Last week we briefly spoke about central bank policy and the reason that investors should stay calm given some of the incentives that are currently driving the market. Subsequently we have seen some calming of treasuries Stateside (whether this has been direct intervention by the Fed we will have to wait and see) as well as in Australia where the RBA has upped its direct purchases and are buying at a rate of billions per day (see the RBA announcement here). The official cash rate remains unchanged at 0.1%, though whether this makes any difference at this point is open for discussion.

This week, I would like to look at two things to watch out for given the current market environment and the implications for investors.

Watch Out for Duration

Central banks have different incentives depending on context and policy preferences. Given the amount of government debt to be issued around the world we must accept that there is very little choice but to keep a lid on yields, there are two different ways this can be done. First, the debt is issued on the short-end and kept rolling over, in which case it is the short-end that is artificially suppressed while the long-end is left somewhat on its own (a particularly bearish case for growth stocks and gold). The second is to control the entirety in the hopes of flattening (i.e. buy longer duration along with the shorter, a situation that results in a business as usual case).

Let’s look at the first scenario and the problem faced there. People and the markets look at the long-end and assume increasing inflation expectations as well as a quicker normalisation of policy even if that is not the case.

I, as a somewhat rational economic participant, might look at the long end of the curve, for example, and expect my tax or debt servicing burden to increase sooner rather than later and as a result spend a greater portion of my income to increase savings or pay down debt as opposed to spending in the real economy. This is the conundrum faced by both Lagarde and Powell, as well as the reason they wish to calm markets in fears of stopping the recovery before it even begins.

There is also a second and seemingly more important problem that comes about under the first option, a problem more acute in nations such as Australia. That is the curious case of real estate. In particular longer duration mortgages (30 years) that make up a significant portion of the real estate market. Most longer term mortgages are tied intrinsically to the long-end of the curve, which might create a headache by 1) increasingly having people on shorter-term variable rates and/or 2) pricing a substantial chunk of would-be homeowners out of the market despite the seemingly lower interest rates.

For all intents and purposes this inhibits credit growth given that there might be a greater unwillingness to fix rates longer term or creates risks to the markets in the sense that more and more go onto variable rates. Potentially exacerbating risks further down the track as the economy becomes evermore vulnerable to even slight increases in rates.

On the other hand, let’s suppose that the above risks are unpalatable and we go to the second option and assume that central banks decide to jawbone the bond market into subservience by effective yield curve control, where increasingly longer duration is bought with the hope that inflation expectations are kept in check while the recovery takes place. This creates all-together different problems. Namely, the exacerbation of existing trends, misallocation in terms of risk as we continue to see money flood towards risk assets and the market goes into bubble-like territory (or further in). There are also the risks of an increasing zombification of the markets, something the Japanese are perhaps more familiar with after close to a two decade romance with the notion.

Somehow though, my view is that central banks will go with the first option rather than the second and hope flowery language will keep the long-end in check. This is especially so in the case of the US whose Federal Reserve has a tendency towards being reactionary rather than proactive (hence the hope part of policy making) and as was made abundantly clear during Q4 2018 when I first alluded to the impossibility of monetary policy normalisation. In Australia, there is a different incentive given the level of household wealth tied to property and the necessity of facilitating credit growth in the real estate market.

The RBA, we make the call, will have a greater willingness towards yield curve control than its counterparts. A higher proportion of variable rates and shorter duration makes the system vulnerable to liquidity squeezes.

Takeaway: Understand that if central banks refuse to control the long-end of the curve, the higher growth stocks will see red and the pivot to value will be quicker than would otherwise be the case. That’s not to say companies like Apple won’t continue to be good businesses but much of their price action in recent years has been predicated upon multiples expansion which will not be sustainable if the curve is not flattened. Think the Nifty 50 during the 1970’s which came into the decade at all time highs, they continued to perform for much of the decade and earnings continued to grow but it didn’t reflect in their share price. If you want something more recent, think of Microsoft after the dot com burst during Steve Ballmer’s time at the helm. The business continued to grow earnings with net income surging 215% and revenue more doubling, this however was not reflected in the share price (the valuation just playing catchup).
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Timing

I’m sure you’ve all heard some variation of the saying “it’s not timing the market but time in the market that matters”. Remember that, now more than ever, the shorter-term movements are just that. We are just at the beginning of continued fiscal dominance globally, underwritten by the monetary side of the equation. At home, the AUD continues on a strong playing field which leaves the RBA with a lot more firepower than might be imagined given the cash rate. For example, in a circular manner, as global demand for iron ore and other commodities continues to rise due to infrastructure spending, this will continue to put upward pressure on the AUD and, as a nation with monetary sovereignty, the RBA finds itself in a position to be accommodative for longer without seeing ramifications in terms of inflation (and by doing so it also continues to help exports).

For all you property owners, this is one area you might seek to stay in for a little longer. There will come a time when this changes but long-duration assets, with an accommodative central bank that is unlikely to change course on a nominal basis, is what will continue to drive asset prices in the absence of any adjustments. I am of the fundamental belief that returns in those asset classes, just as with equities, are more a function of cost of capital than so called fundamentals like population growth (they only give you alpha and don’t account for the vast majority of the returns),

Similarly, REITS, industrials and, in adjacent categories from an income perspective, mining services companies look particularly attractive in my view. REITS and industrials, being leveraged entities that would’ve locked in longer duration as mentioned last time, will see their debt wiped away in real terms while mining services will see you benefit not only from a higher commodities prices but increased capex across the space. Where I don’t quite feel comfortable are the financials. This is due to a flat curve and arguably financial suppression on the part of the central bank, though they do remain protected species  in Australia and are a more viable substitute than treasuries.

How long can this keep going? Believe me, we have seen this kind of thing before and, as we often say, remember the words of Mark Twain: “History doesn’t repeat itself, but it often rhymes.” The closest thing is probably the wartime economies of the 1940s, where fiscal dominance increased money supply while deleveraging the private sector. A period that saw inflation but on a manageable basis and where most increases in money supply were a function of direct intervention. A situation where it is central banks financing and governments “spending the money into existence.” The pandemic, one might convincingly argue, has functionally created a wartime economy.

Alongside this global pandemic we find ourselves in, we have increasingly frosty relations between global superpowers and those superpowers are vying for influence across most of the planet. If that “Cold War-time” type situation isn’t a close second to a wartime economy, I don’t know what is. In the similar period that followed WWII, the music continued to play for close to two decades even after the war, reconstruction also creating some strong growth.

WWII was devastating, yes, but equities investors continued to annualise around 9.6% p.a. Apparently even wars, be they between nations or against a virus, wont stop capital from seeking a return. Who knew? It just depends on where one looks.