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We are sometimes told that value investing will never work again because interest rates are going to stay permanently low thus favouring bonds and bond-like equities. Ignoring the fact that there is no long-term evidence of a correlation between interest rates and relative performance of growth versus value, and that interest rates appear to have hit a floor, these claims seem to assume that inflation will never be an issue again. That certainly seems to be the view of most investors.
In response to the economic damage caused by the UK lockdown, the last few weeks have seen the introduction of fiscal and monetary stimulus on an unprecedented scale that must at least increase the probability of a rise in inflation at some stage.
This note looks at what new measures have been employed, their theoretical origins, and why they could stimulate inflation in the future. It should be clear that this is not a prediction but merely an attempt to challenge the prevailing wisdom that the world will remain locked in permanently low inflation or deflation. The conclusion is that investment portfolios built for a world of low inflation and falling interest rates might struggle if that economic backdrop changed and that investors might want to hedge for such a scenario.
Failure of monetary policy
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An equity investor’s guide to Modern Monetary Theory
Central bank’s post-financial crisis policy of cutting interest rates and quantitative easing is largely deemed to have been a failure. It has:
Failure of fiscal policy
Among other things, the global financial crisis was largely considered to be a problem of too much debt making the financial system extremely fragile. Governments have responded by taking on even greater levels of debt, albeit that much of it has shifted from the private to the public balance sheet. This has led some to suggest that there are negative consequences of continually increasing debt to GDP.
This debt has not created economic growth but instead has slowed it. In the past 20 years, the ratio of federal debt to GDP has leapt to 105% from 60% and GDP has grown at 1.2% a year, 37% below the long-term average. As Lacy Hunt of Hoisington Investment Management observes: “Large indebtedness eventually slows economic growth as resources are transferred from the highly productive private sector to the government sector.” Ultimately, more and more debt is required to finance every dollar of GDP.
The deficit is not self-financing as much of it is not put into productive assets, but rather used to fund welfare programmes.
Given these failures of post-crisis economic policy, it was not surprising that a new type of doctrine would be considered, and Modern Monetary Theory (MMT) is one such innovation.
In the UK, economists at Citi estimate that the Treasury will borrow £273bn this year taking the deficit to 14% of GDP (compared with 25% in the Second World War), and it is expected to remain above £100bn until 2024/25. A leaked Treasury document discussed in The Daily Telegraph outlined an even worse scenario in which “the Treasury’s own ‘base case scenario’ for its budget deficit by the end of this financial year is £337bn – more than £280bn more than pre-pandemic forecasts“. The Treasury’s “worst-case” scenario is for a deficit of £516bn, although in the most extreme case it could be as high as £1.2trn.
Altogether, the IMF estimates that so far, world leaders have committed to almost $8trn to battle coronavirus, which will drive debt up to dangerously high levels. They expect global debts to hit 100% of GDP, jumping from 79.6% in 2012. The IMF expects the burden on developed countries to rise to more than 120% of GDP this year with the US at more than 131% and Italy’s debt rising to more than 155%.
Fiscal response to the coronavirus crisis
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In a nutshell, MMT is the financing of government deficits via money printed by the central banks.
MMT has the potential to be immensely popular with the public and politicians alike since it effectively removes any limits on spending and allows the financing of projects likely to be popular with voters. Whilst I find it unlikely that full-scale MMT is ever going to be implemented given its inherent flaws, I do believe that a version of it is currently being trialled as central banks start to finance (implicitly if not explicitly) the ballooning deficits required to deal with the coronavirus crisis.
How likely is it that MMT will be implemented?
Returns for a convertible portfolio come from volatility
Returns for a convertible portfolio come from rates
The duration of convertibles tends to be shorter than for straight corporate debt, and nearer-term maturities may be preferable now at a time of high uncertainty compared with the greater repayment risk for a long-dated bond.
Second, convertibles have fewer of the frictions and challenges from passive flows that exist in corporate bond markets. For example, an ever-larger cohort of investment grade bonds have ratings in the BBB band. Should these issuers get downgraded, some active portfolios as well as ETFs may be forced by mandate to sell, and the high yield investor base may not be able to absorb these fallen angels quickly. We also note an observation from one of our counterparties that convertible trading volume has been 2.0 to 2.5x the size of the market, while for high yield the comparable figure is 1.0x.
First, there is clearly elevated volatility in markets, and the enormous uncertainty around the coronavirus outbreak means that the playbook
of the Great Moderation, where markets move higher after central banks
step in to keep rates and volatility low, is pretty much out the window.
As noted, higher volatility is an environment that suits convertible bonds,
and if separately valuing the combination of a bond plus option and solving
for market prices today, embedded options are trading at cheap levels not seen since 2008-2009.
