The great regime change: growth and cheap money are dead

After decades of disinflation, ultra-low rates, and never-ending money printing (aka quantitative easing), we finally, belatedly, welcomed the inflation crisis that was the predictable consequence of myopic politicians and policymakers hedonistically pouring cash on every problem that ever presented itself. After all, if cash is costless, you can spend unlimited amounts.

When inflation was never a binding constraint, you could cut interest rates to zero (or even negative levels), run massive budget deficits that were very cheap to fund, and then have your central bank print hundreds of billions – if not trillions – of dollars of fresh moolah to bid up the value of all asset classes by slashing discount rates to record lows.

Remember the low-rates-for-longer paradigm? It’s gone the way of the dodo.

I recall an incredibly talented interest rate trader at a US investment bank telling me that he thought he would never see an interest rate increase from the Reserve Bank of Australia during his lifetime.

The absence of a decent risk-free rate of return rationalised the proliferation of numerous high-yielding, and often more illiquid, income solutions in equities, property, and fixed income. And the illiquidity was appealing precisely because it concealed the much greater underlying risks.

That party is now over: all investments need to offer attractive risk premiums over 4 to 5 per cent cash rates and government bond yields. Some sectors, like the liquid equities and bond markets, have adjusted immediately.

More illiquid areas, like housing, commercial property, private equity, venture capital, and the high yield loan space, could take years before they fully reprice. Concurrently, investors will discover the price of that illiquidity, which will be borne out by, among other things, a withering default cycle.

Even in listed equities, there is a case that cyclically adjusted price/earnings multiples are still far too high and not fully pricing in the global recession that is bound to come. To be sure, equities have likely adjusted to the change in discount rates – it is, however, unlikely that they are reflecting the retrenchment in future earnings growth.

For the time being, anything that promised growth is basically dead. And this is taking with it the pandemic meme trades of tech, crypto, fintech, and the entitled attitudes of Millennials who were conditioned to being always able to find well-paying jobs.

When cash paid you no return at all, or a negative return, spruikers could push “digital currencies” such as bitcoin as an alternative on the basis that it was a great inflation hedge, a safe store of wealth, a portfolio diversifier against other assets such as equities, and a medium of exchange for buying and selling stuff.

Of course, bitcoin has proven to be none of these things: all these claims were bogus. And most, if not all, cryptocurrencies will end up being zeroes.

In late 2021 and January 2022, this column laid out some core hypotheses regarding what the future might hold for a range of asset classes. Our key proposition was that persistently stubborn inflation pressures would force the US Federal Reserve to lift its cash rate to multiples of the very modest 1 per cent high watermark that was being priced by bond markets in December last year.

This would in turn push US 10-year government bond yields beyond 3.2 per cent.

And we argued that the big jump in discount rates would force US equities down by at least 30 per cent, trigger a US recession, precipitate a massive crypto crash, hammer fixed rate (rather than floating rate) bond prices (as yields soared), and push investment-grade credit spreads at least 100 basis points wider.

In October 2021, we also projected a record 15 to 25 per cent Aussie housing draw-down after the RBA commenced raising rates in mid-2022. We were pretty much negative everything, including our own asset class.

All these things have come to pass, or appear likely to do so. The outstanding questions are whether we get a US recession, which our modelling implies is highly probable, and the magnitude of the great Aussie housing crash. Capital city dwelling values are already down almost 9 per cent from their May 2022 peak, with Sydney prices off almost 13 per cent.

Perhaps the more interesting issue is what surprised in 2022. Our biggest miss was not anticipating that high inflation would become a cost-of-living crisis that would transform preternaturally dovish politicians that always want cheaper money, into interest rate hawks.

This opened the door for the inflation-fighting zealots inside the central banks to raise rates with unprecedented speed and global synchronicity.

We had thought that politicians would throw sand in the wheels of interest rate increases, slowing down the central banks. Instead, they became an accelerant, although this is unlikely to last as the cost of much higher interest rates – via job losses – becomes much more visceral in 2023.

Our main conviction for next year is that the economic and financial impact of the interest rate shock will be worse than people think. Central banks are implacably committed to engineering the slowdowns required to crush the strongest consumer price pressures in 40 years. This means job losses, defaults, corporate closures, and much weaker wage growth.

It also means the death of the hordes of predominantly real estate and tech zombie businesses that have thrived on the availability of cheap credit for decades without actually having the earnings to service their debts.

This column has previously highlighted the sobering RBA analysis that shows that 15 per cent of all borrowers could end up with negative disposable income if Martin Place lifts the cash rate to 3.6 per cent, which is not far from its current 3.1 per cent mark.

While it is all but certain that central banks will have to reverse course at some point in 2023 or 2024, cash rates are likely to remain structurally higher than they have in the post-GFC period. This is because the experiment with zero rates and “QE-to-infinity” is dead for the time being.

Central bankers have been badly scarred by completely missing the corollary of their cheap money policies, as have politicians who have for years run profligate spending programs in the name of bribing punters to keep their sorry behinds in power.

Crucially for investors, this means that all asset prices need to adjust permanently lower to reflect higher interest rates on cash. And it means that investors should not expect the ebullient bounce in asset prices that they became accustomed to seeing in the post-GFC period.

Future asset price growth may be dictated more by sluggish income growth than interest rates, simply because the option of cutting rates to zero and printing money to bid up the value of everything has been taken away from the central bankers by this inflation crisis.

The world may never look the same. We are going to have to rewire the neurology of both business and the capital markets that fund them to account for a permanently higher cost of capital, which in turn reflects the lurking presence of inflation risks that investors, politicians, and policymakers had simply assumed did not exist.

My best advice is to continuously remind yourself that the last 30 years of data could be a bum steer for this new reality.

We are going through a structural break – a fundamental shift in the way things work. In some ways, this definitionally makes the future even harder to predict because we cannot rely on the empirical experience of decades past.

Originally published in The AFR here.