Although only 12 months ago, it seems like an age since we were queuing for toilet paper and steak.
With apparently (hopefully) the worst behind us from a medical crisis perspective, and with massive fiscal and monetary stimulus pump-priming economies globally, many see this current period as a new age for investment. Instead, we believe the next part of the investment cycle to be littered with threats to client portfolios, which if successfully navigated, could see quality opportunities for future wealth creation. These investment opportunities could have significant upside, but will require careful consideration and review. As such, we firmly believe that looking forward, dynamic and well considered investment implementation of client’s investment strategies will outperform simple “set and forget” portfolio management.
Expectation, Speculation and Wealth Creation
If queuing for toilet paper seems like an age ago, then stretching memory back to 2009 is an exercise in the dim dark past that for many may seem almost insurmountable. To that, many participants in the market today may well have been at school or only newly anointed in the workplace at that time. As a result, and with those participants having no benefit of immediate hindsight, many of the excesses at play today are mirrored by those which led to the Global Financial Crisis (GFC) - the worst share market and economic collapse since the 1930’s, albeit with new complications at play.
Back then, housing speculation and derivative products tied to the property sector resulted in rampant excesses across markets. Even sophisticated investors, who despite recognising these excesses, continued to participate in the market at their peril. One only has to note the (now infamous) interview with Citigroup CEO Charles Prince when he said:
“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
At the time, Citigroup’s share price was over $500. Shortly after, the music did stop and now, 14 years later, the shares are $72 – a paper loss of 85%. It is uncertain whether Charles was attempting to time the market, however he obviously understood the dangers at play. Regardless, his firm chose to continue to participate, with significant wealth destruction occurring.
During the GFC, Central Banks (particularly the Fed), faced with a deepening crisis and perhaps an unwinding of capitalism itself (via “too big to fail” institutions), stepped outside the usual remit of standard monetary policy (the adjustment of interest rates) and instigated a programme of Quantitative Easing (QE) – whereby debt is used to purchase bonds and hence, artificially influence the market rate for long-term bonds yields. This was an Economics 101 supply vs demand exercise, which had effectively never been tried before. The government stepped in, increased demand for debt which drove the price of the bonds up (and hence, the relative interest rate down). It was to be short-term and only used in this unique time of crisis. This strategy was observed at the time to be unconventional and untested, but worthwhile given what was at stake.
Now, however, QE has formed a cornerstone of regular Fed intervention every time the economy faces a downturn. But his “magic bullet” solution is not without costs. Each time the Fed steps in to buy bonds, it must do so using debt and hence, government indebtedness grows and grows in order to hold back the tide. The market has priced in a “don’t fight The Fed” mentality whereby every time there is a market hiccup, the Fed will jump in, buy bonds and in effect, capital guarantee the market.
This is unsustainable.
We fear that as a result of government interest rate manipulation, cheap credit and a Fed who appears to capital guarantee the market, this has led to profound market excesses which are primed to disappoint, particularly in regard to growth biased companies and bonds.
Where are the excesses?
In short, nearly everywhere. Rather than translate to wage growth and normal measures of inflation, QE and generationally lower interest rates have resulted in asset speculation across both property (despite the slowest Australian population growth since WW1), the growth portion of the sharemarket and in fixed interest (bonds).
Helped by low-cost trading technology, speculation has skyrocketed not only in the more traditional “speculative end” of the market (see below):
But also, the wider market as a whole:
Notable in the above image is that trading volumes are higher than they were during the height of the COVID-19 pandemic when investors were rushing to get “out the door”.
Meanwhile, options trades have seen a huge increase in demand, with 90% of positions predicting the market will rise further:
So, the market is energetic, trading vigorously and with expectations for further upside dominating.
A reminder is due here.
Investments typically roll over (aka “fall”) as a result of data which is materially disappointing. Simply, if a company was predicted to make a profit of $100m in a given year and made $90m instead, the share price (all things being even) would be anticipated to fall on the disappointing news. Similarly, a company that was predicted to lose $50m in a year and only lost $30m, might rise in value, despite losing money because this news is better than expected.
