Government / Market
Policymakers Try to Cancel Capitalism
For all of its flaws, global capitalism plays a critical role in the efficient allocation of scarce resources. The main mechanism for this function is the pricing of capital. While it may take years to show up, when capital is mispriced, bad things happen. Policymakers’ responses to the financial crisis, especially the significant role played by the major central banks in suppressing interest rates, will have long-term implications for the global economy. How quickly—or whether—debt and equity markets move back to a normalization of the pricing mechanism for capital will shape economic performance in the years to come.
In addition to adopting extraordinary monetary policy to suppress interest rates, the most significant responses to the financial crisis were moving debt from the private sector to government balance sheets, a substantial public-sector fiscal stimulus, and an overhaul of swaths of banking and financial market regulation.
These responses are causing blockages and gaps in the systems of financial-market liquidity and credit transmission, and have evolved into permanent deficit policies in the developed world and higher sovereign debt levels in the emerging world. The financial crisis may have been caused by debt, but that hasn’t stopped global government and corporate debt from increasing by 40% since, to the mind-bending total of $164 trillion as of end-2016.
Some of those responsive measures probably helped avert a second Great Depression. They also continue to support risk appetite by artificially suppressing the volatility of the economic cycle and distorting the creative destruction of the business cycle and the price of capital. While some individuals and smaller companies have struggled to borrow and raise capital, the corporate sector in general has taken advantage of an unusually extended economic cycle and artificially low interest rates to borrow more, leading to huge growth in the corporate bond and loan markets.
While governments, central banks and regulatory authorities in the major developed economies have been intervening more purposefully in markets, we have also witnessed the rapid growth in the size and influence of the centrally planned and still relatively closed economy of China. Overall, governments are touching and steering a growing proportion of the world’s economic activity.
All of these phenomena, together with lingering questions about the sustainability of pre-crisis growth rates, could add up to substantial headwinds to economic growth and investment returns. A newly constrained banking system balks at very tight private-sector risk premia and lends only to sovereigns, crowding out productive investment. It no longer provides sufficient liquidity to capital markets to facilitate the smooth repricing of risk. Zombie companies set the marginal prices in the economy, exerting deflationary pressures. In the meantime, inequality grows between the individual saver who owns assets inflated by central bank policy and the individual saver with no assets who earns very little disposable or investable income above inflation.
We anticipate that the normalization of the pricing mechanism for capital in the developed world, not to mention the transition toward a more open and liberal market economy in China, will be a very gradual process.
Following a decade of official intervention to hold up asset markets, return outlooks are likely to be lower over the next decade while risk is likely to be higher.
- Longer Business Cycles
- Central Banks
- Market Liquidity
Our Three Investment Implications
1. Readying for the cyclical opportunity in corporate-debt downgrades
We think governments will try to monetize and inflate their debt away over time. Corporate borrowers have no such luxury. As the cycle matures over the next couple of years, growth is likely to slow down and interest rates are likely to rise. That could put pressure on companies that have exploited a long period of low volatility and low rates by taking on more debt.
Credit markets have deteriorated in quality even as they have grown. Over the past 20 years the average credit rating has fallen from A to BBB as more and more companies have succumbed to the attractions of cheap debt. The search for yield by investors has fed exceptional growth in BBB rated bonds as well as high-yield loans, European corporate debt and emerging markets debt.
We expect the credit cycle to turn at some point over the next two to three years. When that happens, a considerable “threshold risk” could be realized as a substantial proportion of the bloated BBB market is downgraded from investment grade to high yield. Many credit investors are able to hold only a limited amount of non-investment grade debt. They have been joined by institutional investors facing post-crisis capital-requirement regulations, such as Solvency II, that make it prohibitively capital-intensive to hold onto bonds that have been downgraded to high yield.
Yet another set of post-crisis regulatory interventions—in the form of the Basel III banking accord and the U.S. Dodd-Frank Act—has made it much more capital-intensive for investment bank broker dealers to “warehouse” securities on their balance sheets. Those inventories are used to make markets and provide liquidity to clients as they buy and sell stocks and bonds; as they shrink, the liquidity of the public markets dries up and the potential for gaps in pricing, and higher volatility, rises.
