​We remain in an environment where leverage continues to grow at a considerable pace. This was perhaps best illustrated by the Archegos fiasco which showcased that, despite the GFC and the regulations that followed, risk was transferred from one area (i.e. namely the banking sector into the shadow banking and non-financial sector). This, combined with a whole generation off new investors seemingly driven by FOMO, should give us pause to take a step back and take time out to think.

​Context 
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Despite the rhetoric coming out off most central banks across the planet (including Stateside), who continue to maintain a view that any inflation is rather transitory and normalisation of policy is unlikely, we would like to take a contrarian approach. No, its not the “this time it is different” line that is a surefire way to pain but rather understanding what has been happening. For the investors amongst you who have lived through the last great recession, you are probably aware off the doomsday-sayers who, at the time, predicted runaway hyperinflation when non-conventional policy was first implemented. But where the so-called pundits got it wrong was, I believe, a fundamental misunderstanding of the way and manner in which QE actually works. So, let us begin with that.

QE is simply put a mechanism by which the central bank effectively buys longer duration assets in return for liquidity into the financial system. For those off you not quite aware of how the financial plumbing works, please refer to my previous article where I did my best to explain in simple terms how the central banking system works and how cash rates are set in practice, you may be in for a surprise (I did get one particular call about the cash rate being taken to zero wrong though).

While QE does increase money supply in theory, it is not in the way in which you’re thinking. When you deposit cash with say ANZ or CBA, the bank is required to pay you interest. The bank has two options in this instance, the first is to lend against said deposit or alternatively buy interest bearing securities, say treasuries for example, which are still considered risk-free, and pay the differential in that. The problem occurs when commercial banks choose the second option and accumulate treasuries since the central bank will effectively swap them again in return for liquidity. And so, the cycle continues and money accumulates within the financial system as opposed to being seen as credit growth in the real economy. This is the reason credit growth across the EU and Japan has been stagnant through much of the last decade, as shown was shown by the first negative mortgages underwritten in Denmark a few years ago.
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Unfortunately, what is required in this instance is the continued expansion of deposits despite the low rates. Although money supply seems to grow on face value it is in fact trapped in the financial system, the ultimate liquidity trap that also creates deflationary pressures. Ironically, Australia has avoided this scenario in many ways given the uniqueness and centrality of the property market to our psyche. We arguably created the ultimate “too big to fail” asset bubble, but it got the liquidity out of the commercial banking system.

​So, what has this got to do with equities and what we are talking about here? For one thing, this context has also created some rather unforeseen headaches. Ironically, in their fixation to avoid inflation at all costs, the design of QE has created another problem: asset price inflation. More particularly, the lack of return in risk free assets has in many ways pushed liquidity into riskier asset classes. This is perhaps the reason why Credit Suisse and Nomura, both institutions that are domiciled in jurisdictions which have seen this happen, were so willing to take outsized bets on a single entity in Archegos (apart from the magnitude of the counterparty risk not showing up on the balance sheet). The lending, apart from showing up in the real economy, has shown up in margin lending and swaps to date. The below graphs shows margin debt-to-GDP. In Australia’s case this has shown up in household debt-GDP (more important metric given the centrality of property).

So Where to Next?

The case till now sounds as though I am arguing against equities but here is the kicker. It was covid and the related selloff that has made me rather more bullish. Not for the reason you’re thinking, Personally, I’ve never believed in the V-shaped recovery and I don’t kid myself into believing that the world fits such idealised textbook models but rather my argument is predicated on what liquidity is doing and inflation is likely to do. Remember that the central part of my argument is that QE ended up trapping liquidity in the financial system, it did so because there was no mechanism for MS (Money Supply) to enter the real economy which is why we didn’t see core CPI pick up. What happens however when, because of say a pandemic, governments start to enter the spree?

A spree that, given current electoral and geopolitical imperatives, is unlikely to see financed by tax increases (at least on an income tax basis)? When direct stimulus, whether through infrastructure or legislation, puts upward pressure on wages? All this at a time when the biggest deflationary catalyst of the past century (not innovation), China, not only moves up the wage curve but is flexing its geopolitical and economic muscle? So, “we have a localisation of supply chains, increasing share of labor in GDP and liquidity that enters mainstream, including a lot of the new generation of leaders asking for a “bailout” of “mainstreet”. If these aspects aren’t inflationary, one must really ask what is.

Combine this with loose monetary policy, remember central banks (aside from ensuring the stability of the financial system) are also their respective nations’ bankers and (increasingly) primary lenders, and we might have a rather changed investment environment. Why does this make me bullish on equities? Simple, show me a better option to preserve wealth.

