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Rate rise will crush asset prices - Chris Joye
February 17, 2018
Chris Joye, AFR 17/2/2018 writes:
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 bonds (or "interest rate duration") 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.
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.
To date the script has played out.
The 4.1 per cent US unemployment rate is sitting materially below its full-employment level and yet the Fed's cash rate remains at an extremely stimulatory 1.4 per cent, half its average since 1990. Dole claims in the US are at their lowest levels since 1973. In fact, the US has only had a smaller jobless rate once (when it hit 3.8 per cent in 2000) in the last 48 years.
Annual wages growth has climbed steadily from a trough of 1.6 per cent in 2010 to about 3 per cent today, which was the shock that triggered the equities sell-off in February. This nonetheless remains a significant margin inside the 4 per cent-plus annual wage growth observed before the GFC.
Finally, core consumer price inflation has been building towards the Fed's 2 per cent target after being crushed by the plunge in oil prices in 2015, with the latest data this week surprising investors with its strength.
The bottom line is that notwithstanding all the doves' dreams of disinflation for decades, if you continuously pump demand ahead of finite supply for a sufficiently long time, you will get price pressures.