The wave of forced selling of downgraded bonds is therefore likely to be larger than in previous cycles, and the capacity to bear risk much lower at broker dealers. Specialist high yield investors struggling to absorb all of this new supply are likely to demand substantial discounts.
Credit markets got a small taste of that dynamic in 2015, when a number of BBB rated bonds from the commodity sectors had to be discounted as low as 50 cents on the dollar to be absorbed into the high yield universe, before heading back toward par over the next 12 months. We anticipate a large opportunity for high yield investors in the more stressed parts of the market, beginning as the credit cycle turns in two to three years and lasting for perhaps a year or two thereafter. That could be an opportune time to establish some core positions to carry through the ensuing recovery, taking us toward the 20th anniversary of the financial crisis in 2028.
2. Rethinking risk diversification in long-term investment portfolios
The financial crisis was, above all, a credit event, and a good reminder that fixed income and credit can be subject to major loss events and long periods of poor real-terms performance. In fact, three decades of declining interest rates may have allowed investors to forget that, before the 1980s, the number of long-term periods of poor total returns for bonds is far greater than for equities. Of the 81 rolling 10-year periods since 1927, the total return to the 10-year U.S. Treasury bond was greater than the total return of the S&P500 Index in only 13. Long-term bond outperformance was seen during only three periods: from the late 1920s through the ‘30s, from the late 1960s to the late ‘70s, and between the late 1990s and 2011.
Since the financial crisis debt has exploded in both the sovereign and corporate sectors. The Great Disinflation of the past 30 years, and its attendant bond bull market, may be coming to an end. As yields have fallen they have caused a mechanical lengthening of duration, increasing the interest rate sensitivity in bond markets. All of these phenomena raise important questions about what constitutes a “low-risk” asset and how to balance risk in a long-term investment portfolio.
We believe a viable solution for income investors has three elements. First, it involves seeking higher yields from alternative sources of income, from emerging markets debt to loans, real estate securities, high-dividend equities and options-writing strategies. Second, it requires investors to exploit the risk-reducing power of diversification to the fullest. Finally, it calls for dynamic asset allocation to recognize the very cyclical nature of the performance of alternative income investments.
Alternative sources of income undeniably can be less secure than the income from investment grade bonds—but it is important to understand that steps like these do not simply add risk to portfolios, but rather exchange one type of risk (that is, interest rate risk) for a range of others. Thoughtfully combined, alternative sources of income can diversify away a lot of the extra risk associated with holding them individually.
In a new era of low income from traditional sources, higher interest rate downside risk, higher volatility and higher cross-asset correlations, rethinking the best way to get both income and diversification in long-term investment portfolios will be a signature challenge.
3. Sharper distinctions between passive, smart beta, quantitative and active management
When the capital cycle is suppressed and authorities intervene more in the pricing of risk and the allocation of capital, the role of active asset managers comes into question. At the same time, the prevailing global debt burden is likely to suppress global growth and market-level returns, putting more pressure on investors to generate excess returns at lower overall cost.
Cost-effective does not always mean “cheapest.” As asset management fees become more competitive, investors will increasingly focus on the alignment of interest embedded in fees and fee structures. That means active managers will need to be clearer about their value proposition—the risks they take to generate meaningful excess returns, and the resources they dedicate to researching and taking those risks prudently. We believe that a process behind a good track record can and should command a premium even from cost-conscious investors. Those processes may involve deeper research and analytical resources, more active and engaged ownership of portfolio companies to add value over time, and full integration of the big data that companies and their customers leave behind them in our increasingly digitized age.
These developments will continue to blur the dichotomy between passive and benchmarked-active strategies. We will move toward a more considered differentiation between commoditized passive and smart beta, scalable active quantitative strategies, genuine high-conviction and engagement-based active management, and the increasingly important private markets.
Taking market risk more purely and cost-effectively should free investors’ cost and risk budgets for more focused alpha generation. Sharper distinctions between alpha- and beta-focused strategies should also enable investors to manage their risk budgets more tactically, recognizing that the balance between market risk and idiosyncratic risk can be dialled up and down with the perceived “alpha richness” of the environment through time.