In search of what’s normal

Written by Tony, 06 August 2019

The first part ‘How we got here’ argues that the world’s financial markets and their participants have not recovered from the Great Financial Crisis (GFC) which ended ten years ago. The actions of central banks in their efforts to stimulate growth created distortions which have been so deeply embedded for so long that today investors barely notice them. What are these distortions? Do they help us or threaten us? As investors how should we respond to them?

Before the GFC inflation was 2-3% per annum and interest rates 4-6% per annum. Today we live in a world where inflation is steady at around 1-2%, with interest rates close to and sometimes below zero. Which of these is the norm? Should we expect an eventual return to pre-crisis conditions, or has the world slipped into an era of permanently low inflation/deflation and permanently negative interest rates? Why hasn’t inflation picked up and will it ever return?

One response to the crisis was the policy of austerity, an attempt to curb government spending to cope with the huge deficits which arose as tax receipts slumped. Savings were made by means of a series of cuts to public services which fell mainly on vulnerable people and may have contributed to the growth of populism in politics and to the Leave victory in the EU referendum. How has the situation developed and where might it go from here?

Superimposed onto a backdrop of financial market distortions and an embedded culture of risk aversion, the prolonged Brexit crisis has created a unique value opportunity in UK assets.

The second part of the blog ‘The eye of the storm’ looks at the positioning of the TB Wise Multi-Asset Income fund today. The wheel has come full circle since the time a little over two years ago when after a period of exceptionally strong performance, we were compelled to replace around a third of the holdings in the fund which had become fully valued. Today, much of what we own looks irrationally cheap. We will look in depth at the fund’s holdings to understand how their prices have reached their current distressed levels at a time when most commentators describe the financial markets as fully valued.

How we got here

Comparing business cycles

Imagine we are coming to the top of a normal business cycle, the sort we were used to before 2007. Most commentators do imagine precisely this and are concerned because the expansion has continued for a decade, which is an unusually long time.

So here we are. The economy is hot, employment is full, the stock market is hitting new record highs daily, everyone is confident and optimistic. People are buying cars and booking holidays, businesses are borrowing to fund expansion. It all needs to be reined in, so the central bank starts raising interest rates, making money more expensive. After a few such hikes, it becomes less attractive to borrow to your limit for the nicest car you can afford, so people leave it a while, or buy a smaller one. Business becomes a little less brisk, companies postpone expansion plans and eventually start laying people off. The malaise spreads, the economy turns down, and eventually the central bank has to begin cutting rates in order to rekindle activity, and the next up-cycle begins.

It isn’t hard to see the differences between the situation we find ourselves in today and the top of a pre-crisis boom. For a start, economies aren’t exactly booming. They seem to need a great deal of stimulus in order to grow at even half their pre-crisis growth rates. It’s true that employment is high, but people in employment have never felt less secure. What’s entirely lacking is confidence. People are terrified that the next recession lies round the next corner. Consumers are reluctant to spend and businesses to invest. There is no pressure for central banks to raise interest rates. In the US, the world’s largest economy, and currently one of the few that is growing at a decent rate, the central bank (the Federal Reserve, or ‘Fed’) has been trying to ‘normalise’ interest rates by raising them from historically low levels, but has given up the attempt, and has recently made a cut. Even the mighty US economy probably wouldn’t be growing as fast as it is without the stimulus of tax cuts introduced by Donald Trump early in his term as President.

Judging by its length, the current economic cycle should be nearing its zenith, but it has been slow and muted, and the excesses which typically appear at the top of business cycles are notably absent.

In the ‘normal’ pre-crisis cycle, fixed interest investments, known as ‘bonds’ and company shares moved in the same overall direction. Bonds pay a fixed interest, so when the bank rate rose at the top of the cycle, fixed bond yields became less attractive by comparison and their prices fell. Shares fell too, after a time-lag, as company prospects become less favourable in a weakening economy. In the recovery phase, the same thing would happen in reverse – fixed interest recovered as interest rates were cut, and then share prices recovered as economic prospects improved. The sequence went bonds down, shares down, bonds up, shares up.

