Calendar Week 10-2023

For over a decade I have raged at Quantitative Easing as an evil instrument, a band-aid solution that ultimately just shifted wealth from the middle class to the upper class. Once the largest group, the middle class has all but disappeared now and the gap between those that have and those that do not is even larger.

 

For over a year I have spoken and written of the shift in the economic landscape as inflation has bitten and stagflation risk becomes real. However, on the weekend, Christopher Joye, portfolio manager of Coolabah Capital Investments sent me this missive and he writes so more eloquently than I that this week I will leave it to him to explain.

 

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In the AFR I write it’s important to zoom out and synthesise the big structural changes that are taking place before our eyes, which will irreversibly alter optimal asset-allocation decisions. The bottom line is that you want to be liquid and avoid the unusually high downside risks of illiquidity right now.

 

Since January 2022, our economists have forecast a US and global recession arising in late 2023 or early 2024, and their modelling continues to imply that this is likely.

 

Central banks are singularly focused on demand destruction and crushing inflation back to their circa 2 per cent targets. They are actively hiking rates while explicitly forecasting recessions in countries like the UK and New Zealand.

 

This is an existential battle for central bank credibility, and we do not think policymakers are worried about downside economic risks. Indeed, they have to secure these downside scenarios to deliver price stability.

 

The central bank “put option” – which has consistently bailed out equity investors and those long risky asset classes, like junk bonds, since the 2008 crisis – is dead and buried.

 

We do not think that a serious recession is priced into stocks or high-risk debt. Equities have priced in the discount rate changes, but not recessionary probabilities, in our view.

 

Unfortunately, illiquidity is creating extreme cognitive dissonance in asset pricing. With global cash rates rising above 4 per cent to 5 per cent, many highly rated government bonds offering 4 per cent to 5 per cent, bank deposits paying 4 per cent to 6 per cent, and bank bonds paying as much as 6 per cent to 7 per cent, the minimum hurdle rates for all other asset classes have soared.

 

To allocate to anything other than cash and high-grade bonds, one would want to be paid a risk premium of 4 per cent to 5 per cent, which translates into minimum expected returns of 9 per cent to 10 per cent.

 

Yet valuations in illiquid markets – such as residential property, commercial property, private equity, venture capital, high-yield debt and private loans – have been incredibly slow to adjust. And less sophisticated investors are continuing to allocate capital to assets trading on inferior yields to cash and government bonds with vastly higher probabilities of loss and little-to-no underlying liquidity, which makes scant sense.

 

Default cycle

The global economy is about to experience a very serious default cycle. Interest rates have risen by a record margin. Households are carrying record levels of debt. The economy will go into recession or experience a radical retrenchment in growth. Sadly, scores of businesses and families had predicated their finances on the assumption of the “low rates for long” paradigm persisting.

 

We face the spectre of high rates for a potentially very long time. Central banks are scarred by missing this inflation crisis, which our modelling suggests was fuelled as much by excess demand as supply-side rigidities. While central banks should pause this year, there is a non-trivial risk that there will be a second phase to this hiking cycle if core inflation rates do not promptly move back to their 2 per cent targets.

 

Disturbingly, markets do not appear to be pricing in any possibility of a second phase to this monetary cycle: they universally assume rates will peak this year and then drift lower.

 

When central banks do come to cutting, they will be slow – and eager to avoid over-stimulating again. None of them know where the true “neutral” cash rate is, and they will be careful as they approach it. Most central banks do not expect to cut until 2024 or 2025, and the cuts may be modest when they come.

 

Zombie wipeout

Our systems show that the share of listed companies that don’t have sufficient profits to pay the interest bill on their debts has almost doubled in the US, UK, Europe and Australia over the last decade. This is based on 2021 financial data – before rates started rising.

 

These zombie companies will be wiped out. That is what the central banks want: they are actively seeking job losses, higher unemployment, lower wage growth and the demand destruction required to get inflation under control.

 

Since the global financial crisis and the advent of the search for yield, many business models and asset classes were predicated on the persistence of uber-cheap money. The pervasive search for yield saw demand for income-rich equities, residential and commercial property, high-yield bonds and private loans explode.

 

In the period after 2008, this dynamic was amplified by global regulators forcing banks to reduce lending to the sectors that had historically accounted for big balance-sheet problems and bank blow ups. Regulators made it difficult for banks to provide finance to residential property developers, commercial property owners and high-growth zombie firms.

 

This “sub-prime” business lending shifted into the rapidly growing non-bank sector, which sits outside the regulatory net. The growth in high-yield issuance, private lending and crypto finance was fine for as long as credit default risks remained contained. But this required interest rates to stay very low.

 

That cycle has turned. Lenders will be reluctant to acknowledge loans going into default, and will be restructuring them to extend terms, reduce repayments and/or swap debt for equity.

 

One way or another, a substantial default and restructuring cycle is inevitable. In contrast to every other shock since the GFC, when risky borrowers were bailed out by zero rates and endless money printing, this time around many will face insolvency.

 

The history of the financial world teaches us that during recessions many non-bank lenders die, while the banks need to be backed by explicit government-guarantees and the availability of central bank lending facilities.

 

The huge increase in the yields on cash and liquid, high-grade bonds will likely see a shift of asset allocation away from equities, property, infrastructure and junk debt.

 

We are seeing this in record book-builds for new highly rated bond issues. This process will be amplified by the regime change for defined-benefit pension funds globally. For decades, these have run large funding gaps that have recently transformed into surpluses as a result of the giant increase in interest rates slashing the present value of their current liabilities.

 

Previously, when defined benefit pension funds in Australia, the US, Britain, Europe and Asia faced funding deficits, they were forced into chasing yield (risk) to try to close these gaps via allocation to public and private equities and other racy sectors, such as commercial property and junk debt. But with the sudden emergence of funding surpluses, they are looking to lock in this security by reallocating back to high-grade bonds paying lofty fixed interest rates.

 

This is also driving an enormous increase in the demand for fixed-rate as opposed to floating-rate paper. These yield-based buyers could in turn compress credit spreads sharply for as long as overall yields remain high, and alternative investments fail to compete in risk, return and liquidity terms.

 

This has been evident in recent fixed-rate bond transactions that have experienced striking spread compression for as long as they continue to pay an attractive total yield.

 

No boom next time

Investors should not expect the classic post-GFC boom in asset prices once the correction has passed. After every shock since 2008, central banks floored rates and ran quantitative easing to infinity. They could only do this as long as inflation remained very low. This time around, the structure of interest rates is fundamentally shifting higher.

 

Central banks are revising their estimates of the non-accelerating inflation rate of unemployment (NAIRU) and the neutral cash rate back up to more normal levels, after experimenting with the idea that NAIRUs had fallen and neutral rates might be lower than in the past.

 

It is likely that this will unwind some of the shifts in asset allocation that flowed from the secular decline in interest rates, and the advent of very benign price stability, since the adoption of inflation targets in the early 1990s (i.e. the huge equity and illiquid assets binge).

 

The risk is that central banks struggle to get inflation rates back to their 2 per cent policy targets, and have to precipitate deep downturns to secure price stability.

 

This would be bad for all asset classes, except cash. Asset prices have to adjust permanently lower in response to permanently higher discount rates, and potentially a period of permanently lower growth as household and business balance sheets deleverage further.

 

Rather than the big post-GFC bounce that many have hoped for when they “buy the dip”, one may be better off “selling the rip” when these bear market rallies emerge.

 

For years many crowed about a “new normal” of cheap money for as far as the eye could see. We are returning to the “old normal”, where money is much more expensive and cash will offer a decent return above expected inflation.