Where to hide in an inflating bubble
After starting out as an equity portfolio manager at Daiwa International Capital Management in London during the late 1980s, Tony Cousins is now Chief Executive & Chief Investment Officer at Pyrford International, a value and quality-focused global asset manager.
In this fascinating and wide-ranging Q&A conducted on the ground in London, Tony sat down with Livewire to discuss everything from the importance of having the backbone to stick to your process, how asset management has changed over the past three decades, and the dangers of rising inequality around the globe.
He also touches on the "lunacy" of negative-yielding bonds, while also explaining why monetary authorities have led markets into "desperately uncharted territory".
Q: You've been with Pyrford for 30 years now. What do you think have been the things in markets that have changed the most over that time?
I think asset management has become massively more professional. It used to be sort of an all boy's club. It's become way more diverse. It's attracted in far better talent.
When I started, no one had a computer. You had an old Intel 286 or something like that. Computing power was rubbish. The availability of electronic data and the ability to crunch a lot more numbers is required. And that has required a greater degree of sophistication and professionalism, and qualifications.
Things like the CFA Institute, who have encouraged far better educational levels has been extremely important. I think that education professionalism has gone up.
At the same time, the reliance on the sell side has basically petered out completely. When I started this business, the kings of the business were stockbrokers, who would just use their analysis which is … I go back and sometimes look at it and just say, 'My gosh, how desperately simple and unsophisticated that was!'
All that's gone completely and it's a far more meritocratic, diverse intellectual discipline than it was. Hand-in-hand with that has obviously been the compliance burden, which has brought in a lot more bureaucracy. But it's also raised the bar in terms of ethics and professionalism, eliminating hidden costs, and treating clients fairly.
Q: Conversely, looking back over the last 30 years, what makes you sit back at your desk now and just say, 'Some things just never change?'
We’ve managed our products through three bubbles. The dotcom bubble in the late 90s. Prior to that, it was the 87 bubble as well, but that was much lower. Then you've had the credit bubble, and now you've got a liquidity bubble.
It's just the unwillingness of policy makers around the world to allow there to be a clearing process in markets. They just keep inflating bubbles. It's a repeating process because nobody wants it to go wrong on their watch.
Ultimately, someone is left holding the baby, and it does go wrong, because you just can't keep inflating bubbles forever. They do eventually burst. Then when they burst, it's that much more serious. You're coming down from a much dizzier height than you were in the past. That didn't use to happen to the same extent.
Policymakers see maintaining market levels, the stock market, as part of their remit, and I don't think it should be. They actually have a constitutional remit to maintain inflation and keep the real economy going, in terms of higher employment, people having jobs and growth, and prosperity.
A regrettable and repeating process has been that they have seen the value of financial assets as something that they need to maintain. That has had some unforeseen consequences, particularly in the quality of society, because a lot of people, the middle to lower end, don't have a big stock portfolio. Whereas, the concentration of wealth is in the top 10%, and you've seen the gap because of this perceived responsibility to maintain financial assets and keep the bubble going.
Gini coefficients, measures of inequality, have just ballooned, particularly in Anglo-Saxon economies. That is ultimately a dangerous development. But it's certainly an unwelcome development.
Q: How big is the bubble now?
On a valuation perspective, it's not as bad as the dotcom boom in equities. In fixed income, it's worse. It's never been worse than this. It reached its nadir in May of 2016, and nearly half of the quality bonds in the world were giving you a negative nominal yield.
That's returning now. Something like $13 trillion worth of high-quality government bonds are giving you a negative nominal yield. The Czech Republic euro bonds are giving you a negative nominal yield.
This is utterly absurd. How you get a decent return for investors when you're actually paying governments to borrow from you is bizarre. It's utterly bizarre. This is the most extreme effect of the current bubble.
Now, that didn't happen in '87, 1999 or 2007/08. None of those conditions are prevalent now, because governments didn't print money. This is the first bubble where governments have employed large-scale quantitative easing to the tune of $14.5 trillion over the last 10 years, which has inflated a fixed income bubble.
The fixed income market has always been more rational than the equity market. It's been bigger and more liquid. That is where probably the worst of the excesses are today.
But it's all driven by policymakers losing sight of their remit. Their remit is the real economy. It's how many people have jobs, and are they earning a decent living wage, and all that sort of stuff, and having a balanced economy.
It is concerning, very concerning.
Q: Why would anyone want to invest in negative yielding bonds?
I have no idea. I think the reason people do it is an example of greater fool theory. I don't think they're stupid. I think they rationally believe that while they're buying a highly overvalued asset on its fundamentals, then the momentum of the changes and yields are such that they will be able to get in and get out and sell it to someone else at an even more inflated level.
Now, this is greater fool theory – there is always a bigger fool who'll come along to buy it from you. But somebody will be left holding the baby. This is the importance of process, that you don't get sucked into that game, because that's a momentum market timing game.
A lot of people play that in our industry now, because the short-termism means, 'Well, I'll buy this today … if you buy a German government bond with a -50 basis points yield, the only way you can make money is have -50 go to -60, or even lower'.
