchphrase “Make America Great Again”. (I wonder if Trump struggles with pronouncing the multi-syllabled word “exceptionalism”.)

Europeans seems disdainful about crass American slogans but Fraser could easily counter that the economic growth in the USA continually confounds commentators as does the extraordinary exuberance of its debt and equity investors.

The S&P 500 has risen by nearly 50% in the past two years, unfazed by enormous fiscal deficits, wars, domestic dysfunction, not to mention weather/insurance events.

The MS technology giants (Amazon, Meta, Tesla, Nvidia, Microsoft, Alphabet, and Apple) comprise a stunning 35% of the world’s biggest index of 500 companies.

The banks, the manufacturers, the retailers, the energy, food, transport, construction and engineering companies have become barely relevant to the growth of the S&P 500 valuation.

American exceptionalism, as Fraser observed, has led to the exciting development of Artificial Intelligence, an undeniable piece of evidence in support of that description.

Many of my generation will have no idea how to identify the real oysters from mountain oysters so, as investors, many default to the logically inane philosophy of buying the whole of the S&P index, ensuring they capture the astonishing winners (at the expense of the scores of losers).

(Does anyone back the whole field at Trentham?)

In his introductory Taking Stock published before Christmas, our chairman-elect, James Lee, noted how at the start of his career the “dotcom” boom saw many high-flying “dotcoms” within a year or two become objects of derision.

Implicitly he asked the question, would the AI boom lead to balloons so over-inflated that they would perish?

I recall an absurd example of investor mania in the dotcom boom, when a wireless technology company morphed into a dotcom company that warehoused “adult toys”, believing the internet purchasers would make the company millions. Its share price soared and collapsed within months. Curiously, nobody was accountable for such nonsense.

Yet “American exceptionalism” are the words that feed the confidence of the vast majority of our investment managers, who are busily investing other people’s money into American index funds and ETFs. They base their strategy on the unknown future progress of companies enabled by AI and their somewhat unwise belief that more American debt will see US interest rates fall while the US dollar keeps getting stronger. Markets this week do not support that optimism.

These non-sequiturs obviously trump the boring old investment philosophies based on analysis of fundamentals.

The bold new strategies will succeed until they do not.

This is okay if each investor has calculated how much of his savings should accept obvious risk in search of high return.

In the very short term, the US companies will benefit from the cost-cutting that results from a growing exit from strategies aimed at “zero carbon” and an abandonment of awkward “Biden” initiatives in areas like gender diversity. These initiatives cost money. In recent weeks the six largest banks have scrapped such policies.

Even before he takes over, Trump seems to have emboldened corporate America to discard any role in social engineering.

In short, Americans are to return to eliminating expensive social pursuits in pursuit of high short-term gains (and bonuses), enhanced by stock buybacks and, I guess, all of this fuelled by “exceptionalism”.

I guess that summarises the case for confident, index-based investment with other people’s money - for the moment, and for the amount that accepts the level of risk.

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THE bold pursuit of returns of around 15% per annum rewarded investors (and fund manager bonuses) in 2023 and 2024, in spite of the issues highlighted in previous paragraphs (wars, debt etc).

During those two years another risk has surfaced but has been ignored, crowded out of discussion by the high returns (and bonuses).

That risk relates to the possibility of collapses in the private equity (PE) and private credit (PC) funds, where high returns will always correlate with high risk.

The global amount directed into this opaque, loosely regulated, under-capitalised area of investment reached US$13 trillion (yes, trillion) in 2023, and very likely at least $15 trillion by the end of 2024.

New Zealanders’ money caught up in this vortex would barely be $20 billion. Most of this would have come from our KiwiSaver managers, other pension funds (NZSF), and other managed funds (ACC, etc).

The current market and political sentiment seems to be that fund managers should bulldoze even more of other people’s money into this market segment in pursuit of higher returns. The government seems to support the strategy.

It is true that the private equity/private credit managers have certain advantages.

