Quarterly Publication - October 2017
A Decade of Distortion - October 2017
As we approach the 10th anniversary of the global financial crisis, there is again much to worry about. In one word, complacency is the biggest investment risk at present. Over the past ten years, new risks have appeared – more specifically in the areas of volatility and liquidity. Quantitative easing has created the delusion of permanent liquidity, as well as encouraged the mispricing of risk. Pretty much every asset class is currently making new highs, supported by a range of positive factors. The strongest of these supports is the steadily improving rate of global growth (albeit to levels well below those prevailing in the last decade before the crash), coupled with inflation remaining subdued. Investors have concluded that the combination of these factors will be positive for corporate earnings. Additionally, this is within an environment in which monetary policy remains very accommodative. Although central banks wish to ‘normalise’ monetary policy, the fear of a policy error is holding them back from implementing the process any faster than ‘extremely gradually’. Essentially, investment markets are currently in a positive virtuous circle.
As mentioned, global inflation remains low, despite improving growth. In the US, the country at the top end of developed market inflation, the core inflation index is increasing at an annual rate of only 1.4%. This is well below the Federal Reserve’s (Fed) inflation target of 2%. In Europe, the core inflation rate is currently 1.2% – again well below the 2% target set by the European Central Bank (ECB). In Japan, inflation is running at a mere 0.5%. Even in emerging markets, inflation presents no meaningful pressure, with the Bloomberg inflation index for emerging markets currently at 3.4%. The net result is that, despite the intention to normalise monetary policies, central banks continue to expand their balance sheets to support growth in the developed nations. Research suggests that, over the past 12 months, the sum of the ECB, Fed and Bank of Japan balance sheets has grown by 11.4%.
The combination of improving global growth, moderate inflation and supportive central bank policy has therefore provided a positive backdrop for global equity markets this year. And barring a shocking turn of events in North Korea, that same positive combination seems likely to continue to support equity markets in coming months.
Given the prevailing investor complacency, equity valuations need to be monitored carefully. It can be argued that global equity markets trade at reasonable valuations, with price earnings ratios for the MSCI World, MSCI Europe, Australasia and Far East, and MSCI Emerging Markets indices trading at 16.4, 14.5 and 12.6 times forward earnings respectively. Put another way, earnings yields of 6.1%, 6.9% and 7.9% on these equity markets respectively still seem quite competitive relative to prevailing government bond yields. To give this context, for example, the real yield on 10-year inflation-indexed US Treasuries is trading at only 0.3%. Real yields in Europe and Japan actually remain negative.
THE GREAT UNWINDING
This relatively benign interest rate environment for developed market nations should give emerging market central banks latitude to ease monetary policy on a discretionary basis in response to country-specific inflation trends. To illustrate this, in August we saw rate cuts in India, Indonesia and Colombia, while rate cuts are expected soon for Brazil, Hungary and Russia. The weakness of the US dollar this year has also given emerging market central banks more latitude to opt for easier monetary policy where appropriate.
There are of course several sources of economic uncertainty beyond the North Korean issue. The disruptive force of Hurricane Harvey is likely to add volatility to US economic data in coming months – at a time when the country has to grapple with the ongoing potential for a government shutdown. There is also concern that China’s negative credit impulse could slow growth in coming months. Still, recent Chinese data have been notably resilient, with the official Purchasing Managers’ Index strengthening to a solid 51.7 in August, which is the second-highest reading for the year.
On the current state of complacency, it should be recalled that a decade ago, subprime problems were thought to be contained, global stock markets were scaling record highs, negative interest rates were unimaginable and barely anyone had put the words ‘quantitative’ and ‘easing’ together. However, this state of Nirvana met its demise soon after, and quantitative easing has been a feature of the economic and investing landscape ever since. Therefore, despite the current sanguine approach from investors, the Fed’s announcement that it will begin rolling back quantitative easing should be seen as a defining moment in the post-crisis era. That said, many investors remain dismissive about its implications.
ARTIFICIALLY LOW COST OF CAPITAL
A further point that investors should not overlook is the fact that borrowing costs for companies are at record lows. It must, however, be pointed out that the overall borrowing cost for companies is depressed largely because of historically low government bond yields. Credit spreads – the difference in yield between a treasury bond and a company bond – are still some way from their tightest levels of prior cycles. For instance, credit spreads for US investment-grade companies are currently around 135 basis points (bps). They were actually well below this level in 2007 and in 1997. Meanwhile, European investment-grade spreads now trade at about double their 2007 level of near 60 bps. The conclusion of this is to remind investors that the corporate sector is not necessarily mispricing risk; it is the whole interest rate curve that is distorted by ongoing central bank interference.