You cannot look at that and just say, 'Well, if I compound this rate, I'm going to end up with a really good total return in five years' time,' because you're ending up with an even bigger negative return. You've got to compound a negative rate of return.
That's obviously lunacy. We come from a point of view that that's what we do – we look at compound rate of return over five years. They must be taking an extremely short-term view, whereby the momentum of the downward direction in yield is such that they think they can eek a bit more out of it.
At some stage, it will stop. That's when someone gets left holding the baby. It's not a good place to be.
Q: Do you think bonds in general are as defensive as they used to be?
No. Absolutely not. The mathematics of a bond are determined; its price sensitivity is determined by its duration, its modified duration or Macauley duration, whichever one you want to choose.
When yields are falling, you want a lot of duration. When yields are rising, you want no duration. There are times when there's very good evidence to say that yields will be falling.
In the great financial crisis, you were offered a 5% real yield. Now, history tells you that that's a bargain, and you should buy it and take as much duration as you can get. Today, you're being offered anything between a 0 and -3% real yield. History tells you that is to be avoided like the plague.
Because if you buy that duration, , a 30-year bond will have a duration of about 23. Ignoring convexity for the minute, that means if yields go up 1%, you'll lose 23% of your money. Which is a fairly disastrous outcome. We think yields need to go up way more than 1%, because they are just at the wrong number. From that point of view, bonds are incredibly risky today.
Now, there's been bond bear markets in the past, but those have been driven by rising inflationary environments, the 70's. People lost a lot of money in bonds in the 70's. This time, they will lose money for an entirely different reason, that is the nominal yield is just way too low.
We are not bearish on the outlook of inflation. It's just the bond yields have been manipulated to such a low level that it's just the wrong number, even relative to a middle of the road expectation for inflation.
We've never seen negative real yields in the past unless it's been in a very high inflationary environment, and we're not looking at a very high inflationary environment.
If you look at the economic textbook, the chapter on money printing is a really thin one. It consists of the Weimar Republic in the 1920s, Argentina in the 1990s, and Zimbabwe. Frankly, none of which are models for your economy.
That's what Japan is doing now. It's printing money in order to meet obligations in its bond market, and to keep bond yields suppressed – this is what's called financial repression, down at zero. The mathematics of compounding – when you have 200% debt to GDP, you have to do that.
You can understand why they're doing it. But it can't possibly work. It works until it doesn't work anymore. This is what the Germans found out in the 1920s. The theory is that this will create greater inflation, which will allow you to ease the burden of your stock of debt. Well, there's two great fallacies in this.
One, that it can create inflation. Because the central bank that has printed more money relative to the size of its own economy is Japan, and it's created no inflation whatsoever. It just hasn't succeeded in doing that.
The second is, even if it were, then you would be able to control it. You would know when to stop. Or you would be able to stop? I think it's a policy that is fraught with real dangers, is highly unorthodox, and going into the unknown. But yet, we've all become dulled and complacent, because it's been going on for 10 years.
Some of the people who work here, they've never known a world where central banks haven't printed money. They just think it's a normal course of events. It's a normal monetary tool. Which is what it's seen as now. Whereas, in financial history, it's a highly unorthodox monetary tool that would've been horribly frowned upon prior to the financial crisis.
I think we are in desperately uncharted territory here.
Q: I know your equity screen is very specific. Can you take us through a recent addition to the portfolio that ticked all the boxes in your testing?
The key characteristics we look for going into a portfolio, are current yield plus growth in the income that generates that yield. It's a total return approach. We look at this in the knowledge that current yield contributes about 50% of total returns. Having a decent current yield is important.
A company we bought, it's called SGS, Societe Generale de Surveillance, in Switzerland. This is a company that is in quite a consolidated industry and becoming more consolidated. It does inspection services, largely of imports and exports, looking for quality, making sure, for example, toys don't have very much lead in them, for grades of iron ore, testing efficiency of products.
As products become more complicated, the barriers to entry are getting higher, because a lot of this is lab-based. You need, as a company, to be able to commit more capital to this and more expertise to this. This is why the industry is consolidating. A consolidated industry leads to a better pricing model, less competition leads to better pricing.
There are essentially three companies leading this consolidation. SGS, another company called Bureau Veritas in France, and one in the UK called Intertek. Now, we own SGS and Bureau Veritas, but SGS is the most recent one we bought.
This has always been a very good company. It's a fairly capital-light model. It's a recurring revenue model in that they have to keep doing the job, keep testing and inspecting, and occupying this position of impartiality between two trading partners. You don't need vast amounts of capital. You just need to have a very good reputation for doing a good job in this.
But it's becoming more capital-intensive because the expertise and lab requirements, and technology requirements are great, which freezes out the little companies. They are gradually acquiring lots of little companies. You can actually see a good growth path for this company. We've always liked it. We've looked at it for a long time. But it's always been too expensive.
Then along comes Donald Trump with his protectionist rhetoric, and anything which is trade-related got hit very hard. The key is, you do your work, identify a good business model. We keep a sort of reserve list of companies which meets all those criteria that we look for; high return on equity capital, strong balance sheets. But we also require them to be cheap enough.
