Leverage Plain and Simple – The Path to Riches or Ruin
When you stretch the time horizon long enough, you find things are less about winning or losing and more about playing or quitting. And leverage.
Boiling this down to what this means in the world of business and investment, it means that the trick is to stay in the market. If you can do this through lean times, then good things happen when good times return.
Being forced out of the market is bad because it happens at the worst possible time when valuations are low, or business gets tough. If you can choose the timing of when you leave the market, you are well on the way to success.
What causes being forced out of the market is your leverage. If there is one thing that you have to keep your eye on above all else is the level of leverage you employ in your business or investments.
Leverage is the critical factor because with no leverage, it is difficult to succeed. Too much leverage increases the risk of losing control.
Stay In The Market
The example of leverage that comes to my mind is the close call that Rupert Murdoch had in 1990 when he came close to losing his empire. He had expanded heavily in the 80s with the help of bank loans.
When he faced a credit crunch because of a recession, the banks brought close to the brink of ruin.
High leverage nearly put an end to his ambitions as cash-flow and asset valuations dropped. It was also high leverage that catapulted him into the next stratospheric stage of wealth accumulation when he could hold out.
Leverage can be a high stakes game and although it is not for the fainthearted, it is unavoidable. To understand this, try buying a house without leverage. It is impossible for most people without access to leverage.
It is the same with personal investing. In that case, it is also bankers who will ask for money back if loan to valuation ratios are breached or if repayments are not met, forcing liquidations at fire-sale prices. This sort of forced liquidation is something that is very difficult to recover from.
Have You Kept Enough In Reserve
There is little that can be done to prepare for periods of economic turmoil when you are already in them. Preparations must be made prior.
This is all about having reserves. Never fully committing all resources at the cost of holding onto a minimum level of reserves for safety.
Because of the inflationary environment that has taken hold in Australia, the Reserve Bank has implemented a series of interest rate rises to take excess demand out of the Australian economy.
Monetary policy of the type being used is famous for the long and variable lags involved in its implementation.
With Australia enjoying a low unemployment rate and benefiting from a high terms of trade resulting from the demand from our primary mineral and agricultural output, the implementation of monetary policy has been running into the momentum of an economy that refuses to relinquish its propensity to bid prices up.
This momentum is helped along by the pipeline of infrastructure projects in various states and the high levels of net overseas migration.
The household sector has been doing its bit to consolidate in preparation for a rainy day. During Covid the household savings ratio rose as many households used the support provided by the government to build reserves.
This may be a large reason why despite the aggressive interest rate hikes of the last year and a half, there has been such a high degree of resilience in the household sector. It has been a failure of government policy over decades that forced the household sector to take on the high levels of debt required to get on the homeowners ladder.
We may soon be entering the season where all the planning for difficult times will be tested along with the adequacy of the level of reserves.
A Tipping Point May Be Near
It is likely to be after the Christmas holidays and lazy days of January when the momentum of economic activity will slow. February is a time of reckoning for many households who face the music of overspending during the festive season and must prepare for the return to school of children.
According to the Australian, the signs are already building business insolvencies and loan failures looming.
Business confidence has started to slide and although this slowdown eventually shows up in lower inflation, it does so with a lag. During the first half of 2024 households and businesses are going to have to endure negative growth in real incomes, high interest rates and increasing levels of unemployment.
The Federal government on the other hand will have an embarrassment of riches according to the MYEFO. Income tax and corporate tax receipts are rising. This is especially strong with respect to income tax receipts with bracket creep accelerated through high inflation.
Our society will also be tested with the third tranche of income tax cuts coming into effect on July 1. This will directly benefit high income earners while inflation, higher interest rates and falling real wages falls disproportionately on the lower and middle income brackets.
The government will be sorely tested to help those in need but the hard heads, if there are any, will counsel against it as it is likely to feed into inflation.
