Just like you, our investment strategy and process remain unswayed by views of where the market is going. We have our investment process, just as you have yours, and it remains unaffected by the vicissitudes of market sentiment.
No doubt, your own asset allocation decisions will be unmoved by the words of a single commentator, but it does help to be informed.
So to help you in conversations with your clients – if they ask – I thought you might be interested in our interpretation of current investing conditions.
Fundamentally, we believe there are several aspects to current conditions you should be aware of.
The first is that the global economy looks like it is improving. Of course, to some extent the belief in continued global growth is dependent on China continuing the trajectory it began in early 2016.
That said, interest rates are low and inflation is showing little risk of breaking out, despite emerging economic and employment growth, or the re-emergence of animal and entrepreneurial spirits. The world’s central bankers – from the European Central Bank’s Mario Draghi the US Fed’s Janet Yellen to the Bank of Canada’s Stephen Poloz and the Bank of England’s Mark Carney – all are suggesting ultra-low interest rates or accommodative monetary policy has done its job.
If interest rates start to slowly rise, and growth begins to accelerate but inflation remains in check (and keep in mind US inflation remains below the Fed’s 2 per cent target, even though unemployment has halved since the post-GFC highs), these are goldilocks conditions that favour growth assets such as shares. They could go higher. In fact, its not inconceivable that a euphoric bull market emerges. This is the ‘reflation trade’ you have probably heard many others describe.
If inflation does emerge, without getting out of hand, it is one way that the world’s mountain of private, corporate and public debt can be eroded; remember, debt is denominated in old dollars, dollars that are worth less in the future thanks to inflation.
This scenario is currently the preferred option and that preference is reflected in the very low levels of volatility evident in the stock market and bond market.
It is also perhaps fuelling excessive risk taking, which we will come to in a moment.
Debt concerns
The next consideration when thinking about present conditions is the debt itself. There is undeniably a great deal of it. Too much debt, along with the emergence of any impairment to the ability to pay it results in a period of ‘deleveraging’ that crimps growth and can cause defaults and recessions.
Although US household debt has declined since the global financial crisis, corporate debt has risen to levels similar to the leveraged buyout boom of the late 1980s. The Bank of International Settlements is concerned by the rise of “covenant-lite” junk bonds, which now account for 75 per cent of all leveraged bond issues. Moody’s says covenant quality is at its lowest level since it started measuring this in 2011. We have previously reported to our investors the credit market record level of triple-C rated junk bonds due to be refinanced in 2019.
Again, let me repeat, the debt may not be an issue if inflation-free growth emerges and interest rates are gently normalised.
If there is, however, any interruption to the growth story (for example, China slows), or inflation accelerates and rates are forced higher more quickly, then the debt picture could very quickly create a vicious spiral, pressuring corporate margins, triggering layoffs and defaults…credit spreads would widen and a global economy emerging from the GFC falls right back into something akin to it again.
First to leave the party
The final aspect of present conditions that you should be aware of is valuations.
Now, we are value investors so think of us this way: If there’s a party going on, we are the wallflowers standing very close to the exit. If nobody comes up to talk to us, because they’re partying too hard, we’ll happily leave early and go to bed. You will usually find value investors calling valuations excessive early. You won’t find us trying to run for the exits at the same time as everyone else once the band has stopped playing, because we’ve already left.
Of course, when it comes to portfolio management, it is folly to be all in or all out. It is much better to manage by degrees. Those degrees can be determined by any number of factors but we reckon one of the best is the difference between price and value. The higher the price is above value, the less enamoured you should be about overstaying the party.
It is safe to say we think prices generally are stretched.
This is perhaps best illustrated not by the record prices being paid for art, or wine, or NZ stamps or NSW low-digit number plates, or collectible Australian historic cars, which we have alerted investors to previously. Instead, it could be that a recent Argentinian bond issue best typifies the excess in asset prices today.
Anyone with any knowledge of history will know that Argentina is an economy that can be characterised a number of ways. But none of those ways can include the word ‘stable’ in the description! In the last 90 years, Argentina has endured three periods of hyper inflation, with the worst, of 5000 per cent, occurring most recently, in 1989. The country has experienced more military coups followed by civilian uprisings than are worth counting, foreign investment flows, in and out, that resemble tsunamis and, as recently as 2001, the country declared what was then the largest-ever sovereign default. Only last year did Argentina finally emerge from that default.
And little more than 12 months after that, it has issued a 100-year bond. What is special about this issue is the fervour with which investors have piled in. According to Reuters, Argentina offered $2.75 billion at the final yield but it received $9.75 billion in orders. The final yield, by the way, was just 7.9 per cent or just 5 percentage points more than what investors are willing to lend at for the US Government.
The question is, do you think there could be, or will be, inflation, a credit event or rising interest rates in Argentina in the next 100 years? There have been plenty in the last 90. If the answer is yes – which it is – then bond investors holding to maturity are going to have to endure some serious pain. And investors not holding to maturity may find a few other revellers trying to leave the party at the same time.
When the fear of missing out replaces the fear of losses, you know its time to be cautious, irrespective of whether you believe the economy is growing or going.
Vaporising value
Finally, another way to think about asset pricing at the moment is to look at the stock market broadly. Investors there appear to be playing a relative game. The market, generally, is expensive and investors are justifying it on the grounds that interest rates are low. If you consider US Treasuries are trading at 2.15 per cent, they are effectively trading at 46.5 times earnings with no growth. If you can find a stock with earnings growth on a P/E of less than 46.5 times, it is reasonably priced. But this is a relative assessment only. As soon as rates rise, the apparent ‘value’ vaporises.
This was the concern the Bank of International Settlements recently articulated in its quarterly report. It noted US sharemarket valuations make sense only when the low returns on bonds are taken into account, stating: “Valuations seem to be aligned with historical benchmarks only after account is taken of the level of bond yields.”
The BIS added that the US market is being propelled higher by record levels of margin debt – at $US250 billion, substantially more than during the peak of the dotcom boom – and that equity markets continue to be vulnerable to the risk of a snap-back in bond markets, should term premia return to more normal levels.
Keep in mind that, in some cases, there are assets offering implied future returns little more than those available on cash. Where that is the case, cash offers a better risk-adjusted return and investors should prefer it.
As always, what happens next in the economy depends on whether growth, without inflation, continues and central banks are permitted to normalise rates gently.
Any other scenario puts asset prices at risk, and as we’ve pointed out, they are already stretched.