As fads and phases in markets and economies come and go, the smouldering wreckage of once hyped ‘must have’ investments often lie in a worthless crumpled heap next to people muttering.
‘But I really thought this time was different’
It rarely is!
So, it pays to be highly sceptical when phrases like ‘new paradigm’ are being bandied around, it usually isn’t.
But that said, things can occasionally fundamentally shift as the internet has demonstrated and the ramifications can then be profound and widespread.
The opposite of the above scepticism and caution is then required, as sticking to yesterday’s game plan can mean holding onto assets which don’t fit the new world.
This is demonstrated currently by the bankruptcy of the ‘old world’ package holiday operator Thomas Cook. It can be applied to the likes of Heinz who make tinned food, Tesco which has a huge bricks and mortar expense to bear (in a cut throat, over supplied sector) or Ford who make their profits from gas guzzling pickup trucks in an electric vehicle future.
INTEREST RATES – A new Paradigm?
We have written often over the last 5 years about the historically low levels of interest rates and the likelihood logically that they would return to higher levels.
In the last quarter of 2018, the US Federal Reserve (equivalent to the Bank of England) started raising US interest rates and reducing the size of their balance sheet, by not replacing Treasury Bonds as the holdings they’d accumulated under QE matured. This was known as QT (Quantitative Tightening) which was the long-term game plan of returning to a previous status quo as financial conditions post crisis allowed. The likes of Goldman Sachs and Merrill Lynch, at the beginning of 2019, predicted 3-4 rate rises for the year in the US.
SO, WHAT HAPPENED?
In actuality there have been 2 rate cuts already in 2019, with possibly another before year end. The QT has been halted and at the last Federal Reserve meeting Chair Powell indicated a light version of QE could be reinstated. So, a total reverse of direction by the Fed.
The ‘why’ in relation to the Fed’s wishes in late 2018 to raise rates and reduce the balance sheet is twofold. The first reason is simply that it was always their eventual plan when rates were slashed and QE initiated and as the saying goes, never waste a plan.
The second reason is that Central Banks have always acted as a counterbalance to their economies by tightening (raising) rates in good times and reducing them in bad.
The West is 10 years past the Financial crisis and rates are still at very low levels. Economies are growing so they understandably wished to edge them up to then have the ability to bring them back down in tougher times.
WHY DID THEY SHIFT BACK SO QUICKLY?
The first reason and a big one was that markets went nuts and plunged 20% in late 2018 as they were told rates would be rising.
But probably more importantly long term, the Fed realised that the US economic strength and growth was far stronger than the rest of the world’s major economies and to put rates up would hugely strengthen the dollar, but reduce corporate profitability. Now that could be justified possibly if inflation was increasing but it isn’t, or if there was outsized corporate borrowing and over exuberance but again, there isn’t. So, the wish to tighten in an economic upswing to ward off excess wasn’t necessary, which left the advantage being to have room to cut in a downturn. The downturn however was likely going to be induced by them raising rates in the first place, so it was going to be a circular journey to nowhere.
INTEREST RATES GLOBALLY
The ECB has cut rates this year and reintroduced a form of QE to stimulate member economies.
The Bank of England has kept rates on hold, but one suspects to retain the dry powder to cut them hard if Brexit creates economic problems.
China has cut rates to help offset tariff-induced weakness.
At the beginning of 2019, the US 10-year Treasury rate was around 3%, at its low in August ‘19 it was at 1.6%; it nearly halved in 9 months.
German Bunds (like our Gilts) are negative yielding, not negative in the sense that they pay less than inflation, but 0.6% negative meaning buyers are guaranteed less back than they pay.
It has been estimated that globally up to £16 trillion of debt is paying a return less than inflation, meaning the value of the asset including interest is losing value in real terms.
In August the S&P 500 index had an average dividend yield higher than the 10-year Treasury, which is highly unusual. This means investors get a better effective interest rate from holding stocks than from bonds.
SO, WHAT DOES ALL THIS MEAN?
The Japanese experience of negative yields on their sovereign bonds since the early 1990’s is highly instructive. After their domestic crash in asset prices in the late 1980’s, they have continued to struggle with deflation.
One of the key drivers for Fed Chairman Bernanke, who was a Japanese economic scholar, post financial crash was to flood the economy with QE liquidity to prevent a Japanese style deflationary spiral. Deflation, when asset prices fall year over year, is an economy killer-encouraging consumers to defer expenditure as it will be cheaper in the future; the opposite effect to inflation. Japan got stuck in a deflation spiral with no inflation and negative rates.
By comparison the West currently has inflation of around 1.75% on average, economic growth of around 2%, full employment, a robust consumer and stable housing values so actually it’s all pretty decent. The fear is that conditions worsen which is why markets are hyper vigilant for signs of recession, but apart from areas such as German manufacturing which is having a horrid time it’s mostly looking ok.
SO, WHAT DOES MEAN GOING FORWARD
- If super low interest rates are going to be the norm for the foreseeable future and it looks like they are, then there are asset classes that may well rerate up in value.
- Holding bonds ongoing, especially those yielding negatively, means receiving a miserly return with little upside potential. A ton of pain awaits if rates rise.
- Recessions don’t materialise for no reason. They are caused by excess borrowing and excess spending. Economic expansions don’t die of old age, they are killed by excess and exuberance. There is no real indication of that now outside of bond markets, where prices are bubbly because as an example there are huge pension funds and insurance companies that must own a specified level of bonds so have no choice but to keep buying. If you talk to them privately few are happy about doing so.
- So, investors are going to have to look for returns away from cash and bonds, because neither will give yields which protect against inflation dilution let alone provide one above.
- We suspect that this will mean investments such as strong dividend paying equities, Commercial property and infrastructure funds with recurring fee income paying dividends will attract money and so increase in price.
In conclusion, to create positive returns from a diversified portfolio going forward requires some new thinking and allocation structures, because quite possibly:
‘It is different this time’.
Note: This is written in a personal capacity and reflects the view of the author. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.