In the last decade this relationship has broken down so completely that most finance professionals below the age of 40 don’t recognise it. As far as they are concerned, bonds are things to buy when you are nervous and want safety, and shares are things to buy on the rare occasions when you are feeling confident and want exposure to risk. Shares have become ‘risk assets’, while bonds are the ‘risk-free asset’. As you would be unlikely ever to feel both scared and confident at the same time, you would only ever want to buy one or the other, not both, therefore you would expect the asset classes to move in opposite directions, as they have done, on the whole, in the last decade.

It is well known that the yield curve inverts before a recession and is a reliable predictor of a recession within 6-18 months. An inverted yield curve is where you get a higher rate of interest on short-term bonds (ones with less than a year to maturity) than on the ten-year bonds. At the top of a pre-crisis boom, the yield on the short-term bond would rise with interest rates, and the curve would invert because the short bond yield rose while the long bond yield stayed unchanged. Today’s yield curve inversion has arisen for the opposite reason – the geopolitical events of the last year have caused a flight to the safety of bonds – mainly medium and long-term bonds, making their prices rise and their yields drop. This inversion has been caused by the longer yield falling rather than by the shorter yield rising. In other words, the yield curve has inverted because of investor risk-aversion rather than because of precautionary interest rate rises to cool an overheating economy.

Flogging a dead horse?

Early in 2009, faced with the collapse of the global banking system, and desperate to restore the confidence the financial system needs in order to operate, central banks hit on two policies to provide a quick fix, ZIRP (the Zero Interest-Rate Policy) and QE (Quantitative Easing). The first would help millions of over-indebted households and companies to afford the interest payments on their loans, which would otherwise overwhelm them, and encourage new borrowers. QE works through the purchase of vast quantities government debt. This was expected to produce several beneficial effects. Governments are the biggest creditors of all. Buying government debt in vast quantities would raise its price and lower its yield, making it cheaper for governments to borrow new money. The lower yields on government bonds would make them less attractive as investments and encourage investors to invest in other riskier but relatively cheaper assets, such as shares and commercial property, which would help to boost the real economy and create employment.

In June 2012, following a period during which the Euro appeared close to collapse Mr Draghi, the head of the European Central Bank (ECB) declared in a speech that he would do ‘whatever it takes’ to save the Euro. Over a period of 7 years, the ECB has cut rates to below zero (the current rate is minus 0.4%, which means that depositors are paying for the privilege of letting banks have the use of their funds) and bought a total of E2.6 trillion of government bonds. Last week, following a period of slowdown which has left the Euro area close to recession, Mr Draghi prescribed more of the same medicine for his patient.

Have the central banks’ monetary policies been successful? QE has kept the cost of government borrowing at extremely low levels. The knowledge that central banks stood behind their economies ready to defend them in all circumstances undoubtedly restored a degree of confidence, but with a corresponding anxiety that there may be very little left in the policy toolbox for use in the next recession.

And there is little evidence that bidding up the prices of government bonds has had the desired effect of boosting investment in the real economy. On the one hand, government bonds look expensive, but on the other hand everything else looks risky.

Government bonds look so expensive as to be un-investable. An example is the UK government’s Treasury 4% 2060, which at its current price offers a 1.27% yield over the remaining 41 years of its life. Assuming that the government hits its 2.0% inflation target during this period, investors will see the inflation-adjusted value of their investment in the bond eroded by 0.73% a year, guaranteeing a steady erosion of spending power. But it could be worse - there must be at least a chance that inflation will be much higher than 2.0% at some point in the next 40 years. Some may remember the 1970’s, when inflation hit 20%. These low-return fixed-interest investments would be defenceless in such conditions, and their prices would collapse. And there are many government bonds offering even lower returns than Treasury 4% 2060. One third of the world’s pool of government stock offers a negative return – a guarantee that the investor who buys them will lose money. Captive investors such as banks, insurance companies and pension funds are compelled to accept these returns, but it is hard to see how anyone who had a choice in the matter would be tempted.

After the inflationary decade of the ‘70s, UK gilts paid their holders around 15% per annum, one of the highest yields in history. It has taken four decades for yields to drop to their current rates around zero.

At what point in this journey from very cheap to very expensive did gilt yields pass through their ‘normal’ range? Assuming that a ‘normal’ rate of inflation is 2.0%, the rate most central banks target, then a gilt might be expected to give its holders the rate of inflation plus a margin of profit, so a ‘normal’ return from gilts might be in the range 2.5-3.5% per annum. For Treasury 4% ‘60 to yield 3.0%, its price would have to fall by 36%. However, most commentators expect the 40-year bull market in bonds to continue, and for bond yields to continue falling as their prices rise.

