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Steen’s Chronicle: The Marginal Cost of Everything

Chief Economist & CIO / Saxo Bank

– Denmark

  • Profit both drives and explains stocks
  • Rising cost of capital will filter through to profits in autumn
  • Ignore rises in capital costs at your peril
  • Best advice? Stash your cash and use it later

Studying economics, to be honest, is of little practical benefit, but one thing I did learn which continues to help me is this: Capital should always be allocated to the “marginal cost of capital”.

What’s interesting in this context is that the stock market in its most simple form is really an input–output black box: In goes the “cost of capital” – out comes “profit”. I don’t think anyone will disagree that long- and medium-term it’s the profit which both explains and drives stocks best.

The most profitable companies get the best stock returns, Philip Van Doorn explained recently in a MarketWatch column. (See his list of the most profitable S&P 1500 companies here.)

Van Doorn’s conclusion reads:

Van Doorn Conclusion

This brings me to the “dilemma” of today’s market: The marginal cost of capital is significantly higher. My own Marginal Cost of Capital chart (50% US, 25% Germany & Japan 10-year yields) is up from -3.0 Z-score to +1.0 since the low in late January – a significant move by any standard.

Of course there is a delay in time from rising rates to profit – the “black box” takes 6-9 months to process the changes in input prices (cost of capital) but it increasingly clear that should the stock market continues up, and the consensus is more positive than any time before, it will entirely be driven by increase in multiples.

The credit cycle peaked in March/April last year and now the cost of capital has been rising since January (six months) which means by September/October the full impact will be felt on profit. There are also some good reasons to expect buy-back programmes to lose some steam as the continued aggressive buy-backs are mostly funded not from free cash flow created, but new net lending meaning we are getting “worse” quality earnings on top of rising input costs.

I note that several people love to comment that I am always “negative” on stocks, that may be the case when journalists quote me, but in terms of money managed I am neutral – not long, not short – I have not done a stock index deal in more than six months and I maintain my equity exposure at the required 25% mainly through mining and commodities now.

The real peak was in April 2013, with a new “lower” peak in April 2014. The above chart shows US high yield (HYG) vs. YoY return in the S&P500. The correlation seems reasonable….

Leveraged loans – high risk credit lending – is also coming off.. again, the peak was April 2014ish…

In more liquid assets – the 10-year and 30-year generic US yield and the 30-year average mortgage rates look like this:

Saxo Bank Graph

You can ignore these rises in capital cost at your peril but I would warn that this is NOT going away – we can discuss Fed next move in 3D, 50 colors and with conviction but the cost of capital is rising already even before Fed is starting its “normalisation”. The Fed is now priced to go most likely in December, but I remain with September as December becomes political with primaries and US elections. The data should be “good enough” – not great but the trend will be rising (from a very low point).

The strategy for most assets remains one of wait-and-see to me: I keep recommending the few people who want advice to bring back their stock portfolios to a January 2013 level – keep the profit in the “piggybank” to be used later. There are too many unknowns to proceed full steam ahead – the tax of “volatility” in now again increasing:

Saxo Bank Merrill Lynch

The “catalyst” for change is the first Fed move – It will be a full blown “margin call” – if you add my models plus the Fed consensus together with the “prediction” made in February, things are suddenly interesting…. What is clear is that the market “expected return remains zero over 3, 5 and 7 year and how you tackle that downbeat scenario really is an exercise in capital preservation.
Safe travels,

Steen