Why equities ponzi and related Greenspan/Bernanke put option may expire...

Christopher Joye

Coolabah Capital

In the AFR I write that while the comparatively benign Omicron variant of the virus may provide a path out of the pandemic, it will only serve to amplify the inflationary pulse that is compelling sluggish central banks to move much more quickly to start unwinding their unprecedented monetary policy stimulus.

And this time around they may not be able to slash interest rates to zero and print vast quantities of money to bid-up all asset prices when markets take a massive dive, which has been their policy reflex since the 2000 ‘tech-wreck’ in what is often described as the Greenspan/Bernanke ‘put option’.

This is bad news for riskier asset-classes, including listed equities and, in particular, tech stocks that have been boldly pricing off revenue, rather than profitability, multiples and the assumption that discount rates will remain low for long. It’s been a ponzi-like game of pass-the-parcel in the hope that there is always a greater fool who is prepared to accept the low-rates-for-long meme.

And yet despite the warning signs, many commentators bravely claim that 2022 will be another solid year for stocks. This could prove correct if 2022 plays-out like the last time the US Federal Reserve normalised policy back in 2017.

But there are demonstrable differences in 2022. In 2017 core inflation was below, not above, the Fed’s 2 per cent target, wages growth was very weak and running at 2-point-something per cent, and consumer expectations for future inflation were anchored around the central bank’s credible target.

Today the Fed faces the spectre of core inflation more than doubling its target, consumer inflation expectations drifting up to their highest level in decades (and miles above the Fed's target), and smoking hot wages growth steaming at close to a 5 per cent annual pace care of a fully employed labour market.

The Fed’s December board minutes surprised both the equities and bond markets by signalling that it could commence quantitative tightening (QT), or balance-sheet shrinkage, ahead of investors’ assumptions. This means that rather than reinvesting the proceeds of maturing bonds that the Fed had previously bought into new bonds, it will simply allow them to run-off its balance-sheet. At the margin, this will put upward pressure on longer-term interest rates by reducing the demand for these securities.

And chatter is now intensifying around the possibility of an early rate hike quickly following, or even synchronously with, the end of the Fed’s bond purchase, or quantitative easing (QE), program in March.

Given the multi-year lag between changes to a central bank’s cash rate and the full economic impact of these adjustments, and the fact that the US economy’s growth, employment, wages and inflation profile appears to warrant a current cash rate at or above its neutral estimate of circa 2.5 per cent, it is hard to understand why the Fed would only hike three times this year. That would leave its cash rate sitting at less than 1 per cent.

A rapid normalisation of long-term interest rates, and hence the discount rates used to price all assets, is not just bad news for growth stocks. It is also bad news for venture capital, private equity, property, and fixed-rate bonds.

In Australia, for example, the benchmark 10-year government bond yield has jumped from 1.55 per cent in mid December to 1.90 per cent today. US 10-year government bond yields have similarly leapt from a December nadir around 1.35 per cent towards 1.75 per cent at the time of writing.

There is arguably still a lot of run-way left in these moves. When the Fed finished its last hiking cycle in 2018, lifting its cash rate to around 2.5 per cent, the US 10-year government bond yield pierced 3.2 per cent. And that was with benign inflation and wages outcomes!

The key message for investors is that this cycle may be very different. We have not seen a fully-employed US economy with wages and inflation characteristics like this since the early 1990s. The worry is that Omicron is only fanning these flames by introducing yet more constraints on the availability of labour and therefore supply chains. The risk is that elevated consumer inflation expectations remain stubbornly high and eventually bleed into wage-price spirals as the balance of negotiating power in labour markets shifts from employers to employees.

And for all the hype about crypto being a great inflation hedge, which has underpinned much of the marketing spin around these non-government backed stores of wealth, the fact is that Bitcoin trades like it is an equity proxy. When this column last wrote about Citadel boss Ken Griffin’s concerns regarding crypto as deposits start paying significant positive interest rates again, Bitcoin was trading at almost US$52,000. In sympathy with the sharp equity market drawdown in recent days, it has slumped to as low as $42,435.