Compared with the typical corporate bond issuer, especially in high yield,
the issuer mix for convertibles is quite different. There tends to be more tech and healthcare issuers, but fewer energy, deep cyclical, or transport-related issuers. It is true that many corporates choose the convertible market because of flexibility to accept non-rated bonds, but it is possible to build a portfolio that is investment-grade quality on average.
1. Elevated volatility
2. Less friction
3. Different mix
4. Shorter duration
What is Modern Monetary Theory?
Money is a creation of the state and therefore sovereign governments cannot run out of money as they can always print more. This also means a government will never default on its debts since it can always print money to meet the debts coming due.
A government can borrow as much as it likes if it is not owed to other nations. It is feasible to keep bond yields in check if your central bank is buying most of your debt, but if you are reliant on the ‘kindness of strangers’ then
you are at risk of a buyers’ strike
in government debt and a sudden surge in bond yields.
Ian Lance has thirty years of experience in fund management and started working with Nick at Schroders in 2007 before joining RWC in August 2010. Whilst at Schroders he was a senior portfolio manager managing the Institutional Specialist Value Funds, the Schroder Income Fund and Income Maximiser Fund together with Nick. Previously Ian was the Head of European Equities and Director of Research at Citigroup Asset Management and Head of Global Research at Gartmore.
Nick Purves joined RWC in August 2010. Nick worked at Schroders for over sixteen years, initially starting as an analyst before moving in to portfolio management where he managed both Institutional Specialist Value Funds and the Schroder Income Fund and Income Maximiser Fund together with Ian Lance. Prior to Schroders, Nick qualified as a Chartered Accountant.
John Teahan joined RWC in September 2010. He was previously portfolio manager at Schroders where he co-managed the Schroder Income Maximiser with Nick Purves and Ian Lance. In addition he co-managed the Schroder Global Dividend Maximiser, Schroder European Dividend Maximiser and Schroder UK Income Defensive funds, all three of which employed a covered call strategy. During his time at Schroders John also specialised in trading and managing derivative securities for a range of structured funds. Previously he worked as a performance and risk analyst for Bank of Ireland Asset Management UK. John is a CFA Charterholder.
The BoE has restarted its QE programme and plans to buy another £200bn of bonds, in addition to the £445bn of bonds the bank already owns, but at a recent Monetary Policy Meeting two members of the committee voted to increase this to £300bn. The BoE is now directly monetising the deficit through the expansion of the ‘Ways and Means’ facility, which will allow the government to bypass the bond market entirely until the Covid-19 pandemic subsides, financing unexpected costs, such as the job retention scheme.
The government announced it would extend the size of this facility from £370m to an effectively unlimited amount, allowing ministers to spend more in the short term without having to tap the gilts market. In 2008, a similar move saw the facility rise briefly to only £20bn.
The BoE are insisting this is not helicopter money because it will be temporary.
Monetary response to the coronavirus crisis
Some have suggested that this increase in money printing will not lead to inflation because previous QE did not lead to consumer price inflation.
QE merely changes the composition of private sector savings from bonds to reserves, while it does little to change the level of savings.
As John Hussman explains: “Quantitative easing is nothing but an asset swap. It doesn’t change the total amount of government liabilities in circulation. It only changes the form of the government liabilities that must be held by the public. The central bank buys government bonds and in return it creates base money (currency and bank reserves) that must be held instead. What QE does not change is the total quantity of government liabilities in circulation. That decision isn’t under the control of monetary policy but is instead determined by fiscal (tax and spending) policy.“
Thus, while QE failed to create consumer inflation, it generated much
asset price inflation due to huge reserve creation that worsened
Why did previous QE not lead to inflation?
Others have also suggested that the near-term outlook is more likely to be deflationary than inflationary. In the near term, rising unemployment, increasing levels of bankruptcies, debt defaults and a hit to both household and corporate income will likely be deflationary.
Near-term outlook is deflationary
For at least the 12 years since the financial crisis ended, investors have been used to an investment landscape in which interest rates fell, central banks printed money without any inflationary consequences and nearly all asset classes went up. Within equities, long-duration stocks (quality and growth) went up the most, and businesses were encouraged to take on ever-increasing amounts of debt via share buybacks, which also had the side effect of driving their shares prices up.
I might be wrong, but it does not feel like the next 10 years is going to be business as usual and I do wonder whether we might be witnessing the start of a regime change in which governments run significantly higher deficits financed in a major way by central bank money printing.
Investors need to be aware that the central tenet of MMT is that government spending is not limited by debt and deficits but merely by inflation. The idea that there is someone inside a government department who can spot inflation in advance and then persuade politicians to increase taxes or cut spending is fanciful. In which case, it seems to me that governments have been given the green light to massively increase spending, debts and deficits and will only stop once inflation has become established. Just as toothpaste is hard to get back in the tube once it has been squeezed out, so inflation is hard to bring under control once it has taken hold and changed consumers expectations.