The government bond market has been distorted by QE. The proof of this statement is the fact that the central banks who have bought the stock can’t sell it back into the market. The US Federal Reserve, the only one to have tried so far, stopped its programme of sales as of August 1st.

Central banks have succeeded in making gilts expensive, but not in persuading investors to embrace what are now universally known as ‘risk assets’, in other words any asset whose price fluctuates in what is now considered to be an unacceptable way. Investors want the safety of an asset whose price fluctuates only mildly, and which pays the kind of yield (5.0% per annum plus) that was on offer in the days before the GFC. The history of the past ten years is of a search for acceptable safe alternatives to government bonds.

The first place to look after government bonds is high-quality company bonds. The prices of these investment-grade corporate bonds surged in 2009 after QE was announced and have continued rising since. Unilever has recently been borrowing at 0.0% in Euros. An investing institution hands Unilever its money, and the exact same amount is returned three years later, without interest.

With corporate bonds now as expensive as government debt, investors have turned to alternative sources of safe income. These are assets which offer a high degree of certainty that the payments will be made when due, and the investor’s money will be returned at the end. Such assets are offered by governments or the most reliable companies, and are long-term in nature, ideally with an element of index-linking. Examples include social infrastructure projects such as schools and hospitals (though these have been less popular since Mr Corbyn’s Labour Party announced its intention to re-nationalise them), long-let property including care homes, solar and wind farms and even aircraft leasing. The ‘absolute return’ fund industry has flourished in the aftermath of the GFC. Such has been the demand for safe income that as soon as an asset class is identified as safe, prices soar in that area and yields drop. In ten years, the reach of QE-induced distortion has extended a long way beyond just government bonds.

Central banks have played a crucial role in all our lives over the past decade, since they stepped forward in the depths of the GFC. Have they been saviours, or have they made the original problem worse? Central banks wanted to make government borrowing cheap and have succeeded beyond all expectation. They wanted to restore confidence, and that has happened to a limited extent. Their attempt to restore animal spirits in the financial markets has failed, an issue we look at in more detail below.

We may now have reached the limit of what QE and ZIRP can do. These policies were designed to make borrowing cheaper, helping people who already borrow, and encouraging new borrowers. The problem is that if people don’t want to borrow money when it costs almost nothing to do so, they may not be any keener to do so when it costs nothing or less than nothing. You can take the horse to the water, as they say, but you can’t force him to drink. The other problem is that as you reduce rates to, and then below zero, you discourage people from saving. Saving is a social good as it brings stability to people’s lives. By making people pay to save, you are stoking up the bubbles that we are seeing in all safe income assets.

Historians will tell us whether the policy initiatives of a decade ago to rescue the financial system were a stroke of genius or an act of folly. What seems clear is that however well the medicine worked at first, the patient stopped responding to the treatment years ago. The incompatibility of the economies of northern and southern Europe, corruption, the migrant crisis, populism, the paralysis of the Italian economy, Brexit, and the end of the Merkel era – these things won’t go away however much you lower the interest rate.

Bonds, shares and the yield ratio

What does a normal relationship between shares and bonds look like?

As an investor, you have a choice. You can either lend a company money through buying its fixed-rate bonds, or you can become a part-owner of the company, by buying its shares. A company has a legal obligation to pay its bondholders, first the instalments of interest on the bond when they fall due, and then the nominal value of the bond issue at the maturity date. Bondholders take precedence over other creditors in the event of insolvency. Companies pay dividends to their shareholders, and try to raise them every year, but there is no obligation to do so, or even to pay any dividend at all. Shareholders stand at the back of the queue, receiving part of what’s left after everyone else has got theirs (staff, creditors, bank etc). It follows that dividend payments are riskier than bond income. On the other hand, good companies raise their dividends over time. Unilever, an excellent company, has raise its dividend every year since 1981, an unbroken run of 38 years.

A bond pays a regular fixed amount like an annuity. A share dividend is like an index-linked annuity, but with the risk that it may be cut or not paid at all if the company you’re investing in finds itself unable to do so.