The 18 per cent decline in the value of Bitcoin in a short period of time does not lend confidence that it can be treated as a stable store of wealth, setting aside Grifin’s questions around whether it can serve as a viable medium of exchange in global payment systems dominated by government-guaranteed banks.

The normalisation in discount rates is also hammering fixed-rate, as opposed to floating-rate, bonds. Since 29 December, the value of the benchmark AusBond Composite Bond Index, which only holds fixed-rate bonds with an average duration of about 5.8 years, has plummeted 1.52 per cent. By way of contrast, the AusBond Floating-Rate Note Index has risen by 0.01 per cent over the same period.

Whereas the first index has almost 6 years of interest rate risk embedded in it, which means the index performs better (worse) when interest rates fall (rise), the second index does not have this risk. This is because it only holds floating-rate bonds that pay higher interest rates as the cash rate climbs with the price of the bond unchanged, all else being equal.

If this inflation shock is persistent, and long-term interest rates really do have to normalise to, say, the 3 per cent plus levels observed in 2018, it would be reasonable to expect some pretty material reductions in the value of many asset-classes, including equities, fixed-rate bonds, property, venture capital, and crypto. And there will be frankly few places to hide.

Obvious destinations including short-selling if you can get the timing right, real cash (ie, bank deposits), and perhaps high-grade floating-rate debt. The flip-side of this coin is that there may be some very attractive re-entry points in the next year or two, especially if markets overreact, as they tend to do.

A crucial insight, however, is that this time is different, and unless inflation does crash back to earth, central banks will not have the free-option of bailing markets out via interest rate cuts and QE, as they have repeatedly done since the ‘tech wreck’ of 2000. The Greenspan/Bernanke put option may have just expired…

Investment Disclaimer Past performance does not assure future returns. All investments carry risks, including that the value of investments may vary, future returns may differ from past returns, and that your capital is not guaranteed. This information has been prepared by Coolabah Capital Investments Pty Ltd (ACN 153 327 872). It is general information only and is not intended to provide you with financial advice. You should not rely on any information herein in making any investment decisions. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. The Product Disclosure Statement (PDS) for the funds should be considered before deciding whether to acquire or hold units in it. A PDS for these products can be obtained by visiting www.coolabahcapital.com. Neither Coolabah Capital Investments Pty Ltd, EQT Responsible Entity Services Ltd (ACN 101 103 011), Equity Trustees Ltd (ACN 004 031 298) nor their respective shareholders, directors and associated businesses assume any liability to investors in connection with any investment in the funds, or guarantees the performance of any obligations to investors, the performance of the funds or any particular rate of return. The repayment of capital is not guaranteed. Investments in the funds are not deposits or liabilities of any of the above-mentioned parties, nor of any Authorised Deposit-taking Institution. The funds are subject to investment risks, which could include delays in repayment and/or loss of income and capital invested. Past performance is not an indicator of nor assures any future returns or risks. Coolabah Capital Institutional Investments Pty Ltd holds Australian Financial Services Licence No. 482238 and is an authorised representative #001277030 of EQT Responsible Entity Services Ltd that holds Australian Financial Services Licence No. 223271. Equity Trustees Ltd that holds Australian Financial Services Licence No. 240975. Forward-Looking Disclaimer This presentation contains some forward-looking information. These statements are not guarantees of future performance and undue reliance should not be placed on them. Such forward-looking statements necessarily involve known and unknown risks and uncertainties, which may cause actual performance and financial results in future periods to differ materially from any projections of future performance or result expressed or implied by such forward-looking statements. Although forward-looking statements contained in this presentation are based upon what Coolabah Capital Investments Pty Ltd believes are reasonable assumptions, there can be no assurance that forward-looking statements will prove to be accurate, as actual results and future events could differ materially from those anticipated in such statements. Coolabah Capital Investments Pty Ltd undertakes no obligation to update forward-looking statements if circumstances or management’s estimates or opinions should change except as required by applicable securities laws. The reader is cautioned not to place undue reliance on forward-looking statements.

Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs $7 billion with a team of 33 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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