Introduction

Since the Global Financial Crisis (GFC), macro-economic policy has increasingly influenced market sentiment. With the onset of COVID and its related government interventions, the interrelationship between market psychology and macro-economic policy has been cemented. Central Bank and Government Fiscal policy decisions are now one of the key determinants of short-term investment performance.

Low interest rates, and the growing belief that rates will remain low for a long time, are driving asset prices higher, with elements of market exuberance emerging. The scope for investors to continue to generate historically attractive returns from the current elevated asset prices has diminished. However, the prospect of not investing is equally unattractive.

Generating higher investment returns requires very selective investment exposure. We are particularly attracted to businesses that retain pricing power, as this insulates against inflation risk. The year ahead sees markets performing a high wire act, with central bankers and politicians holding opposite ends of the wire. We discuss the perilous journey facing investors below.

Key statistics

Cash rate lowered through the quarter to 0.10% (as anticipated in our commentary on Monetary Policy)
Australian economic growth was -3.8%
G7 GDP growth was -4.1%
Employment growth was -0.6%, unemployment up to 6.8%.
- Underemployment is up and unemployment remains masked by government income replacement schemes (job keeper and cashflow booster).

Economic commentary

2020 revision

RBA Governor Philip Lowe, in a speech near the end of 2020, said it was ‘indisputable’ that low interest rates fuel higher house and asset prices, and this is the RBA’s intention - “that support to balance sheets is helping people be confident about the future and they will keep spending”.

Central Banks the world over remain focussed on protecting ‘balance sheet strength’ as this encourages consumer confidence, resulting in consumer spending remaining well supported – up till now at least. Consumer spending flows to businesses who invest to ensure production capacity meets demand.

Meanwhile, investors weigh the ‘opportunity cost’ of capital. With interest rates so low, the relative value of income generating assets remains well supported. Even distant future and hypothetical business income has become highly (and sometimes improbably) valued.

2020 has left its mark on markets. Lower interest rates and substantial government support led a sharp recovery in consumer confidence and asset prices.

The magic pudding Central Banks are trying to bake is: ‘if enough free money is mixed in, a dash of extra spending and business investment should lead to economic growth’. The challenge for the baker: Will the economy rise before a debt induced stomach-ache develops?

Looking ahead at 2021

In the short-term, markets appear to have the stomach to continue rallying further. However, some respected commentators are not so sure - “the market is now checking off all the touchy-feely characteristics of a major bubble” – Jeremy Grantham (Jan 5th, 2021) & “[this bubble] is entitled to break any day, having checked all the boxes, but could keep roaring upwards for a few months longer. My best guess as to the longest this bubble might survive is the late spring or early summer [Northern Hemisphere], coinciding with the broad rollout of the COVID vaccine”. Full article here

We do not share the full weight of Mr Grantham’s pessimism, in so much that predicting when a bubble may burst is difficult, but particularly so when the opportunity cost of not investing remains so high (i.e. holding cash is so dismal). We agree that markets appear fully valued and some markets appear distorted by real interest rates being at zero.

Troubled waters

It is true that within some markets there are signs we are in a bubble. Buy now / pay later businesses and opaque credit providers have proliferated. Artificial asset markets (like digital currencies) along with some ‘growth’ investments are at dangerously high values. Each of these businesses/markets appear to be held by like-minded investors.

Markets are usually efficient at pricing assets (‘wisdom of crowds’). However, this market efficiency partially relies on sufficient diversity in thinking amongst investors. When there is a loss of diversity amongst investor thinking, market efficiency can break down. In the case of a stock like Tesla, whose market cap requires each Tesla car to be sold for USD$1.2m (PE ratio at 1,674), few if any rational investors are likely to remain on the share registry. Thus, the remaining shareholders are mainly founders, employees and true believers in the Tesla perpetual growth story. Thus, with few sellers available, even a small volume of new buyers can lead to a steep rise in share price and this has seen the stock move into bubble territory. The same is true of Bitcoin and has been true for all preceding asset price bubbles.