Across most of our portfolios we have pivoted away from growth and toward a reflation trade. The high growth stocks that we have become used to might not have it in them to 1) substantiate their valuations; and 2) to continue their trajectory in the face of increased government intervention. The liquidity will continue to grow (there is not much of a choice for the central banks) but it will flow in different directions.

The likely uncertainty around corporate tax (not income, corporate), anti-trust, increasing share of labor in profits and government scrutiny will probably impact the top-end of the market disproportionately, which may just answer the question as to why Mr Bezos was so forthcoming in arguing for a higher tax rate. What looks particularly attractive, even from a valuation perspective, are the so-called old-world industries – sectors like Energy, Real Estate, Consumer Discretionary and Infrastructure – which should not only benefit from the tailwinds of increased consumer demand but are a tried and tested way to hedge inflation. Additionally, they are usually a great way to generate consistent dividend yields. Having said all that, here are a few Energy companies we own.

Exxon Mobil (XOM.NYSE)

​With a dividend yield of about 6.3% and P/E of x10.3 Exxon not only looks cheap but, given my conviction on a continued rebound in oil prices through the rest of the year along with supply constraints across US shale production, this is one stock that should be on the radar of any dividend hunter with substantial upside as the company continues to prove its emissions and green credentials (essential for institutional flows with the continued rise of ESG).

Enbridge (ENB.NYSE)

​For those of you unaware of the company, Enbridge owns and operates the largest footprint of crude oil and liquid hydrocarbon systems in North America. It has been caught up with some recent political grandstanding with the Governor of Michigan seeking to decommission Line 5, which crisscrosses the Great Lakes, despite Enbridge’s exceptional track-record in safety (it has been operating it since 1953). However, given the support it has received from Trudeau in stating that the issue was non-negotiable we think it is somewhat de-risked, even with the change in the US’ administration. The dividend yield stands at a stellar 6.3% and, perhaps more importantly, a growth rate of 7% for the past ten years (we expect this to continue).

​Anyone that has seen the hot property market, including the recent “best month in 32-years”, might feel a little uncomfortable and scratching their heads at what has been happening. You wouldn’t be alone. The RBA minutes have shown that the board has been watching this particular area quite closely. The case is not isolated either, the S&P500 Stateside has hit all-time highs, the Asian markets continue to roar ahead and Vancouver now has the distinction of being the second-least affordable housing market on the planet (that particular example is apt  given the Canadian economy’s similarity to Australia, both being commodities driven). Anything with scarcity value, from crypto to artwork or even pokemon/sports cards, have seen their owners gain immense fortunes. All this, at a time when the market is still recovering from a global pandemic. Policy and geopolitical uncertainty continues to haunt the peripheries but we continue to seemingly ignore it. All this might suggest that we are in the midst of a bubble and you would be partly right. The problem might be in how we investors assess a particular thing and what we are assessing it against.

Let me elaborate. It is true that equity market valuations have hit all-time highs and asset valuations continue to skyrocket, but against what? That is where the question becomes more nuanced. Since the beginning of the covid pandemic, money supply indicators, including broad money, have shown double digit growth, 20% USD, 11% AUD, 10% in the Yen and the numbers continue across most of the world.

Going back to a view that I have previously touched upon, is it valuations going up or money (in this instance the commodity that those valuations are measured against) being devalued? It was Friedman who said that inflation everywhere is a monetary phenomenon, he forgot to mention that also translates to asset price inflation. Is it any wonder that Bitcoin, which has a finite supply of 21 million, remains a scramble. Even if you don’t agree that it has any intrinsic value, you must accept the premise of the argument. By the way, I continue to believe that the argument of intrinsic value in this instance is a fallacy and I say so despite my reluctance to trade that particular asset class. Gold’s valuation far outstrips its actual useful or practical value, a large chunk of the valuation is simply in its role as a store of value. By an extension of that logic, a luxury good, say a Rolex, should have no more value than any other watch assuming the same quality. You are just paying a premium for a belief and a mental programming that says said product makes a statement.

So that is the first point, for the much older investors, the markets may not be as irrational as they may appear. Coming back to the RBA and IMF. There were two things that the board addressed and the IMF corroborated. The first, you get the feeling that they feel asset valuations are a cause of concern though the Governor didn’t go that far as to explicitly state it (and neither should he) but even if this were the case that should not necessitate a normalisation of rates. Rates being the most important factor when it comes to asset prices.

