Eating away at the equity premium – and what it could mean for the future

The papers have recently been reporting Macquarie Bank’s hunger for assets most of which share certain characteristics. Macquarie is on a buying spree that has made a splash around the world.

Recently they have been either buying or bidding for a global company that leases out airport trolleys at airports, an airline leasing company and the London Stock Exchange which sacrilegiously goes under the acronym previously reserved for the London School of Economics (LSE).

The assets very often involve what I think is called in the trade ‘clipping tickets’. Typically the total return is not that far below equity returns, but the yield is much more stable than equity more like property.

And some of these assets end up demonstrating a big (usually one-off) upside. Upon acquisition or after some quaint regulatory protection of the public is swept aside, Macquarie demonstrates that the inherent monopoly characteristics of the asset can be exploited further than had previously been dared. This was the case with Sydney Airport. A journo from the Financial Times rang me and asked for my opinion as to Macquarie’s interest in the London Stock Exchange. I told him my guess was that Macquarie would be interested in further testing the monopoly power of the LSE.

These are two signs of the time for our economy. This post is about the first phenomenon the expansion of demand for assets with very stable yield.

We’ve known of the equity premium for years. Early calculations of an appropriate risk margin for holding equity over government debt using mainstream financial theory suggested the premium should be well under one percent. Yet there’s a persistent difference in annual return of over five percent between equity like and bond like returns. I don’t know what the international literature on property prices and bonds says, but in Australia for a good while now property has performed far better than bonds generally yielding more even before capital gains are considered.

Macquarie’s asset accumulation and management is targeted to a large extent to meeting the demand for assets from the burgeoning superannuation funds that are the legacy of the ALP’s last period in power. And those funds are hungry for assets that have low volatility and which have better performance than bonds. Now the Australian capital market (and Macquarie) are somewhere near the forefront in all this. But it’s going on elsewhere. Other asset classes that are growing fast in the search to lower portfolio risk and/or increase yield are private equity and hedge funds. Hedge fund investment has been expanding at a rapid rate as I think private equity has. Neither class is necessarily low risk on its own, but it can still lower risk in a portfolio by virtue of its capacity to diversify the portfolio.

All of which leads me to believe that the equity premium is finally being eaten away at. Though people have made this prediction before and make it each time there’s a bull market in equities, in this case one can see some of the micro-economics of arbitraging away some of the premium with the development of new kinds of assets or the higher valuation of bond like, low volatility assets.

Of course these burgeoning asset classes are not perfect substitutes for bonds, but they’re better substitutes than equity! Now if the debt equity premium falls one would expect that to occur not just by the increased demand and higher prices for equity, property and quasi-equity and property like assets, but also by reduced demand for bonds, lowering their price and increasing their yields (ie interest rates).

So I’ll add that to the adjustments that our economy might have to make if some of the things that have gone right for us in the extraordinary run of luck we’ve had since the Asian crisis start unwinding. The good luck turned to bad scenario involves commodity prices falling and interest rates rising as the Asians pull back from funding external borrowing of (mostly) the Anglosphere. But add to that a longer term fall in demand for government bonds as the Macquarie Bank and other financial innovators around the globe succeed in intensifying competition with bonds in the world’s financial portfolios.

On the other hand, we’ve been expanding borrowing to invest in these burgeoning new classes of assets. So while increased interest rates might be difficult for us to digest at some stage, borrowing to invest in assets with higher returns makes sense if we can bear the risk and if we’re doing it well.

Who knows if Macquarie et al are as smart as they look or just leaders in the next fad and will over-reach themselves. If it turns out to be the latter, as Kimmy might say to Kath and Sharon, “you can’t make an omelette without getting egg on your face.”

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Paula Rizzuto
15 years ago

I am disgusted with Macquarie. Unlike some, they are very greedy.

Fyodor
15 years ago

This is a very confused post, Nicholas. I don’t see a solid connection between the purported erosion of the equity risk premium (ERP) and Macquarie Bank’s success at buying and managing infrastructure-type assets.

On the one hand, the ERP is known to vary through time, and exists to compensate investors for assuming equity-type risk. If it’s increasing, it’s a reasonable sign of increasing aversion to risk amongst investors.

On the other hand, Macquarie Bank has been very successful at persuading institutional investors (pension funds and their investment managers, mostly) to invest in funds they control, which buy infrastructure-type assets.

