This time ten years ago we were aghast at the vehemence of a Global Financial Crisis which threatened a systemic crash of the global banking system, brought down Lehman Brothers and triggered a widespread collapse in the prices of risk assets. Yields on US Investment Grade bonds peaked at just over 8% (4.1% at time of writing), yields on US High Yield bonds soared to over 20% (currently 6.3%) whilst the Standard and Poor’s US Equity index by March 2009 had finally slumped to its low of 677 (currently 2751).
The extent of the shock to the global system convinced many investors that we were in a “new normal” economic environment of low inflation and slow growth that in turn would result in an extended period of low investment returns. Ten years on we see that global growth has indeed been sub-normal whilst inflation has remained in very low ground.
Asset returns, however, over the past ten years have been dramatically good. Quantitative Easing (QE) by the developed world central banks has been the dominant driver of this outcome. The central banks, led by the US Federal Reserve, have amassed vast holdings of government bonds and other high quality assets, driving yields to extraordinarily low levels. The low returns available on high quality assets have driven investors into riskier assets in the search for yield. In total, the central banks have, through QE, bought assets to the value of some $14trn. To put this number in context, it equates to about 20% of global GDP.
Now however it is clear that the peak of QE volumes has passed. The Federal Reserve has begun unwinding its QE purchases. The European Central Bank has slowed its rate of purchasing and is expected to stop altogether from the beginning of next year. Central bank purchases peaked in 2017. They are currently falling and are expected to reverse, i.e. dip into negative territory, in the middle part of next year. (Chart 1)
Chart 1: Q.E. The Critical Driver
The impact of QE on corporate bond yields and on global equity markets is illustrated in Chart 2.
Chart 2: Q.E. and Markets
Of course, QE was not the only influence on markets during the period. Bond markets benefited from low inflation and improving government finances whilst equity markets benefited from economic recovery. Nevertheless, it seems to me that by far the dominant influence on markets over the past nine years was QE. If that is indeed the case, the expected path of QE, as shown by the dotted line in Chart 3 is cause for concern. The ending and eventual reversal of QE will mark a fundamental and negative watershed in the supply/demand balance in asset markets.
Chart 3: Q.E. and Markets
On its own the ending of QE would constitute a significant hurdle for markets. Worryingly, its demise coincides with some other causes for concern.
The long-running economic recovery, underway since mid-2009, is mature. The US economy, still the engine of the global economy, is operating close to full capacity with unemployment at 3.7% running at its lowest level for 39 years. There is clear evidence of upward pressure on US wage rates. The Federal Reserve has already increased interest rates to just over 2.0% with more increases to come. The yield on the 10-year US Treasury Bond has risen to 3.15% from a mid-2016 low of 1.6%.Remember that the equity market does not react to but rather anticipates future events. The equity market typically peaks some six to twelve months before the economy reaches its peak.
There is little support in market valuations. Bond yields, particularly in Europe, offer extraordinarily poor value to long term investors. Equity valuations this year have benefitted from strong corporate profits growth, helped by tax cuts, but still look extended on a longer term, cyclically adjusted, basis. International equity markets, already in negative territory year-to-date, don’t look as expensive in valuation terms as the US but it is difficult to make money in any equity market when the US market is in retreat.
Market valuations do not normally act as a precise timing signal for market inflection points. However, they do provide a useful indication for long term expectations of investment returns. Typically, when valuations are low (i.e. yields are high) at the beginning of a period, subsequent long term returns are high, e.g. in 1942 and 1983 in Table 1 below.
Table 1: Valuation Matters: Valuations & Subsequent Returns
On the other hand, demanding valuations in 1966 (i.e. low yields) were followed by low long term returns. The current period 2009-2017 is the anomaly when low initial yields were followed by very strong returns. This I attribute to the influence of QE. It is difficult to avoid the conclusion that we should have modest expectations for investment returns over the next ten years. I’ve compared in Table 5 my own back-of-an -envelope expectations for future returns with those of BCA, a highly-respected independent research house, alongside historical returns.
Table 2: Expected Returns
Finally, there are some “straws-in-the wind” which strike me as akin to the types of excesses that often emerge towards market peaks. Overall global debt levels are higher now than those prevailing before the Financial Crisis. There has been a particularly sharp pick-up in US Corporate debt and this has been applied more to financing share buy-backs rather than to capital investment (Chart 4).
Chart 4: Corporate Debt
Moreover much of this borrowing is “covenant light” (i.e. offering less protection to investors) at 73% of new issues compared to 29% in 2009. Investor leverage (i.e. borrowing by investors to invest in the markets) is running dramatically ahead of the levels which prevailed at the previous market peaks in 2000 and 2007. Finally, Collateralised Loan Obligations (CLO) issuance has returned from the grave and is now running at three times the 2007 level. Admittedly, the rules around CLO issuance have been tightened, but three times the 2007 level is surely sufficient to dampen the enthusiasm of even the most committed optimist.
To summarise, Q.E. has been a tsunami of support for financial markets since 2009. This tide is now turning and will shortly go out. Valuations are demanding and economies, corporates and investors are over-borrowed. Investors are over-complacent. It is difficult to forecast an inflection point for markets but it is even more difficult to avoid the conclusion that any realistic expectations for long term returns from current market levels should be modest, at best.
I conclude that it is time to increase our focus on capital preservation and to move client portfolios to a more cautious stance. J.P. Morgan, when asked to reveal the secret of his success, replied “I always sold too soon”.
Author: Frank O’Brien is an Independent Pension Fund Trustee