​Even pertaining to equity markets, take a look at the below graph. It showcases that US investors had borrowed close to $814bn USD against their portfolios as of late February (the biggest monthly increase since 2007).

​Coming then to the second point both seemed to agree upon, addressing the problem will have to be through non-interest-rate regulatory tools. What are those regulatory tools? Typically, think about credit checks or buffer requirements. Think about minimum deposit requirements or interest only loans. To see how this might have a direct impact upon asset prices a quick example might be Hong Kong. When then CEO Carrie Lam, fighting declining approval ratings, lowered the minimum deposit requirements to 10% for properties up to $8m HKD (as opposed to the previous $4m HKD). While this did undoubtedly help many people afford their own properties, especially first home buyers, it had a secondary impact of putting a boost on property prices when the policy was brought in (Q4 2019, though they subsequently cooled off after, well, we all know what happened).

For a further walk down history lane, it was precisely these requirements apart from the Fed Funds Rate that enabled one of the largest expansions in the US real estate market pre-GFC. This time we are likely to see the opposite happen. Lending standards and capital requirements are likely to see tightening as the economy recovers with the implicit hope of cooling off credit growth. From an allocation perspective, we are unlikely to see any changes to the headline cash rates globally. This however, despite what has been said, is not a choice but necessity. As we have elaborated upon previously, covid has brought about fiscal deficits across most of the western world that we have not seen since the World Wars and the case is similar across most emerging markets. Even slight increases in headline rates will have immense implications upon the debt-servicing requirements and consequent tax burden. To give you a context of the magnitude, the central bank balance sheets of the US, BoJ, RBA and ECB expanded more in the year 2020 than the five years following the GFC.

Stateside this will likely continue under the new administration, an additional $2tn earmarked already. At home, don’t forget an upcoming election down under. If the recent trends regarding longer-term yields are anything to go by, we are probably going to see most of the new spending and debt-issuance end up on central banks’ balance sheets given little appetite from alternative investors.

​So, what does this mean for us investors? The first is simple, the outstanding returns of the past year across asset classes may be just that, an outlier recovery fuelled by loose monetary policy. We have probably seen the easy returns made. As policy makers change tack and work toward trying to taper off some of the risks associated with ever increasing asset prices, investors might need to be a little nuanced in how they allocate. This is necessary, given that the ramifications have broader implications than just from an investment perspective. Take income inequality for example, one of the unintended consequences of covid policy has been a record number of billionaires added to the Forbes list, about one new one every 17 hours. For the investor, expect the asset classes that you have become used to seeing incredible growth in see tightening, including property and the higher growth segments of equities markets.

As for the question of a bubble? Maybe we are in one, but it is potentially the wrong question all together. The more apt question is, given the incentives for policy makers, government and the amount of liquidity that is driving this, what are the likely outcomes? Take the example of income inequality, one might then ask themselves the question, what does this mean for luxury goods? Or within property, what does this mean for high-end vs. low-end properties? If the cash rates stay low and regulatory tightening occurs on the lending side, what does this mean for my bank shares? This core part of so many Australian portfolios is an interesting one. Anecdotally, a home loan specialist at one of the big banks recently told one of our team that they have rarely been busier than in recent months. Many Aussies have taken advantage of the current situation to lock in low rates. What happens when the banks’ NIMs get squeezed further though? And their loan book growth if lending standards are tightened? This might not happen any time soon (maybe when those locked in rates roll off and become variable in five or so years though?) but it is definitely a consideration for many of Australia’s retiree population. The Australian retiree that has the vast majority of their wealth in a “diverse” selection of property and bank shares is placing a lot of faith in what is essentially one big bet. If the property market finally takes a dive, it will take the banks along for the ride. Given the Australian index’s reliance on and weighting toward the Big Banks, a dive from the property market (and the accompanying problems for the banks) could trigger a much broader sell off across Australian equities. This is perhaps the best argument for ensuring you are also diversifying into international equities.

From the fiscal side of the equation, if we are likely to see increased government spending, what might this mean for infrastructure? This has been one of the big thematics for our global equities manager Robert Swift for a number of years now, a theme kicked into overdrive by covid stimulus. Or what about the effect of direct stimulus upon consumer discretionary spending? A segment that our Australian equities manager Ron Shamgar has been very much on top of this past year.

So going back to the original questions, in this particular author’s humble opinion. Bubble? Possibly by historical standards but there is a little more nuance to this than first meets the eye. Irrational exuberance? No, when you consider the nuances mentioned above. Are we at the beginning of a bull market? Probably, might be a lame one though.