If a rate of 2% inflation, the target set by all central banks, is normal, and if at a time of 2% inflation it’s reasonable to expect government bonds to pay something like 3.0% a year, then perhaps we should expect high quality company bonds to pay 4.0% a year, because even the best companies can’t be as solid as governments and we need a margin of safety. If that’s so, then what should the rate of dividend payments be? We should expect the safest companies like Unilever to pay less than others to reflect their quality and the riskier companies to pay more to offset the added risk of not being paid. Over long periods dividend payments have grown. Perhaps it would be reasonable, in the aggregate, for investors to accept a dividend yield across the market of 4.0%, accepting that the prospect of payments rising over long periods was equally balanced by the prospect of things going wrong. If that were the case, then the yield ratio (the government bond yield divided by the share dividend yield) would be 4% divided by 4%, in other words, one.

Over time, the yield ratio has moved a long way. At the end of the Second World War, shares were seen as risky. Investors demanded a high rate of dividend income to tempt them away from the safety of bonds. The yield ratio was a low number back then, around 0.5 (shares paid twice as much as bonds). Then ‘the cult of the equity’ took hold. Shares became more and more expensive, to a point at the end of the 1990’s when investors had become so convinced of the attractions of the equity market that they would happily buy shares paying dividends on average less than half of what government stock paid. The yield ratio at that time was 2.25. A sum that would buy you £9 of government-backed income would only pay £4 in dividends, compared to £18 in the 1940s – but that was acceptable, because dividend payments went up and share prices would go up too, as they had been doing for several decades, whereas gilt yields and prices did neither.

For the last 20 years, things have moved back in the opposite direction, to the point where the relationship appears to have broken down altogether. Today, the FTSE All-Share index of the UK’s 600 largest companies is showing a dividend yield of just above 4.0%, four times the yield on a 15-year gilt. In two decades shares have gone from paying less than half as much as gilts, to paying over four times as much. Who wants to be paid an income that’s much higher than cash with the prospect of that income rising over time? The answer appears to be – no one! It seems that we have become so scared of the future that we can only envisage one outcome – things will get worse, and then even worse. Dividends will be cut and cut again, and finally disappear altogether. This is what the valuation of the market is telling us today.

Unilever’s shares pay 2.8%, but their bonds pay – nothing! An investor who had to choose between a dividend yield of 2.8%, which has been raised in each of the last 38 years, and a bond paying nothing, would appear to have an easy choice. The yield of 0% on the bonds implies that there is no risk at all to the return of the money. If the bonds carry no risk, then the company issuing the bonds must also be risk-free, and if so, then the 2.8% dividend payment would appear to be the more attractive option. But Unilever has been able to issue E1.0bn of its 0% coupon bonds, which investors have chosen in preference to the 2.8% payment from the shares.

The giant property company Unibail Rodamco Westfield provides an even more extreme example. Unibail can borrow money at 1.0%, which is the yield on its bonds. The shares pay a dividend yield of 8.7%. The extraordinary disconnect between the two gives Unibail a yield ratio of 0.11%, 90% below what might be considered a ‘normal’ level. (1)

As far as I know, there is no parallel in history for today’s market distortions. Today’s bubble is unusual. In the internet bubble 20 years ago, investors paid sky-high prices for the riskiest assets, new companies with no history, no profits and in many cases no sales. Today, investors are paying sky-high prices for what are seen to be the least risky assets.

Risk

The paradox of risk in today’s market is that the safest assets are no longer safe because they’re priced out of all reason.

Why then are investors not more willing to look at ‘risky assets’. One reason appears to be a kind of confirmation bias in the markets. Assets which are universally perceived to be risky become more volatile than if that perception didn’t exist. This volatility makes them unattractive however cheap they may become. How does this mechanism work? Risky assets in today’s market are unfashionable and disliked. Their shares tend to be traded less frequently, which makes their prices more volatile and ‘lumpy’, reminding investors of the risk where volatile = risky. As valuations shrink, assets may be abandoned by fund managers as being sub-scale, putting further downwards pressure on prices. Fund managers who continue to hold unfashionable assets underperform, and suffer outflows as investors switch to funds that have performed better, forcing the managers to sell to raise cash to meet redemptions. As shares continue to be de-rated, they become smaller components of their respective indices, and have to be sold by the increasingly influential index funds.

