Nonsense and Sensibility – A Reality CheckBy Jeff Buetow | Jul 19, 2016
As global sovereign term bond yields move to less than zero, equities simultaneously approach new highs. The decoupling of the two asset classes is clear evidence that real economic activity (growth, capital investment, corporate earnings…), is absent over the course of this purely financial exercise. How does economic theory explain current equity valuations when fixed income markets are signaling low economic growth for the foreseeable future? Equity managers would have us believe that low interest rates imply higher valuations, ceteris paribus. But without a growth component the asymptotically low rates argument seems to fall on its face. At the zero bound on rates, valuation increases can only be explained by increasing growth assumptions. This is where the two asset classes are diverging at an accelerated rate. Moreover, bond markets have always been far superior at forecasting economic growth than equity markets. Who will be correct? Time will tell, but in the meantime portfolio managers best be ever diligent in managing risk. This is where experience will be at a tremendous premium.
Any reasonable minded capital markets participant would expect the assumed virtuous economic cycle to value these asset classes quite differently. It seems that Main Street is being almost completely left out of what is ostensibly an ongoing period of financial engineering. While many domestic companies struggle to find growth opportunities global corporations are operating like spread dealers. Domestic only CFO’s aren’t expanding balance sheets despite cheap financing because they have no profitable capital intensive use for the funds. However, CFOs of large global corporations can borrow in Japan or Europe and buy/lend in the United States, Australia or New Zealand and simultaneously hedge away the currency risk. Under the right circumstance it may even be considered an arbitrage. Minimally, they are running spread products – paying nothing on the borrowing and receiving something on the lending. They sit in the middle and turn a profit (boost top line revenue), alter dividend policy in fundamentally unsupportable ways and finance share buybacks. Nevertheless, as corporate management and investors continue to swim upstream against a virtual tidal wave of dovish central bank policies, which to date show little if any success in achieving greater economic growth, it is only logical that they, for the time being, follow their blockers.
It defies all theoretical explanation as presented in traditional presentations on financial economics. Perhaps we are in a new valuation structure where historical reference is meaningless. Valuations across the board seem indefensible given the lack of fundamental economic support. Is this a new paradigm? Rather than wait and try to tactically adjust for the expected reversion we will need to manage assets within this setting. All of our experience suggests that it is unsustainable but it might just be that we have to be smarter and manage risk smarter than ever before. What is confounding is that equities are simply a beneficiary of excessive monetary policy with almost no structural benefit to the economy. It is a perversion with no ending in sight. The corporate sector has become one large banking system playing global rates against each other to engineer financial statements and synthetically increase dividends to be able to be more attractive relative to fixed income rates. This dynamic has been going on for years. Fundamental economic logic in the capital markets is completely absent in this new world and only serves to exacerbate risk components in an already difficult geo-political and confusing investment environment. The capital markets are operating as if the economy doesn’t matter anymore while policy makers are encouraging and cheering from the sideline. The effective leverage is going to make risk assessment critically important going forward.
Conformity demands we can’t run and hide until all of this stuff figures itself out. We need to deliver what we can within the existing framework, with a constant eye on market dynamics. No one can manage to any random binary event – that is luck, despite what marketers try to convince us of. However, we can and must manage portfolios smarter than our competitors. That’s where more than 150 years of investment experience adds considerable value over the investment cycle – and it will cycle eventually. Financial economic forces will eventually dominate once again – it is an unavoidable fact. Monetary authorities throughout the world are implementing policies with no forethought or accountability. Like politicians they give literally no consideration to the collateral damage they are creating with their collective hubris. A negative interest rate environment is perversely contradictory to a properly functioning economy. The effects on economic behavior are astoundingly irrational. In the absence of transactional efficiency why would any rational decision maker pay someone to take their cash? Why not just store it somewhere? The convenience yield can’t be terribly high. When will investors figure this out? Asset/Liability managers and pensioners are being forced to make unsustainable decisions to retain solvency. Has a single policy maker uttered anything intelligent regarding this reality? We don’t raise these issues to frighten only to highlight how important deliberate and experienced portfolio management will be for the foreseeable future.
“Meanwhile, I was still thinkin…” The problem for the professional money manager and the individual investor alike lies in how to most effectively navigate the status quo while fully appreciating that traditional economic and market relationships will in time assert themselves. For the time being, we are forced to exist in an artificial construct driven by historically low and in many cases negative interest rates, which seem only to distort these relationships. Historically meager interest rates and flattening yield curves are fueling a massive yield grab, compressing credit spreads and diminishing appropriate risk premiums in the bond markets. Given the trends of increasing issuance and balance sheet leveraging by corporations and sovereigns, projections for higher default rates, ratings downgrades outpacing upgrades, on the surface this makes no sense. Traditionally, these are signals of deflationary periods, low growth and earnings, typically resulting in widening credit spreads and lower equity valuations. Additionally, the comparative attractiveness of the U.S. economy and domestic rates together with the ongoing flight to safety trade continue to make our markets the overwhelming choice for foreign investors. As long as the prevailing sentiment for QE persists, sheer demand will remain the fat kid on the see-saw outweighing the growing list of “monsters under the bed”. For the moment investors seem to be echoing Richard Gere in the classic “An Officer and a Gentleman” when he pleads, “I got no place else to go!”
So, how does the investor tackle this conundrum? With interest rates at all-time lows and the stock market hitting all-time highs, conflicting data, and global discontent stoking the flames of volatility, managing investments has clearly become a more challenging task. Nevertheless, it is incumbent upon asset managers to leverage research and experience to assess relative value and recognize windows of trading opportunity within a given global-economic environment while at the same time offering investment solutions providing some reasonable balance of risk and reward. Eventually, the ship will begin to right itself and economic realities will assert their influence. Until then, the ice on the pond gets progressively thinner.