In this new MMT world where inflation becomes a higher risk, investors will have to adjust to an investment landscape that has not been witnessed since the 1970s. Specifically, they might think about the following:
• Equities and bonds could become positively correlated but do badly at the same time which as was the case in the 1970s. This would create difficulties for strategies based around the idea that they were negatively correlated such as the traditional 60/40 portfolio and risk parity.
• In the 1970s, real assets performed much better than financial assets: commodities produced a real return of 23% during the ’70s but gold produced a real return of 553% during a similar period. Unsurprisingly, within equities, the best-performing sectors were those that benefited from rising commodity prices such as energy and materials.
• The final lesson is that starting valuation counted for a lot during this decade. The chart below from Research Affiliates shows that the valuation spread between value and growth was very significant at the start of this decade (bottom line) and that subsequently, value stocks outperformed significantly (top line). Point E on the chart represents current conditions where the valuation dispersion is even greater.
What would investors need to do differently?
Anyone who has predicted any increase in inflation in the last decade has been wrong and will now be compared to the little boy who cried wolf. This can, of course, create complacency in investors who assume that because inflation has not occurred recently, it will never happen again. As I stated earlier, this is not a prediction that inflation is imminent, but it is evident that continued very low inflation is being priced into financial markets. Given this widespread certainty that the status quo will continue, a shift in the level of inflation expectations would have serious consequences for asset prices.
As I have argued above, recent policy initiatives are both different and far larger than previous actions (and I don’t believe they are yet exhausted) and this must suggest an increase in the likelihood of inflation occurring at some stage. I would never attach a probability to this but I know it is not zero and hence we believe investors would be wise to think about altering their asset exposure to at least give them some protection in the event that financial markets start to price in a rise in the level of inflation.
Increased inequality by boosting the prices of assets mainly owned by the wealthiest and hence fuelled the rise of populism
Created a series of asset bubbles that are now in the process
Failed to generate inflation above 2%, which is the objective of most central banks
Failed to generate sustainable levels of growth
Finally, although these policies were originally justified as a temporary response to the Great Financial Crisis (GFC), they were not unwound before the latest downturn. This meant that central banks had nowhere to go when the latest downturn struck and went into this crisis with interest rates near zero (or negative in some cases) and with bloated central bank balance sheets.
Ratio of federal debt to GDP, up from 60% in past 20 years
Growth in GDP per year, 37% below the long-term average
4. Shorter duration
3. Different mix
2. Less friction
1. Elevated volatility
Fiscal spending should be disconnected conceptually and practically from its financing. Spending should be focused on achieving full employment and should not be limited by deficits.
MMT‘ers believe that the only constraints on spending are the real resource constraints of the economy, and that inflation will result if spending is increased to a level beyond the productive capacity of the economy. Basically, anything (Medicare for All, Green New Deal etc) can be financed by printing money so long as it doesn’t trigger inflation. This means the government takes a greater role in the allocation of resources in the economy and reduces the influence of the private sector.
Taxes are not used to finance government spending (as this
is financed by money printing)
but instead are used to slow the economy down.
‘Just as toothpaste is hard to get back in the tube once it‘s been squeezed out, inflation is hard to bring under control once it has taken hold and changed consumers‘ expectations’
The other interesting analogy with the 1970s is that the index was dominated by a handful of quality growth companies so adored by investors that they started the decade on very high valuations. These stocks became known as the Nifty 50 and were a group of high-quality stocks such as Xerox, IBM, Polaroid and Coca-Cola. Most of these stocks were leaders in their industry, with strong balance sheets, high profitability, proven high growth rates and continual increase in dividends. This seems eerily familiar to conditions today as the valuations of quality growth stocks re-rate ever upwards.
However, even though these market darlings delivered expected profitability, the total returns to investors were disastrous and the Nifty 50 group underperformed the market by c. 40% over the following four years. Investors owning today’s quality growth cohort would do well to heed this lesson if economic conditions ever again mirrored those of the ’70s.
Why might the inflationary risks be greater than with previous QE?
Although the near-term outlook seems to be deflationary, it is important to note that the current economic policies are not identical to those used after the GFC, which means it may not be correct to assume identical effects.
1. Scale of
the monetary intervention
2. Coordinated monetary
and fiscal response
3. These deficits are being funded by central banks
4. The loss of central banks’ independence
5. Will politicians stop?
6. Supply shocks
Projected debt/GDP paths until 2030
HML value factor performance and relative valuations, US,
Jul 1963 - Mar 2020
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