Something happier

One impact of COVID is that government shutdowns left excess capacity within the economy. This excess capacity has reduced the near-term likelihood of inflation, and so with it, lowered the possibility that an inflation induced stomach-ache puts an end to elevated asset prices

Beyond muted inflation risks, it is sentiment and psychology that continue to drive short term market movements, which are impossible to predict.

Longer term view

The market recovery appears well on track, fuelled by the globally accepted paradigm of low interest rates and expanding government debt.

In the US, the Federal Reserve began buying up state government debt, not just federal government debt (like what is occurring in Australia). This could prove particularly problematic as US states do no control currency issuance. A state cannot simply ramp up production at the mint to service debt obligations. There is a real danger that the Federal Reserve becomes the arbiter of whether a US state goes into default! Some potential questions and problems we see arising:

Will ‘The Fed’ impose austerity measures on Illinois, New York, or New Jersey citizens? (these states happen to have the highest level of state debt)
Does it matter if the defaulting state is traditionally Democrat or Republican?
Will ‘The Fed’ force defaulting states to raise taxes and cut pension entitlements, becoming a pseudo political force?
Will ‘The Fed’ forgive debts, and if so what about the other US state debts? The potential for political fallout is massive.
Will the US Federal Government be forced to takeover state debt? If so, will Democrats only do so for blue/swing states?

Like previous financial system risk events, the layering of risks has been gradually accumulating over time. Markets do not appear to be pricing in the increased risk.

Markets, which are just the collection of economic participants engaging with each other, will only price in risk when enough people agree there is a risk. That is, any irrational asset/debt position only rationalises when enough of the irrational market reaches a consensus on their own irrationality!! This is one of the great difficulties in investing. Being right does not make you correct if the market (irrationally) thinks you are wrong.

Many a Tesla short seller has fallen victim to this trap. There is little doubt that technically Tesla is highly overvalued, but to make money from selling it ‘short’ requires some consensus amongst existing Tesla investors that Tesla is now fully valued and it is time for them to begin selling. As Keyne’s famously said “the market can remain irrational longer than you can remain solvent”.

We never have had the stomach for short trading, and not just because attempting to profit from another’s misery is not our cup of tea. Even if it were, in a world of free money, timing when an asset price performs negatively seems much too unpredictable.

So how should an investor assess and respond to the current state of macro-economic policy?

In this new paradigm of nearly free debt and large government deficits, there are two key questions:

Is there a problem with the current paradigm?
If there is a problem, what might a catalyst be for a rationalisation or explosion of the paradigm?

With regards to the first question. Some believe there is no problem with the new paradigm. Some of these believers fall into the Modern Monetary Theorem (MMT) camp. That is, they believe currency issuing governments can run up any amount of debt, so long as it does not cause inflation. Under MMT, Central Banks set interest rates to afford government fiscal policy and it is through fiscal policy (taxation and government spending) that inflation is controlled.

If you do believe there is no material problem with the current paradigm, then it follows that government debt and central bank purchase of this debt is just a progression in economic development, not a layering of risk. On first glance, a seemingly reasonable position.

Further, MMT provides some useful insights, even if you think the overarching theory is flawed. MMT informs us that debts are better held by currency issuing governments (not states within government), and that governments should have a more central role as economic stabilisers.

However, we think ultimately when inflation returns, MMT is likely to come unstuck.

In the face of inflation, central banks will be forced to make a choice between monetary stabilisation (and inflation targeting) or continuing to appease the government spending needs of politicians. They will need to make that choice because there is little chance that governments have the political capital or nous to curtail spending and/or raise taxes to manage inflation.

Enigmatic Central Banker’s will face off against pugnacious politicians. A career of bruising debate sees politicians better prepared and positioned for the battle.

Nay-sayers might think there is no reason to worry about inflation. Alas, a set of continuing demographic changes may add weight to challenge market confidence in the status quo of low inflation for longer.

Inflation and demographics

We do not anticipate any immediate inflation movements. However, we are beginning to form the view that over the medium term, upside inflation risk has been under priced in markets. One factor affecting the value of money and inflation is demographic change.

