In my AFR column I explain how we faded the recent equities shock picking up $159m of cheap assets but why in the longer-term equities and property are likely to be subject to more serious corrections as higher wages growth and inflation inevitably become the dominant investment dynamic, forcing discount rates higher than current levels, albeit that this may take years to fully manifest (click on that link to read for free or AFR subs can click here for direct access). Excerpt enclosed:
"February's dramatic 10 per cent sell-off in shares was the first big correction since the global financial crisis that has been fuelled by economic strength, not weakness. It offered a timely reminder that fixed-rate (or "interest rate duration") bonds can be a horrific hedge against losses in shares when the economy is firming. This was a lesson old heads learnt back in 1994 when equities and government bonds simultaneously slumped as a result of a re-setting of interest rate expectations upwards after the 1991 recession. It is not something seared into the brains of any adviser or investor aged under 41 because they were still at school. This column has previously warned that since the 1890s, the correlation between Aussie government bonds and equities has on average been positive, not negative. So if you want to hedge equities, do so directly with futures, options and/or short sales rather than relying on a rubbery negative correlation that has not stood the test of time. Across the $2.3 billion of cash and fixed-income assets that I run, we generally "faded" the move, spending a little more than normal – $159 million in net terms – buying floating-rate bonds that had temporarily cheapened on the back of the market turmoil. I argued that the underlying economic strength that precipitated the February correction should embolden markets in the near term until we get genuinely high wages and inflation, which could be one to three years away. The experience to date is reminiscent of Brexit, with markets recovering rapidly from the initial shock drawdown. In May 2015 I was sitting talking to Willy Packer, the Perth-based global equities polymath who manages almost $2 billion of shares. At the time, investors had universally embraced the pervasive "low-rates-for-long" paradigm on the basis they believed inflation was dead and disinflation would reign for decades to come. Given the headwinds of anaemic growth, elevated government debt burdens and price-destructive technology innovations, investors were convinced interest rates would never rise – or if they did, by only a fraction of what they had in the past. This thesis had profound consequences for asset prices. The 10-year government bond yields used by analysts as one input into the "discount rate" to value the cashflows generated by listed stocks, private equity and property would be much skinnier than it had been historically. This in turn automatically boosts the present value of all investments, and explains the capital gains we've observed across these asset classes since the GFC. It has helped that governments concurrently engaged in a radical experiment of rejecting freely-moving markets, trying to set their own asset prices. They did this by spending north of US$15 trillion buying long-term government bonds to reduce discount rates and artificially inflate the values of privately traded investments in the name of animating "animal spirits". In my meeting with Willy and every one since, I've sketched out an alternative vision to the low-rates-for-long meme, which has been conveniently pushed by anyone who benefits from cheap money, including equity and bond fund managers long "duration" who will suffer if rates rise. I argued that the US jobless rate would fall well below its full-employment level, which the Fed said was around 5 per cent, and inevitably reignite wage inflation. This would occur because excessively stimulatory monetary and fiscal policy would overheat the world's largest economy (and many others with it). On the fiscal front, populist politicians servicing a 24/7 news cycle would pay little heed to prudence and adopt the more electorally favourable solution of growing their way out of their bloated nominal debt burdens with large budget deficits. After all, inflation is the friend of any borrower who owes his or her creditors a fixed dollar sum. Austerity was indeed dead. At the same time, increasingly myopic central bankers – beholden to their political masters – would be encouraged to look past evidence of brewing wage and consumer price inflation, perhaps even discarding their inflation targets altogether for more palatable alternatives like so-called nominal income targeting." Read the rest of the article here.
Christopher Joye is Co-Chief Investment Officer of Coolabah Capital Investments, which is a leading active credit manager that runs over $2.2 billion in short-term fixed-income strategies. He is also a Contributing Editor with The AFR.
While this is an interesting article, I don't agree with the suggestion that back in 2015 no-one was arguing that inflation would eventually result in a substantial rise in interest rates. I recall, for example, one Livewire article by Jordan Eliseo which noted that a group called Incrementum AG had forecast a shift to 'rising inflation' back in 2015: https://www.livewiremarkets.com/wires/incrementum-inflation-signal-switches-to-rising-inflation There were certainly others at the time who were also sceptical of the then pervading 'deflation is the new normal' narrative. It is the nature of the financial media that the more popular narratives end up getting beaten up, whereas those with contrarian views usually end up getting drowned out.