Like the Chinese car manufacturers, who can use any international technology, have opaque labour and safety rules, and opaque zero carbon rules, the private credit and equity managers have various exemptions from more transparent regulated investing.

1. They are subject to less scrutiny and less supervision.

2. Because they fund from other fund managers or the unprotected hyper-wealthy, they are not subject to the protections in place for retail investors.

3. They typically promise no liquidity so are not bound to match funding to the exit rights of investors, though the patience of investors changes when losses occur.

4. They use the money they raise as “capital” by subordinating it behind whatever bank debt they can raise. (Banks might lend to risky transactions if the risk of failure is underwritten by such subordination.)

5. They report their gains by engaging with “valuers” who “assess” the changing, theoretical value of the PE/PC managers.

6. They have great discretion on rolling over troubled loans, without disclosure.

7. They minimise costs; no branches, no prospectuses, no retail cost, yet high discretion over any covenants.

The trend today is for PE managers to enter the leveraged buy-out market when borrowing costs are cheap, and to switch to PC when rates rise, making lending a high-return activity (providing there are NO bad debts).

PE managers generally seek to use low-cost debt and implement a severe cost-cutting programme (research and development, staff training, travel constraints, lower executive compensation) to lift short-term gains, in pursuit of a high-price sale in the quickest possible time frame.

If their timing is good, they then trade/sell the asset, or if that fails they seek to IPO the asset (sell it through a public listing).

A PC manager gains opportunities from PE-owned companies when poor business conditions or higher interest rates make the traditional banks unwilling to roll over big-ticket loans to aspirational but fragile companies.

The banks will demand more restrictive covenants and higher interest rates to rollover big corporate loans, often with extreme penalties for any breach of covenants.

The PC manager may then step in, replace the bank loan, and hope it can massage the corporate borrower, gaining either through high margins, high fees, high penalties, or through a bonus system if the borrowing client recovers.

The PC lender, recall, is unlikely to have the capital of a bank and is able to be flexible, without public disclosure.

My view is that banks are blessed by a better database, superior analytics, and a broader base on which to calculate risk, as well as by skilled executives with long-term ambitions.

To illustrate the value of such experienced, skilled people, recall the 1980s when almost all our property companies (Chase, an example) sought huge bank loans, often from a syndicate of banks. Some had to resort to American lenders with little understanding of the risks then threatening the NZ market (dreadful governance, improbable valuations, no liquidity).

At that time the NZ banks had an unhealthy focus on market share and quarterly profits, the BNZ being the dopiest, until, in the 1990s its new CEO, Peter Thodey, rebuilt a true banking culture.

The standout banker of that era was (Sir) John Anderson, CEO of the country’s only true investment bank, South Pacific Merchant Finance, wholly owned by the dreadfully led National Bank of New Zealand, itself owned by the later-bankrupted Lloyds Bank (in London).

Anderson took time to analyse Chase. He analysed its debt levels and the mismatch of (short-term) loans to unsaleable, usually glitzy, but badly built property.

He analysed the liquidity and valuations of Chase’s properties.

He observed the cash Chase was sucking out of the company.

He assessed the dubious accounting standards Chase was employing.

He was soon to discover how before Chase became worthless it bought Farmers and then eviscerated Farmers’ pension scheme by using all of its tens of millions to buy a single asset – Chase shares – and thus reduce to rubble the savings of thousands of people. (Yet nobody was ever accountable.)

Anderson was a real banker, a real leader, a large man with a matching intellect and presence. He commanded attention and could wake up the most indolent bank executive, once famously thumping the board table with such vigour that glasses of water jumped and spilled.

He told the NBNZ that Chase was a doomed “pack of cards” likely to collapse at the mildest zephyr.

When Chase collapsed soon after, costing its lenders hundreds of millions, the NBNZ lost not a dollar, having responded to Anderson’s analysis.

Today there are very few, if any, of Anderson’s calibre but those who have his experience and skill are most unlikely to be chasing high rates from dubious corporate loans. The PC managers will need to find lots of John Andersons.

