Why barking up the equities tree could end with a nasty bite
It’s fully 65 years since William McChesney Martin, then chair of the Federal Reserve, said it was the Fed’s job to take away the punch bowl when the party was really warming up, and just over 40 years since Businessweek infamously pronounced the death of equities.
It would, I think, be fair to say that both comments are long forgotten. For most investors, equities are the only game in town precisely because the current Fed has pretty much said that far from taking the punchbowl away, it will pour in as much of the hard stuff as it can to keep markets partying. This is so it can pursue its asinine inflation target.
In 2020, the US central bank went all in by buying corporate bonds, thereby cutting corporate borrowing spreads. Despite a pandemic and an especially nasty recession, risky financial assets boomed. Flows into equity exchange traded funds smashed records. So did issuance of investment-grade and high-yield debt. Globally, investment-grade companies issued about $4.8-trillion of debt, of which $2.5-trillion was in the US. Junk-bond issuers borrowed $432bn in the US alone, one of the busiest years ever for this market.
Finding someone with a bad word to say about risk in general, or equities in particular, is about as easy as it was finding someone with a good word in the late 1970s. Following are some bad words.
The first problem, albeit a short-term one, is investor positioning. Everyone has the same view and the same positions. Regardless of their longer-term performance, this is a fairly common problem at the start of a year, irrespective of asset classes. That’s why those with a few grey hairs and a little perspective do very little at the beginning of the year. In 2021, though, the consensus is even more remarkable.
The second problem is valuation. Take equities. If you bung a low bond yield into a standard dividend-discount model and leave everything else unchanged you’d end up with very cheap valuations. But this is wrong-headed. Investors should also cut their growth assumptions. They don’t, of course, but that doesn’t really matter because such models aren’t any good in the long run at predicting returns. I know this because I had them tested when I was working at Rubicon Fund Management.
The best models — those that are mean-reverting and which have provided a good guide to long-run returns over more than 100 years — are very expensive indeed. So is corporate debt. Buying investment-grade and junk bonds was a fantastic thing to do in early 2009 and I went hoarse saying so at the time. In early 2009, BBB bonds yielded something like 9.5% and junk bonds about 20%. Now junk bonds yield about 4.5% and BBB bonds a smidgen over 2%. Though they’ve never yielded less, investors are buying them as though they’re about to go out of fashion. I strongly suspect they will.
The third problem is that the Fed has already unleashed a huge short-term speculative wave with its actions. We already know that the central bank is about as likely to apply what we might dub the McChesney doctrine as Donald Trump is to admit he got something wrong. That’s why rate expectations and bond yields are already on the floor. They might go down a bit, but they’re more likely to go up a lot at some time. You shouldn’t buy one asset on the basis that another asset yields nothing, because at some stage that other asset will start yielding something. It’s simply that bond valuations are more extreme right now.
Which is where we get to the fourth problem. I think inflation is about to pick up sharply, especially in the US, a problem compounded by the falling dollar. Suffice to say that investors have bought high-quality bonds for two reasons. The first is that prices have gone up over the past 40 years or so. The second is that they’ve diversified risky assets. The two things aren’t the same. Two perfectly uncorrelated assets can end up at the same point. Correlation simply tells you how they got there.
At some stage, I suspect sooner rather than later, the bond bull market will crack and over time bond yields will head higher. Bad enough, for sure, given how much speculation in equity markets has drawn succour from bond yields and rates of as close to nothing as makes no difference. Worse, though, is if correlations were to flip positive, with equity and bond prices moving in the same direction. Pretty much every risk-management system used by institutional investors would force huge selling of both bonds and equities.
Such a correlation flip may not happen now, but given the expensiveness of both asset classes it’s a much bigger risk than almost anyone realises. The research department of the Bank for International Settlements, roughly the central banks’ central bank, has said long and loud that central banks can’t target both inflation and financial stability. I think this year we’ll find out how true this is.
• Cookson was head of research and fund manager at Rubicon Fund Management. He was previously chief investment officer at Citi Private Bank and head of asset-allocation research at HSBC.
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