The outlook for investors is deteriorating
For much of the last fifteen years since early 2009 we have remained reasonably positive about equity markets and risk assets in general. When central banks started to rein back liquidity before both the COVID lockdowns (2019-20) and the Silicon Valley Bank implosion (early 2023), we dialled down our optimism. Generally, however, we have believed in surfing the liquidity wave; older investors might call this the Greenspan put – the view that central banks will come to the rescue of markets if anything goes seriously wrong.
For the first time in 15 years we spy serious trouble ahead. The background is the combination of stubbornly high inflation, mushrooming government debt, and the ever-increasing thirst for finance from both private and public entities. Financial crises are caused when somebody is unable to pay or refinance what they owe. The dominoes then begin to topple: it has happened since time immemorial, and Overend and Gurney (1866), Northern Rock (2007) and Silicon Valley Bank more recently are just three examples.
Loose monetary policy is continuing
Western central banks have not changed monetary policy. It is still loose, driven we believe by both worries over a global slowdown and the fragility of the financial system (witness the spike in repo rates in early October) rather than inflation. We are not as optimistic about interest rate falls as some in the market, but the important aspect of monetary policy is that central banks are increasingly turning to short-term finance.
The Federal Reserve in particular is financing more through T-bills – witness the approximately 13-month drop in the average weighted maturity of their debt programme. They are doing this in order to reduce the supply of T-bonds (and hence keep their yield down), but also to reduce the quantum cost of debt service. T-bills are issued at a discount and don’t involve coupon payments. This is to all intents and purposes Quantitative Easing (QE) by another name.
QE may no longer protect investors from trouble
Today there are several candidates for the catalyst to upset the applecart. Our prime one is China. It is no secret that the Chinese economy is struggling with low growth, high levels of private debt, and deflation, perhaps caused by greater trade barriers. The authorities have made some effort with fiscal policy to stimulate the economy. However, they have kept monetary policy relatively tight in a misguided attempt to support the yuan. If this ends up forcing Chinese entities to refinance in the global market, and thereby suck up some, even much, of the available liquidity, it will put pressure on the global financial system.
But there are other possibilities too. The market is now well aware that levels of government debt are rising inexorably – i.e. we are all off to the magic money tree. The U.S. election looks most unlikely to result in any substantial change to fiscal policy: they will continue to run a substantial fiscal deficit. Moreover the Treasury debt ceiling is due to be reimposed in January 2025, which is likely to lead to the kind of brinkmanship among politicians and volatility in bondmarkets which we have seen in the past. Our concern is that at some point bond market buyers will call government’s bluff by refusing to buy at current yields.
An alternative scenario is unexpectedly stubborn inflation. I appreciate that I am writing this just after the U.K. inflation rate has fallen to 1.7%, but the underlying trends, especially in the U.S., are less positive. Our friends at CrossBorder Capital point to the gap between the yield on Treasuries and similar government-backed mortgage agency bonds. They have historically traded tightly in line, but in the past two years have opened up a gap of around 70bps. That suggests that the market’s real estimate of break-even inflation is about 70bps higher than the standard calculation of break-even inflation using Treasuries.
Finally, financial markets are still very fragile. This can be seen from both the spikes in repo markets, which are the bedrock of today’s credit markets, and the interest rates which small to midsize companies are having to pay to find finance because banks no longer lend to them.
As always, watch government bond yields
At the centre of all this is the future path of government bond yields. There are powerful forces to send them higher: inflation, historically low term premia, the inevitable increase in supply as governments attempt to finance their borrowing, and the reducing creditworthiness of governments. What would happen if the result of the U.S. election were disputed, perhaps for months? On the other hand, central banks are suppressing yields (see above), and an era of lower growth and possibly lower interest rates also leans in the direction of lower yields.
We do not know how these counterforces will interact with each other. We do note that over the last 15 years central banks have by and large been able to win their skirmishes with bond vigilantes – for example in Japan recently. In our view, fundamentals will inevitably reassert themselves eventually, which means much higher yields, but we accept that that may be five or more years away.
So our best guess is that in the short and possibly medium term there will be significant volatility in bond yields, but that they will continue to trade in roughly a 4 to 5% range unless something jolts them out, we would suggest upwards rather than downwards.
How to invest in this more difficult world
Our final question is what assets will do well in an environment of volatile bond yields, low growth, and easy money? To our mind, the easy answer is to start with a flexible approach. We think there will be more opportunities for tactical timing as bond yields swing from risk on to risk off. Long duration assets such as infrastructure and growth equities in particular may trade up and down quite significantly.
But that presupposes an ability to time the market, which is not always the case for longer term institutions whose approach is closer to buy and hold. Carefully chosen equities bought at a sensible price will continue to grow. But equity indices, dominated by so few companies in the U.S., exhibit significant specific risk. Would a break-up of Google be good or bad for the share-price? Could a Trump administration ramp up anti-trust legislation?
We are happy to buy investment grade and government bonds, and particularly index-linked ones, but only at the right price. We do not think that is now. Today we prefer to look at credit markets where there is a functioning market between demand and supply of finance, and yields are not distorted by government or regulators’ actions.
That largely means the provision of finance to small and mid-cap companies, as large companies tend not to need or want it. But even here there are distinctions to be made. Are the companies borrowing to refinance existing debt, or to invest for the future? Is it better to rely on sponsored lending (i.e., to companies which are sponsored by private equity) or direct non-sponsored lending? We favour the latter, if only because it is a less crowded market.
Real assets are attractive as a hedge against higher inflation in the longer term, which we believe to be inevitable as a consequence of our rush to the magic money tree. But returns in the short-term may be mundane because of over-supply. We can't help noticing the amount of real estate on the market right now.
Flexibility will be the key
Our conclusion is that flexibility is going to be the key. That is both because we expect more volatile markets and because we want to build up inflation hedges against the future, but only at the right price. That leads us to the view that institutions without the ability to trade in and out of markets will be better off with broader mandates where professionals can make the decisions are better than narrower ones. Depending on appetite for fees and risk that may mean currently unfashionable vehicles such as diversified growth funds or hedge funds. It gave me confidence the other day to hear four investment consultants in a row dismiss diversified growth funds (see the graphic at the top of this page!).
Another implication is a higher cash weighting. It will be a drag on performance in the short term, but it also provides that flexibility to take advantage of opportunities.
Comments