Advanced economies are aging rapidly. The young make up a shrinking percentage of an advanced economy’s population, while retirees make up a growing share.

As the trend continues, the number of workers producing goods and services shrinks relative to consumption demands. This will lead to a squeeze on labour markets and supply side capacity. This results in resource constraints emerging, increasing the cost of those resources (i.e. wages for labour), leading to inflation.

This contraction in labour markets underscores a reversal of labour market trends from 1960, a factor, in conjunction with Central Bank targeting, that assisted in moderating resource constraints and thus kept inflation lower.

The COVID-19 pandemic has led to an increase in unemployment. This has served to create temporary excess employment capacity in markets, masking temporarily any gradual longer-term trend that demographic changes will have on labour markets. Although COVID has reduced any supply side inflationary pressure in the short term, it may have expedited demographic shifts, as it appears to have brought-forward a permanent exit of some baby-boomers from the workforce, evidenced by a downtick in the participation rate.

Like a river carving out a canyon over time, the force of a demographic change is gradual but unyielding. We think inflation will in time return, particularly when current employment capacity is absorbed. Following a recovery in employment we expect to eventually feel inflation pressure, which typically leads to higher interest rates and with that, a rationalisation of asset prices.

If interested in this area of thinking, we would encourage you to read this excellent article from Martin Wolf.

Investment Commentary

Although our economic commentary strikes a more cautious tone, few investors can afford to simply stop investing. Nor would we recommend that.

So, what are an investor’s options? We share the views of Howard Marks, from his memo ‘coming in to focus’, on the following options available to investors:

Invest as you always have and expect your historic returns. Actually this one’s a red herring. The things you used to own are now already priced to provide much lower returns.
Invest as you always have and settle for today’s low returns. This one’s realistic, although not that exciting a prospect.
Reduce risk in deference to the high level of uncertainty and accept even-lower returns. That makes sense, but then your returns will be lower still.
Go to cash at a near-zero return and wait for a better environment. I’d argue against this one. Going to cash is extreme and certainly not called for now. And you’d have a return of roughly zero while you wait for the correction [– whenever that might be]. Most institutions can’t do that.
Increase risk in pursuit of higher returns. This one is ’supposed’ to work, but it’s no sure thing, especially when so many investors are trying the same thing. The high level of uncertainty tells me this isn’t the time for aggressiveness, since the low absolute prospective returns don’t appear likely to compensate.
Put more into special niches and special investment managers. In other words, move into alternative, private and “alpha” markets where there might be more potential for bargains. But doing so introduces illiquidity and manager risk. It’s certainly not a ‘free lunch’.

As you can see, none of these are particularly attractive. We would also add to that list, chasing flavour of the month investments that are wildly priced - but we would avoid these.

Portfolio positioning

As we believe inflation may be a trigger in a resetting of interest rate expectations, it follows that there is value in having some inflation protected income streams, particularly as this view is not yet shared by the market. This can be sought in infrastructure assets as well as businesses that retain pricing power. As Warren Buffet said on pricing power – “the single-most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you’ve got a terrible business. I’ve been in both, and I know the difference”.

Floating rather than fixed rate credit exposures are also preferred lower down the risk curve, albeit yields remain low across the fixed interest asset class.

Another interesting consideration is whether the USD continues to retain its safe haven currency status during risk events. How much further can US domestic economic conditions and fiscal indebtedness deteriorate before markets question the value of a US dollar? To date, foreign exchange (FX) exposures (particularly when in USD) moderated volatility in Australian portfolios, as overseas losses during the deepest COVID-19 sell-offs were partially offset by USD FX gains. However, as a trading friend once described it to me, playing FX positions is the closest thing to pure gambling in finance.

Wholesale investors should consider alternative asset classes, like private equity. However, this asset class comes with costs, both in fees and liquidity, as well as requiring minimum parcel sizes thresholds - and some risk.

Active management remains particularly valuable. If possible, do not take the market weighted position in an overvalued business, of which more are materialising.

Snowgum Quarterly | Summer 2021