Recently an investor posed us a question that flowed from his readings of a “doomsday” commentator who suggested that markets were vulnerable to an interest rate shock likely to flow from the predicted adjustments of US cash rates.
He had also read the pronouncements by the US Federal Reserve (the Fed) regarding cash rates and the likely reduction in the Fed’s balance sheet. His readings suggested that investment markets would traverse a long period of historically low returns or worse – markets would tumble and investment capital lost.

We summarized his concerns and the resultant investment dilemma this way –

“The ultimate question nobody can answer accurately is – At what level will “normalisation” (rising interest rates) tip the bond and equity markets into a free fall, and when should one withdraw to avoid capital losses?”

Our answer
No one knows the answer to this and there is much speculation as to what could become the “possible trigger events” for a market calamity. In our view, a calamity could occur if central banks adjusted interest rates too quickly. However, that is most unlikely given the statements made by central banks over the past few years, and there is no evidence that it will occur.
Our perspective – and we admit it is speculation – is as follows.

  1. The central banks (the bureaucrats) are acutely aware of both the problems and the financial environment of which they have created. We should not think that the “doomsday” commentators have a unique perspective. Many suggest calamity either because they wish to profit by such an event, or to gain notoriety;
  2. Given this view, we believe that the central banks will continue to do whatever is necessary to hold the ecosystem together. They may not know what will work, but they certainly appreciate which factors could tip the world into a severe economic downturn;
  3. The overwhelming majority of people (investors) and institutions are concerned with the maintenance of their capital and they do not want to endure a depression. However, the extreme “doomsday” commentators are forecasting a market collapse, flowing from central bank activity, that would surely result in a depression;
  4. Mankind might be stupid, but we will avoid pain and loss if possible. This will drive central bankers who are guided (and indeed employed) by politicians – themselves driven by political reality. Central banks have held economies together despite the massive dislocation caused by the GFC. They are not about to give up;
  5. By avoiding loss and manipulating financial outcomes, the end result (if it is not punctured by a severe recession or depression) will likely be a sustained period of low returns from financial assets;
  6. The equilibrium (or averaging) principle of long-term returns is observable and well established. Sustained lower interest rates have bumped up returns of investment assets; if a sharp cyclical correction of asset values is not allowed to occur, asset prices will stagnate and overall investment returns will be dominated by yield;

  1. Value investing is based on logic, and it suggests that the value of quality cash-generating assets will rise over time – supported by GDP growth (population) and enhanced or detracted by inflation (real returns) and risk free returns (bond prices); and
  2. While value rises over time, market prices oscillate around value. In this recent era – since the GFC – the price of investment assets has generally galloped ahead of value. Without a “trigger event” to correct the overvaluation, prices will wait for value to catch up.

Therefore, we are currently of the view that the “value” of growth assets must rise to catch up with asset “prices”. This process may well take many years. An ageing western population, slowing population growth and low economic growth suggests that value will not rise quickly unless the asset is specifically influenced by developing world growth (particularly China and India).
The Economist cover this week: The Bull Market in Everything – Are Asset Prices Too High?

Further, we have long stated that the debt created after the GFC, to sustain the ecosystem, would never be repaid and it seems that many commentators and indeed the markets are now coming to this view. Therefore, the outlook is not really about the effect of the “normalization” of interest rates. The low inflation and low growth cycle will ensure that the current “normal” rate of interest, determined by inflation, is much lower than the historically observable average rate.

In our view, normalisation might only result in a 2% lift in interest rates over 5 years! Remember that today’s negative “real” interest rates have already endured for over seven years. Interestingly, Warren Buffett said last week that stocks would look cheap in three years’ time if interest rates were one percentage point higher, but not if they were three percentage points higher.
Importantly, it is the effect of “debt forgiveness” or the renegotiation of debt into the “never-never” (see the creation of 100 year bonds) that will be the critical issue for asset markets to traverse. What will asset markets do if central banks effectively agree that trillions of dollars of government debt need not be repaid and/or that the interest payable on bonds held by central banks need not be made by governments? Will that create a panic? Or will it result in a massive feeling of relief because a solution is found that suggests that financial repression can end!
The purchasing of government debt with printed money has not worked prior to this era, but today it seems to be doing something that no one can explain. There is no evidence of hyperinflation and currencies have not collapsed. Even gold is stagnant and commodities are relatively stable.

Source. The Economist
It seems that many commentators are falling into a trap of looking backwards to speculate on the future. The past is certainly interesting but there is no real precedent for this current era of:

  • Synchronised quantitative easing and negative real cash rates;
  • Massive government debt funded by central banks;
  • Ageing populations across the developed world;
  • Free trade and capital movement;
  • Abundant and cheap energy; and
  • The emergence of an industrial juggernaut (China) that has exported deflation to the world.

Therefore those commentators that do not observe the present, and fail to put it into an appropriate context, mis-diagnose the fundamental problem and mislead with their projections.
Our macro view and analysis is based on this logical principle – Understand the present to predict the future.
Markets and economies are in a long tedious workout with lower investment returns to be endured from this point. Without price volatility the returns will be lower than most expect. The outlook remains dominated by central bank policies and activities. They will observe asset bubbles, and they will attempt to manage these bubbles as they slowly adjust interest rates higher.