The fabulous database held by banks ensure they are scouring out all worrying loans, hopefully more focussed on the return of capital than on the return on capital. They should not resent the PC takeouts. They should welcome them.

I accept the possible status as an outlier but I am happy to forecast that private credit as an asset class will eventually be seen as another iteration of high-risk non-bank lending, just as Equiticorp was in the 1980s, and as were so many (Bridgecorp, First Step, South Canterbury Finance, Strategic, Hanover, St Laurence) in the period between 2004-2007.

There will be some survivors but many corpses.

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YOU might expect any skilled, cautious pension fund managers in NZ to be watching the rapid growth of private credit corporate lending with the same nervousness that drove Anderson to analyse Chase in 1986.

Those managing the money of people who are solely reliant on the fund manager to match investor risk profiles to fund manager asset selections would, you would expect, be highly tuned into matching risk aversion with their investment policies.

There is a special responsibility on these KiwiSaver managers.

By a ratio of about 50 to 1, KiwiSaver users rarely are even remotely inquisitive about the skills or the wisdom of those who manage their investments. Their faith is touching, but misplaced.

Indeed, a double figure percentage of such investors cannot recall which company manages their savings.

We all nod silently when some politician says we needed to improve the education of investors, perhaps reinstating money skills in the secondary school syllabus. (Yes, please!)

The risk of incompetence is not just that a dedicated salesman will be given hours of airtime to sell poorly researched ideas, just as Money Managers did on Radio Pacific in the 1990s. The greater risk is that the essence of KiwiSaver is being threatened, as some salesmen conflate the objective of obtaining returns for risk, with the social objective of using this pool of other people's money “for the good of the country”.

Regularly I read of unaccomplished fund managers preaching that the pool of money should build our infrastructure, or social housing, or the like.

I interpret this as a cavalier or self-focused attitude towards the owners of that pool of money.

The ONLY objective of a skilled, wise pension fund manager is to carefully define the assets in which he will invest, explain the return for risk, manage the quality of the fund, and by so doing attract money that accepts his fund management investment style.

Only a charlatan would promise a particular investment style and then expand his investment style into “social” projects, without receiving highly specific approval by the investors, via their trustee.

If there are any wise trustee companies in NZ, and there is an argument to say there are none, then that wise trust company would very specifically engage with each investor about his desire to fund any opaque investment, where there is no or little validation of value enhancement.

KiwiSaver investors are said to “deserve what they get” if they take no interest in how their money is invested. I disagree.

I can think of one outcome that might change this arrogance.

It would not be the very long term of improving the education syllabus. That would be a 10-20 year solution; worthwhile but not relevant today.

The momentum would change if any new investing adventures produced not just poor returns, but negative returns.

Investing in infrastructure suits companies like Infratil because its investors have given Infratil the mandate to invest in the sector. The investors select that strategy.

They expect Infratil to be skilled, wise, insightful and transparent. (Generally, Infratil delivers.) Investors allocate to Infratil an amount that is appropriate for each of them, individually.

How can a KiwiSaver replicate that without the equivalent of Infratil’s skills and mandate?

And quite why would a government, that can borrow at 4.5%, hand over to KiwiSaver managers a project that must return 6.5% to be commercial?

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CLIENTS are welcome to share this Taking Stock with their families. If KiwiSaver investors wish to discuss our views on choosing a wise manager and suitable investment style, they should find an independent adviser, here or elsewhere. 

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Travel

Auckland - Ellerslie - 30 January - Edward LeeAuckland - Albany - 31 January - Edward Lee

Christchurch – 13 February – Fraser Hunter

Blenheim – 20 February – Edward Lee

Nelson – 21 February – Edward Lee

Napier - Mission Estate - 6 March - Edward LeeNapier - Havelock North - 7 March - Edward Lee

Please contact us if you would like to make an appointment to see any of our advisers.

Chris Lee