There’s no direct link between the two phenomena, unless you want to draw a rather ambiguous “bull market” connection.

Craig Malam
Craig Malam
15 years ago

I’d suspect that Macquarie is simply positioned its self very well ahead of an overall shift, that you could describe as a fad. But the shift might also represent the sort of nice broadening and deepening of the financial sector that theory suggests intermediaries are good for. That is, increased savings being funneled toward the correct financial assets, which involves a significant degree of transformation such as in maturity and risk profile (using diversification). So this is why I suspect the equity premium may not be eroded (well at least not for these reasons). Intermediaries such as The Factory (bless their hearts), only seek out a profile of financial assets that is being sought by lenders (savers). So you have to assume that some impediments existed in the first place that these financial innovations are overcoming, for the relative prices of some financial assets to change. Which I would hazard a guess is possible, in the ways that you suggest. But I would also guess for there to be a bigger fall in the equity premium the change would come in the perceptions/appetite of savers.

James Farrell
James Farrell
15 years ago

Maybe Fyodor missed the bit where you said ‘this post is about the first phenomenon’.

Asd for me, I’m wondering if you haven’t fallen into the old trap of confusing an increase in quantity demanded with an increase in demand.

‘An expansion of demand for assets with very stable yield’ sounds like an exogenous increase in risk aversion, which should in fact widen the equity premium. The super funds would compete for these sassets – whatever they are – that Macquarie is offering, bidding up the price and reducing their yield.

On the other hand, if Macquarie and others have hit upon some technical innovation that reduces the variance of income from a given outlow, then it’s no surprise that people that will no longer pay five cents in the dollar to insure against risk (by buying bonds). But we’re not much the wiser what the nature of that innovation is.

James Farrell
James Farrell
15 years ago

By the way, I like the new look. And I’m looking forward to plenty of argy bargy this year. But was an explanation furnished for dropping (1) Armadillo from the title, and (2) the comment preview?

Ken Parish
Admin
Ken Parish(@ken-parish)
15 years ago

James

Nicholas felt (and I concurred) that a shorter blog title was needed, especially for publication at the foot of newspaper columns etc. Hence “armadillo” had to go, although it’s still there in body if not name.

As for the comment preview function, I’m not sure whether that feature is available in our new WordPress system. I’ll ask Stephen Bounds who set it all up for us. I agree that it’s a useful function.

Fyodor
15 years ago

James,

If this post is about the first phenomenon (i.e. the ERP), why so much emphasis on Macquarie? Nicholas is obviously trying to draw a connection, but I think it’s tenuous at best.

Nicholas isn’t discussing an exogenous increase in relative demand for risk-free assets, which would be associated with increased risk aversion, but an exogenous increase in assets yielding more than the risk-free rate, but with less risk/volatility than equities, i.e. infrastructure-type assets. Nicholas sees this as a demand issue, but it’s just as valid to ask whether it is a matter of supply. Many of these assets (roads, airports, water utilities, etc.) used to be in government hands in our and other countries, and have not been generally available to private investors. Privatisation has provided an exogenous supply shock of investible infrastructure. If that is the case, increased private ownership of such assets says very little about investor risk preferences.

I also want to clarify the issue with Macquarie Bank’s behaviour. Macquarie Bank is not buying these assets for its own account; it is buying them as principal, in order to on-sell them to funds it controls, in which other institutions invest.

Macquarie Bank’s end objective is thus not ownership of these assets, but their stewardship. Why? Because Macquarie Bank gets to charge fees for sourcing the assets and transacting on them, and then for managing the assets, once they’re in controlled funds. It’s the super/pension funds that are taking the asset risk by investing in these funds – Macquarie Bank is facilitating them and is paid handsomely for it. As Nicholas points out, Macquarie Bank is thus the agent for a developing trend, but it is not really a direct (i.e. principal) participant. Macquarie Bank is servicing [and, perhaps, stimulating] this demand, but I don’t think we can read much from its behaviour with relevance to the broader equity risk premium.

Francis Xavier Holden
15 years ago

I thought this might interest you

Club Troppo gets a makeover

http://www.meyersound.com/news/press/conn_troppo.htm

Francis Xavier Holden
15 years ago

I found the above while googling for Club Troppo – how about a redirect or at least a link on the old site?

James Farrell
James Farrell
15 years ago

Ken

JQ uses WordPress, and has comment preview.