With interest rates at low levels and central banks intent on pumping money into the system, it is hard to see (absent a surge in inflation and bond yields) what it is that could derail capital markets. Given the extremely low level of interest rates, and even providing for an equity risk premium on top of that, it is not hard to justify higher equity market valuations ahead. Herein however lies the rub, as the higher equity market valuations go, the higher the levels of investor fear and anxiety. Historically, we all know that high equity market valuations do not have happy endings. Offsetting this, investors also know it is not wise to fight the tape. There is also no point in fighting central banks intent on propping up markets. Interest rates and liquidity always move markets.
Nevertheless, we remain of the view that risk management will be paramount to survival as nobody knows how this ends as we approach the end of the runway. One can only remain as liquid and as flexible as possible and be prepared to change tactics as the data changes. Those that ignore history are condemned to repeat its mistakes. New mistakes will still be made, but hopefully the negative impact can be mitigated, if not eliminated.
It is incredible that we are today in an era with full or near full employment, low inflation, and huge budget deficits that are likely to continue to rise, yet interest payments on long term bonds are 3% or less. Given that low interest rates are the primary driver of markets, the question is whether low rates are sustainable. If so, then earnings multiples could be much higher and equity markets are still cheap, given they are currently discounting only around 3% growth. If interest rates remain low, this level of growth is likely to be exceeded.
Generally speaking, if history is any guide, low unemployment and increasing government deficits would normally be a harbinger of higher rates due either to higher inflation, caused by the former, or higher risk (of default) created by the latter. In the past, rates were lowered because of a recession and high unemployment in order to encourage new investment in the economy to create growth. Keeping interest rates low during a positive economic cycle has added too much debt to the system and made capital investments of dubious profitability investable. So much money is now required for debt service and principal repayment that it has left little funding available for growth. Low growth is primarily a function of these excessive debt levels. As a result, the credit cycle has become more important than ever. The level of interest rates will still have a huge impact on the economic cycle, but the impact on debt levels, being as high as they are, will be of much bigger consequence for investments during the next correction.
Even the US, the best economy in the world, has produced lower than average growth for the last few years as a result of all this debt. It is far from being the “best growth ever” that President Trump likes to brag about, and without the free money (quantitative easing or QE) they keep pumping into the system, there would not be any growth in the economy at all. Charts also show that the upward move in the markets can be directly traced to the day the Federal Reserve started pumping liquidity back into the system. This begs the question of what happens when they take their foot off the gas pedal. The last time they did so was in the last quarter of 2018 and it did not end well.
Low rates today are necessary not just to keep zombie companies alive but also because the larger debtor has become the government itself. When the government has too much debt relative to their tax revenue they have to either raise taxes (not favored politically), default (not good to attract future investment in your country) or print more money (which devalues your currency). All of these outcomes penalize the savers in society.
We know desperate governments do desperate things. That is where we are today as developed economies continue to evolve into printing more money when they run short, if they can. Monetization (printing more money to cover the deficit and debt) has been tried before and it does work for a time, until it does not. In the end if you print too much you end up like Venezuela. Monetization implies devaluation. Cash may be king versus other asset classes for a period of time, but it will be worth less than when it all started. Gold is talked about as the best hedge in this scenario, but historically its price has been manipulated by the government (or confiscated entirely), so its defensive attributes may be limited. Credit markets will of course be the most toxic, as when yields eventually spike higher, as a result of too much printed money, the value of bonds collapses. Given that most of the money has gone into bonds over the last ten years, this asset class in particular should be of concern to all.
Some monetization could well be the necessary evil to prevent, or at least postpone, a major asset collapse if we are to avoid a debt deflation spiral, the outcome of which would be truly ruinous. Already today, high priced larger homes are struggling to maintain their price as millennials are either not interested in taking on mortgages of the size their parents took on, or simply cannot afford to do so. Wages have been flat for over a decade and sadly, even with low unemployment, many cannot make ends meet, or more importantly, save for retirement. This is all before Artificial Intelligence is able to step in and eliminate even larger segments of the workforce. Add in more restrictive immigration policies, low birth rates and an ageing population and growth in the future could be a challenge. It is important to remember that people over 70 spend considerably less as they are forced to live off their (often meager) savings, which is inherently deflationary. If all of this prevails, then governments may well have a longer runway to keep printing their way out of the mess they created.
Capital markets are for the most part driven by corporate profitability, which over the past year has been boosted by one offs such as corporate tax cuts or share buybacks. 2019 started with market multiples of under 15 times earnings and today they are over 20 times. Market increases have therefore been driven primarily by multiple expansion as a result of lower rates and central bank liquidity, rather than by significant increases in earnings. Slowing global growth in 2018 was offset by the resumption of government intervention (through lower rates and bond purchases) in most of the developed economies. With interest rates being as low as they are, higher multiples are easy to justify.
But it all falls apart rather quickly if there is any chance that low rates cannot be sustained. Endless liquidity is only beneficial to growth if it is invested in a way that increases productivity and future growth such as on improved infrastructure. It has no benefit when it is used to shore up companies that should be allowed to go bankrupt (known as zombies) or used for consumption of goods and services. Governments’ printing money to keep interest rates low to prevent asset deflation and to cover irrational spending that does not produce growth will ultimately result in a currency devaluation.
In the near term, improved sentiment, supportive central banks and rising expectations for even more quantitative easing will keep equity markets supported. An election year in the US, where the incumbent needs a strong economy and stock markets to be re-elected, pretty much assures that the current administration will do everything in its power to keep the music going until November, benefiting both the US and global economies. A willingness to cut trade deals alone, will take a lot of uncertainty out of the minds of investors and improve investor confidence.
It is exciting to ride the wave of this liquidity but we would argue you also need to remain very vigilant because at some point liquidity may need to be withdrawn to save us from the threat of inflation . We saw that trying to normalize interest rates, as the Federal Reserve attempted to do in the fall of 2018, did not work very well. The key question therefore remains, how will this happen, without causing any pain? The answer is probably that it cannot.
There are many things that can affect how it all ends and most of them have been seen somewhere at some point in the past, and none of them have ended well. This includes:
Very low interest rates, with low unemployment increasing debt to unsustainable levels.
The leader of the free world going from a champion of free trade and globalization to being the most protectionist of all the advanced economies resulting in higher prices for all.
Political support for the rule of law eroding.
Geopolitical unrest and potential for another senseless war.
A potential pandemic that disrupts supply chains and growth.
Extreme corruption of politicians at the top and widespread acceptance of the population towards this political corruption.
Brainwashing of the population through endless fake news propaganda (today this is made much worse by its quick dissemination though social media).
The rise of populism where all negative things are blamed on the wealthy, making anybody who has any savings the scape goat for all problems.
Ignoring the truth and facts and creating an alternative reality of lies to justify your position to suit your own agenda at the expense of democracy and the prosperity of all.
History should be understood and never be ignored. The bottom line is the goal for 2020 maybe should not be about making more money, but rather about keeping the money that you have made during this last investment cycle. When the system is this fragile it does not take a lot to tip it over: a global pandemic, a large default, the wrong tweet by an uninformed leader, or an election outcome that results in even lower global growth are some of the many things that could derail capital markets overnight.
Is your investment portfolio positioned accordingly? It is more important than ever to focus on how to mitigate risk in your portfolio and be appropriately diversified so that you can maximize your return in the best of times, while protecting your downside over difficult time periods. It is more than ever, about quality and adjusting portfolios for risk.