Financial markets, despite the best efforts of the central banks, have not recovered their animal spirits since the Great Financial Crisis, and have instead become unusually risk-averse. The first thing an adviser does when talking to a potential new client is to establish their ‘appetite for risk’, meaning their capacity to tolerate price fluctuations in the assets in which they might invest. When faced with the question ‘Do you prefer to invest in assets which might lose you a lot of money, or in assets which might not?’ it’s natural to opt for the latter. Lower-risk assets suit advisers, whose fees are often linked to the value of the assets they look after. Several fund management companies offer a suite of risk-graded funds. In all cases the lower-risk funds are very large, and the higher-risk funds tiny.

We live in a world in which people have been conditioned to avoid financial risk at any cost.

Inflation

Today, there are almost no inflationary pressures in the financial world.

Inflation is often described as ‘too much money chasing too few goods’. Authorities have created money on an unprecedented scale, but it hasn’t caused inflation, because the money created has not found its way into the real economy.

There are two possible outcomes.

One is that inflation doesn’t return in the foreseeable future. The reasons why it might not do so can be summarised as ‘debt, demographics and data’. There is so much debt – far more than existed before the GFC – that cash is being spent on servicing loans rather than on more productive spending. New technologies save labour and increase productivity. And older populations tend to spend less.

The other possibility is that the world is still recovering from the trauma of 2007-8, but that inflation will return in due course. It is worth remembering that although there is more debt today than before the GFC, the debt that exists costs less, and has in many cases been fixed at low rates for decades ahead. While the average age of populations is increasing across the developed world the number of people is growing – at the rate of around 225,000 people each day, and standards of living continue to rise in the aggregate. Many of the commodities we use aren’t renewable and will eventually become scarce.

Central bankers, who spent the 80s and 90s trying to manage inflation lower, are now trying to manage it higher. Inflation may remain low, and if it does, today’s financial world, distortions and all, can persist for a while longer. If inflation returns, then central banks would eventually be forced to raise interest rates and the whole negative interest-rate edifice would start to crack. The assets which could best cope with inflation, shares in companies which could raise their prices, and commercial property on which rents could be raised, are currently seen as ‘risk assets’, and for the most part ignored.

Brexit

The Conservative manifesto for the 2015 General Election promised a referendum on our membership of the EU, and a referendum was duly held in June 2016. The process has lasted well over four years, long enough for us to become used to and therefore overlook the persistent effect that Brexit has had on the financial markets, which view our departure from the EU in a less positive light than the 52% of the electorate who voted for it.

Sterling began to fall in anticipation of the referendum, continued afterwards and has fallen to levels only rarely seen before against the US dollar and the Euro. Weak sterling gives exporters a bonus and importers a pay cut. In the UK, exporting companies tend to be larger, and importers smaller. For the most part, larger companies fall on the right side of the Chinese wall in the financial markets as safe assets. Their share prices, already performing well before the referendum, have been turbo-charged by the weak pound.

More than three years after the referendum, we can be sure of two things. One is that none of the issues has yet been resolved, and indeed to the original uncertainties have been added others, such as the possible break-up of the United Kingdom. The other is that the present state of uncertainty can’t to last much longer, because of the deadline of October 31st, and because, even if that deadline is extended, it’s clear that the crisis is coming, finally, to a head.

The financial market behaves as if the current crisis will last forever and has sold certain UK assets down to astonishingly cheap levels. These are risk assets into which the risks have been very fully priced. The accession of Bris Johnson as Prime Minister has not been welcomed by the markets. The pound has sunk to a new low, and UK domestic assets have sold off sharply yet again.

For us as fund managers, the performance of TB Wise Multi-Asset Income has been disappointing to say the least. However, we have been here before, in 1992, 1999, 2009, 2011, and the winter of 2015-6. We know from experience that our best periods of performance usually follow the worst. We know what panic looks like, and we have learned to notice when prices cease to respond to information in a rational way. We have reached that point again. It has taken a world banking crisis, a decade of increasingly institutionalised risk aversion, and in the UK four years of a developing constitutional crisis, to bring us at a point where we can invest in high-quality assets at fractions of their long-term value.

The second half of this blog The eye of the storm will describe the opportunity in more detail, and how we have positioned the fund to take advantage.

  • (1)This point was made recently by respected commentator Jeremy Grime

Please note – this blog contains the personal opinions of Tony Yarrow as at August 7th 2019, and is not intended as financial or investment advice

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