This company met the criteria of having a strong balance sheet, high return on equity capital, it just wasn't cheap enough – until Donald Trump comes along, hits the sector with his threats to world trade and protectionism. These stocks underperform significantly. That gives you an opportunity to go in and buy it, which is what we did.
Now, none of these things come without risk. If protectionist sentiment just really spirals, then that's a key risk for this business, because that leads to a declining world trade outlook.
Decades of history indicate that world trade grows faster than economic growth in general, because world trade is a good thing. It's all built on comparative advantage, all this good stuff. But obviously the risk is politics become involved in this.
It's such an economic no-brainer to promote trade around the world, because it creates jobs, it leads to far more efficient allocation of resources, the whole laws of comparative advantage are that people do what they're best at, produce something most efficiently, rather than allowing the least efficient to produce that thing. People over there, they produce what they do most efficiently. Then we trade it.
That's why it works … you just have faith that politicians go and kill this. For an investment like SGS, it requires you to have that faith. That's the risk. We think it's unlikely to occur. That's one thing that's gone into the portfolio fairly recently.
Q: To sum up everything we've spoken about, what's the outlook going forward?
The outlook is going to be very difficult, because growth is slowing. Debt is astronomical around the world. And valuations are extremely high. The likelihood of accidents, financial accidents, is very raised in those conditions, because lots of debt and a slowing economy don't go very well together at all.
Growth forgives an awful lot of things like debt. But growth is seeping away, the US is slowing rapidly. Japan is going nowhere. Europe is becoming 'Japan-ified'. Even China is slowing markedly.
That activity and demand growth is coming down at a time when debt is at a very elevated level. That's very concerning. All of that would be fine if assets were cheap. But they're not. That's the biggest problem.
We always say, 'You don't have to wait for things to look good to invest and take risks'. You just need to wait for things to look cheap.
If you look at the three best buying opportunities in the last 50 years, they were 1974, 1982 and 2009, when the news was universally bleak, but you were being compensated for that with very good valuations. Today, you're not. That's why I think the outlook for financial assets is really grim.
What you must never, ever lose sight of is the importance of not losing the money. Capital preservation is incredibly important. A long-term track record has been founded on never having a big draw down.
This is simple mathematics. If you lose 30% and make 30%, you're still down 9%. Avoiding draw down is very important. I think that's going to be, looking forward, the most important thing to do, and only take risks where you're being remunerated for it.
I can't see anywhere at all where you're being adequately remunerated for risk. Which is what's different to previous bubbles. There's always pockets where you could point to that.
With the pervasiveness of this huge liquidity flow that's driven all assets to expensive levels, it's very difficult to find places to hide. We are hiding in very short-duration, high-quality government bonds. They can't make you a lot of money, but they can't lose you a lot of money either.
The final thing, financial assets, it's not a zero-sum game, one goes down, the other one goes up. What is a zero-sum game are currencies. You can look at different currencies and say some are very expensive and some are very cheap. Sterling is very cheap, the euro is very cheap, the yen is very cheap.
The two most expensive currencies are the US dollar and the Aussie dollar. That's actually a good place to be, because if there's a mean reversion, we use purchasing parity to measure this, if the Aussie dollar goes down, investing in assets outside the Aussie dollar will yield better Aussie dollar returns. You just have appreciation.
For our sterling-based clients, there's no kicker here, because sterling is so cheap. Sterling needs to rise to be fair value. You need to take away all that forex risk, because if you take it, you'll lose money.
With Australia, you can have a substantial amount of assets in other parts of the world, particularly in the rest of Asia, and the return of the Aussie dollar to a more equilibrium level will generate good return. I don't think in local currency, asset returns will be attractive anywhere, and there may be some significant draw downs.
From an Aussie dollar perspective, as the Aussie dollar returns to a more … and it's already done quite a bit of this. It's already come down quite a lot. I think it's got some more to go. As that happens, then that is a good cushion and stimulus for Australian investors.
That's how we're positioned. From an asset point of view, we only invest in high-quality assets. We are very, very defensively positioned. But we have about as much as our risk parameters will allow us to have outside the Aussie dollar at the moment, because that's a decent return driver going forward.
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BMO Global Asset Management (Asia) Limited (ARBN 618067959), Pyrford International Ltd (ARBN 165504414) and LGM Investments Limited (ABN 19 381 443 479) are exempt from the requirement to hold an Australian financial services licence under the Corporations Act in respect of the financial services each provides to "wholesale" investors (as defined in the Corporations Act) in Australia. Pyrford International Ltd and LGM Investments Limited are regulated by the Financial Conduct Authority under UK laws, and BMO Global Asset Management (Asia) Limited is regulated by the Securities and Futures Commission under Hong Kong laws, which differ from Australian laws.
BMO Global Asset Management (Asia) Ltd ARBN 618067959 is exempt from the requirement to hold an Australian financial services license under the Corporations Act in respect of the financial services it provides to wholesale investors (as defined in the Corporations Act) in Australia. BMO Global Asset Management (Asia) Ltd is incorporated in Hong Kong and authorised and regulated by the Hong Kong Securities and Futures Commission under Hong Kong laws, which differ from Australian laws.
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