There is every chance that the market for growth stocks is in such a bubble as a result of the speculative excess, that even a slight disappointment in earnings or the future of credit costs could see that portion of the market fall. To reaffirm this excess, the infamous chart quoting GDP vs market value (named the Buffet index, after the Oracle of Omaha) can be seen below.
Drawing from the above image, we are now two standard deviations away from historical trend and the last time we were at these ratios was during the “dot-com” bubble of 1999/2000. Notwithstanding this, charts such as these are relatively useless at timing markets. Bubbles can build and build far beyond the wildest extremes of many market plaudits. One only has to recall Japan at the beginning of the 1990’s, whose price to earnings multiples reached an eye-watering 65x. Even renowned investor Jeremy Grantham acknowledges an individual’s inability (including his own) to time markets successfully in a recent article (a worthy read), when he says:
“…requiring that you get the timing right is overreach. If the hurdle for calling a bubble is set too high, so that you must call the top precisely, you will never try. And that condemns you to ride over the cliff every cycle, along with the great majority of investors and managers”.
What could be the trigger?
Even after a downturn, it can be difficult to pinpoint the singular event which causes a market to fall. At present there are a number of factors at play:
· Inflation and the role this may have in dampening investment returns if it moves higher than currently predicted.
· Economies stalling post COVID-19 if stimulus efforts are unsuccessful.
· Emergence of a new strain of COVID-19 which is resistant to current immunisation strategies.
· Chinese aggression leading to conflict.
· A multitude of “Black Swan” events not even on the radar yet.
Given our major concern is in relation to inflation (and hence interest rates and bonds), this is worthy of further investigation.
For the sake of brevity, this will be kept short. Our concern is that current predictions for future inflation are too low, especially given the level of fiscal and monetary stimulus being pumped into the global economy. If the central banks have this wrong and inflation runs higher than expected for a prolonged period, bond yields could rise and this may well have a disastrous impact on markets – particularly those businesses and investments who may find it difficult to increase pricing in line with inflation.
Noting State Street’s recent comparison of government inflation data vs inflation data sourced from internet sales websites, there is disconnect between government inflation data and online pricing:
Whilst it is true that this is likely to be due to a mix of increased demand in some sectors, rising input costs and supply chain issues, should this inflation be prolonged, the market is likely to reassess lofty valuations, particularly in relation to growth assets and hence temper expectations (and prices) for these types of investments into the future. Further, traditionally defensive assets such as bonds, may see yields rise and hence capital values fall. This could have a significant impact on portfolios which maintain high allocations to bonds in the belief that they are consistently defensive.
So, what next?
This isn’t the time to be throwing one’s hands in the air and remaining in cash. If inflation does rise, then the real return on cash savings could effectively be negative. Further, if inflation doesn’t increase and the market continues to ascend in value in an orderly manner, then the opportunity for wealth creation has been lost. Lastly, it is not the time for “set and forget” investment strategies either, because whilst we believe some traditional investments will underperform, others will outperform.
Whilst the BlueRock portfolios currently have a defensive bias, we hold little or no bonds in the portfolios. Whereas bonds are usually viewed as a measure to protect capital value, we believe that the limited return prospects from the interest payment, plus the potential for them to fall in value as interest rates rise, leads us to allocate traditionally defensive capital to other opportunities, particularly in the alternatives space. Here we are biasing capital toward investments which are neither tied to broad sharemarket returns, nor have excessive valuations on the basis of high growth forecasts. We are continuing to have specific, targeted equities exposure where we still believe there to be capital value upside, however we are being particularly concentrated in this regard.
We are investing further in Private Equity space. For those clients with the appetite, we are also spending more and more of our time reviewing quality opportunities to invest in Venture Capital as the Australian market matures. For those interested, please feel free to reach out, either via your adviser or directly to the investment team.
This article is intended as general information only and should not be considered as advice on any matter and should not be relied upon as such. The information in this article has been prepared without taking into account any individual objectives, financial situation or needs. You should therefore consider the appropriateness of the information in regards to these factors before acting, or seek advice before making any financial decisions.