Beware of safe haven assets, fair value adjustments tend to burn later on

Published: 23 September 2019
The Zimbabwean economy is fundamentally going through what the global economy is experiencing as well, albeit due to slightly different dynamics. A safe haven is generally a place where investors "park" their money. Parking money implies that funds are allocated not for an asset's productive agency, but rather an asset's ability to mostly store value, passively. Accordingly, safe haven investing creates deceptive asset valuations.
 
Globally, a lot of asset valuation is at peak in various classes. The cause of these highs is not due to their allure as active investments that have real productive agency. In equity markets, record share buy-backs have pushed up stock valuations more than confidence in earnings. Real estate prices in major cities, both in the Eastern and Western hemisphere, are at record highs, but without accompanying competitive demand by tenants or prospective home owners. The uniform trait amongst these peaks is that asset valuation is due to attraction for investors to park funds. The money behind these assets is not being productive. This is why fears of an impending global recession keep getting more audible and pronounced. Ultimately, funds have to work. They have to be active. Funds have to be productive! Or else, these record asset valuations become bubbles.
 
A way to interpret bubbles is when too much money invests in an asset, and the asset becomes overpriced to its actual productive capacity to yield the returns beholden to it. This is fundamentally what eventually causes recessions too. Economies accumulate entitlements and claims that cannot be met by the productive capacity of the economy. A good strategy to forecast this scenario is to consider the movement of productive metrics relative to entitlements and claims in an economy.

For instance, the table on producer manufacturing indices (PMI) shows falling inventory orders in factories in most economies; India is barely holding on at 0.1 increase year on year. This means that productivity across major economies is actually falling, yet entitlements and claims, as shown in assets valuations are at record highs. This is an undesirable divergence, but one that should be familiar to Zimbabweans.
 
In Zimbabwe, funds have not been productive for years. John Tamny, Director at the Center for Economic Freedom, makes a compelling argument to this point in an opinion piece in Forbes magazine published a fortnight ago. Tamny mentions policymakers' shortcomings to incite productivity, instead relying on remittance financed consumption and central bank credit financing to government to keep the economy going. He says "if consumption and soaring money supply were certain growth ingredients, prosperity would be simple. Politicians could demand that the citizenry consume more, and to enable the buying, they would instruct the central monetary authority to boost money in circulation." He further claims that to anybody with a pulse, it should be clear that this scenario would fail with blinding speed! Tamny is technically correct, though, in Zimbabwe, this strategy has lasted longer than blinding speed. In fact, the economy has trudged along, torturously, with inadequate productivity for nearly a decade now. To the most optimistic, Finance Minister Ncube's Transitional Stability Program (TSP) is relieving jargon for "Alright, enough! This is no longer working anymore!" But, Ncube's plan is yet to offer convincing evidence to productivity stimulus. Commentators and analysts are overdue to start pressuring Minister Ncube on productivity! Admittedly, he may be fighting a miserably lone battle as his counterparts at the Ministry of Industry recently published an uninspiring National Industrial Development Plan, seemingly plagiarized from an A' Level textbook. It has no pragmatic ideas really
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For investors with funds in Zimbabwe, the propensity to park funds at this point seems rationale. There are very few productive value chains to attract active investment. Besides what have become quarterly vows by the Reserve Bank to strengthen its monetary transmission to productive sectors, the financial sector's business strategy is the best tell sign of there being no productive channels in the economy. A reliable income model has been to focus on services and facilitation fees, with regulatory obligations to lend only piling on non-performing loans. It will be a good tip to note, besides the PR overtures it creates such as KweseTV purporting to air local content, Ecocash will not be seriously entering the lending business anytime soon!
 
Rationally, the fear of losing value, not just for banks, but for anybody with scarce capital, has been directing funds to park in safe haven assets! The most trusted safe haven is the US Dollar. There is impetus to park funds near convertibility to the US dollar. Asset allocation instincts are to a large extent driven by this impetus for professional investors and regular citizens alike. The desirability of Old Mutual shares, for instance, is largely due to their convertibility. Citizens hardly leave their incomes in accounts for long; immediate withdrawals on pay day are to convert to the day's exchange rate. This is parking funds in a commodity, the USD, to store value.
 
There is a more fascinating safe haven; real estate and capital equipment, commonly referred to as fixed assets. After the currency conversion in Zimbabwe, fixed assets duly become more attractive because of the accounting practice of fair value adjustment. To a lot of listed companies, valuation comes as a relief as lackluster operations are salvaged by replenishing balance sheets with the exuberance of competitively appraised fixed assets, or in the case of ZIMRE Holdings, fair value gains on income statement? Anyhow, this has happened before, and lessons from dollarization may not have been as broadly appreciated to bring confidence of avoiding calamity in the future.
 
Refer back to 2009, post dollarization; commercial assets like buildings in the CBD were appraised to match US dollar fair values. But, was the economy truly as productive to justify those valuations? Certain 20 floor buildings started having less than 50% occupancy within 5 years. So, the fair value of that commercial asset did not truly reflect the productivity gap that would create inadequate market demand for competitive rentals. An asset owner cannot say a 20 floor property is worth x amount, without truly including a measure of demand for its occupancy. Actually, by raising property, plant, and equipment appraisals, many investors overlook that real wages and consumer demand would have to be rising in proportion to that valuation boost, which in most cases does not occur.
 
If one studies the capital formation trends since dollarization, this error is embarrassingly glaring.  In 2009, currency conversion and fair value appraisal yielded an almost 10% boost in capital formation year on year. This would imply that 18% of economic growth was matched by investment in fixed assets. Not only was this physically untrue, as industrial and business parks did not spring across the country in a single year. This became evidently accounting book untrue, when companies bolstered by new balance sheets went to take on loans leveraged on this inflated asset class. It did not take 5 years for the fa├žade to show. By 2014 companies were begging for publicly guaranteed bail outs, and executives who had boasted of strong balance sheets started to bemoan "retooling" in unison. If indeed, just five years before, balance sheets showed fair value gains, why would an entity need to retool so quickly?

Fair value adjustments also require a sectorial perspective. Property, Plant, and Equipment (PPE) in mining may be more resilient than in consumables. A mining smelter plant is more dependent on global prices and demand for a commodity. An ice cream making factory, on the other hand, is more susceptible to a local market with falling real wages and aggregate demand. While the equipment and component of both factories may have a foreign denominated invoice cost, of say USD$5 million, a fair value appraisal at currency conversion should diverge based on the productivity capacity the sectors pose the two entities. Investors would be wise to listen out for this nuance at briefings and reading managerial notes in interim financial statements. But often, management postures ignorance, merely qualifying third party appraisers diligence to assets that ultimately deprive value from business purpose.
 
Beware of safe havens, particularly as they are misinterpreted to show economic vitality. Of course this error is not as simple to identify as perhaps portrayed here. After all, it is a global practice that frequently precedes recessions. The challenge is for policymakers to ensure that an economy consistently has productivity channels for funds to invest in. And for asset managers and financiers alike, to avoid a herd mentality to park funds, as it creates bubbles that pose loss of value soon enough.
- finx
Tags: Assets,

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