In addition to the distortions caused by the prevailing (artificially low) cost of capital, there is a broader societal theme that worries us. Ageing populations, global sourcing of goods and services, and technical innovations are widening gaps in income, job opportunities, living standards and ideology. Secular headwinds continue to disrupt the lifestyles of many people around the world. The symptom of this is the loss of middle-class jobs, wages and benefits, and therefore prospects for a more secure and prosperous future. It is this erosion of the middle class that has triggered a backlash against the status quo – be that against global trade, capitalism, the financial sector or political leaders.
HIGHER TAXES, FEWER SERVICES
Unfortunately, the dearth of well-paying jobs, resulting wage stagnation and the loss of faith in the future will intensify over the next decade as technology increasingly eliminates or automates tasks – including in the labour-intensive service sector. The real worry is that while job anxiety, frustration and loss of confidence are likely to increase populist pressures to protect jobs, incomes and living standards, governments will have limited ability to respond. This is due to the fact that a growing share of public sector revenue will be absorbed by the pension and healthcare needs of ageing populations and an inevitable rise in debt service costs.
Of course, this gradual unwinding of the social order has been partially masked over the past decade by distortions set in motion by well-intended central bank monetary manipulation. Implemented as an emergency measure to prevent the deep 2008 to 2009 recession from spiralling into a self-feeding deflationary contraction, central bank bond buying has caused, in addition to investor complacency, public sector complacency that fed excessive spending and overregulation. Inevitably, over the next decade, a widening gap between public sector income and spending will lead to higher taxes – for fewer services.
If the distortion of borrowing costs had been short-lived, for say, two to three years, the impact of ‘normalising’ interest rates (and central bank balance sheets) would have been limited in scope and duration. Instead, the protracted suppression of interest rates has had an excessive impact on public spending, borrowing and debt service costs.
Since the Fed became a major buyer of new debt issued by the US Treasury, spending has been unconstrained over the past 10 years and US federal debt has doubled, from $10 trillion to $20 trillion. Fed intervention not only reduced the cost of new deficit spending, it also significantly lowered the cost of rolling over maturing debt. Hence, while the total debt doubled over the past decade, the annual cost of servicing the US federal debt has stayed nearly flat.
AN UNSUSTAINABLE ‘NEW NORMAL’
In our opinion, this situation is ultimately unsustainable. As the Fed (soon to be followed slowly by the Bank of England and the ECB) steadily reduces bond buying, a slow but steady normalisation of interest rates will begin. In 2007, the US paid an average of 5% on its $9 trillion federal debt. This year, the US is paying only 2.28% on its $20 trillion debt. A doubling of the debt is masked by cutting the interest rate in half. As interest rates slowly normalise over the next five to seven years, so too will the cost of servicing a further relentless rise in the total US federal debt. If, for example, the average interest rate paid on debt rises to 2.4% next year, 3% in 2020, and 4% by 2024, the annual cost of servicing the US debt will double. Simply put, during the next presidential term (from 2021 to 2024) the president and Congress must spend an additional $80 billion to $100 billion each year – not on schools, healthcare, defence or Social Security, but to pay the rising cost of servicing the federal debt. The majority of Americans do not yet seem to appreciate the gravity of the debt service problem set to explode in the next decade.
There are of course those commentators who believe that we are today in a ‘new normal’ – and that there is an implicit guarantee that interest rates will remain extremely low for many years to come. In our opinion, it will be unwise to indefinitely suspend sound economic thinking. Investment trends do always revert to normal with time. The current level of developed market interest rates is abnormal – and will not endure in perpetuity.
As long-term investors we just do not know how the current set of uncertainties will play out. Investors must therefore give thought to how to navigate the challenges that lie ahead. Not least of these challenges is the fact that most (known) asset classes are highly priced due to excess liquidity and investor complacency. Setting risk tolerance guidelines is one of the steps when it comes to exposure to risk investments. Within risk investments, finding underpriced investments is rare. The focus is therefore more than ever on identifying stocks that can produce real earnings growth on a sustainable basis