I am Warren Peace, Acting Chief Economist from Fensitter Global Bank and today I am reporting on our latest research into the perennial, perpetual and unending question of whether this time it’s different or maybe it’s not because the future trends in financial markets and their recent performance depend on both inflation and deflation as nobody expects rates will rise significantly and they clearly can’t fall much unless they go into further negative territory and we said rates could never go negative but they did because central banks know nothing about the effect of QE as it’s all an experiment in managing the economy because they have created a bubble with their easy accommodation and fat balance sheets and debt will never be repaid and certainly not in those basket case European countries ...
... while every bond manager with any duration in their portfolio hopes rates won’t rise and I know you Australians don’t invest in bonds directly anyway so who cares but you might worry if the Fed raises rates but they won’t go above 2% for many years as we have a structural decline in inflation so we will never have any more inflation until we do mainly due to the poor pricing power of companies and the rising competition from companies such as Amazon and the market will rise on PE expansion but technical change is disrupting previously powerful companies and let’s face it traditional media is stuffed because all the advertising revenue is going online ...
... and with increasing unemployment there’s no wage pressure which will keep standards of living and inflation low and gradually over time lead to greater inequality where the top 1% of the population own 30% of the wealth and that’s simply the capitalist system so it gives incentives to people to work harder and not go on welfare and there should be tax cuts for wealthy people and more incentives to save for retirement because in another 30 years there will only be 2.5 workers for every retired person and not enough taxes to fund health and education so poor people had better look after themselves because high earners will not tolerate rising taxes as they will take their manufacturing jobs offshore and stop putting money into collectibles ...
... and in any case the Fed wants to stay in front of the curve because they sometimes get behind the curve and they don’t like it as inflation can start to rise which might reduce the amount of government debt in nominal but not real terms seasonally adjusted which happens when you’re behind the curve but it will play out over the long term and in any case, equity market valuations are stretched with record high PEs and a market at the end of a 10-year bull cycle and running out of steam although it might last two to three years longer and maybe five but I don’t see a correction in the next few months and most of the gains have come from the tech stocks and the majority of companies have been buying back their own shares because they have nothing better to do with the money to keep share prices up and boost the value of executive options ...
... but a rising tide lifts all ships and if the market did fall it might represent a buying opportunity or then it might not depending on whether markets subsequently recover and if you look on the screen behind me you can see in this incredibly complicated chart that it happened before in ’97 and ’07 and it may happen in '17 although I do think this time might be different due to lower interest rates and inflation which means the future cash flows are discounted by a smaller factor although there’s doubt about the equity risk premium and modern portfolio theory and just about any other theory that’s ever been proposed as they are not working now ...
... nevertheless, as long as our fund managers continue to earn 2% fees and their incentives are lined up with performance fees especially if they have limited capacity and then the finance industry will increase its share of GDP which will help the economy and property markets especially at the premium end but don’t start me on property because we are in a bubble but who knows how much illegal Chinese money is coming in although based on what I’ve read about CBA laundering there’s a hell of a lot going out as well but when you can finance a house at low interest rates then what will happen to these people when rates rise is they will not be able to afford the repayments and they will have no money left to send their children to private schools as is their right as long as the government does not cut funding and put more into public schools which would be a disgrace but I’ve drifted off the subject ...
... so back on it you need a diversified portfolio which can withstand major market falls which I’m not predicting immediately but you should expect one in the next 10 years or maybe 20 years so don’t buy your children a house because you might need the money if you are caught like the tech wreck or the financial crisis so you could allocate more defensively or do nothing so we need to focus again on China and its growing middle class who like to travel to Australia but they often work for state-owned organisations and 100 million people are moving from rural areas to cities over the next five years or is it 10 and with the increasing influence of emerging markets you should worry when they borrow in a foreign currency due to the potential for a strong US dollar leading to an emerging markets crisis although I’m not predicting that will happen even though they rely on imported capital but who are we to speak with a four trillion Fed balance sheet being reduced to $2 trillion and it’s still a lot of debt but emerging markets are not one single market and they are less vulnerable based on commodity prices anyway ...
... back to whether you should go more defensive you know these days with the advent of ETFs it’s easy to invest in anything and most active managers do not outperform the index because there’s so much flowing into index funds that it’s a trap once these flows stop especially if there is poor liquidity in the underlying securities but it’s possible to identify some good managers although their styles do not outperform in all market conditions and you need to watch survivor bias and I expect active managers to outperform over the next 12 months except for those who don’t and it’s not only results but risk and volatility which might be a special concern when growth stocks outperform value although that’s already been the trend so watch for mean reversion when companies do not produce returns which exceed their cost of capital and they are less resilient in a changing world adding more beta risk so why even worry about alpha and don’t forget delta and gamma ...
... if you can hedge them away but Buffett says hedge funds can’t outperform the S&P500 over long time periods and don’t you hate it when people quote Buffett although less so in recent years whereas we follow a hundred major indicators in our research which show there are no risks in the next few months but you need to protect your portfolio especially long tails on the right hand side and we also watch secondary influences in our quant model such as covenant light loans especially later in the cycle and going up the risk curve as people avoid quality assets leading to a three standard deviation event and what about correlations across asset classes when you think you’re diversified ...
... so did we in the GFC and our clients complained and we said it had never happened before so it was not our fault and how are we supposed to know to the exact day because we said the market had risks and you need to keep some dry powder and avoid complacency but you’ve had 25 years of economic growth yet your economy no longer produces much except for food and minerals and you import all your cars and electrical goods which will be cheaper when Amazon arrives so don’t worry about the currency and don’t get me started on Donald Trump.
I hope that’s clear. Any questions?
Warren Peace III is Acting Chief Economist at Fensitter Global Bank and all his assets are held in a bankruptcy-remote family trust in the Cayman Islands so there is no money available even if he were responsible for this article which he is not because he is only acting (and apologies from Graham Hand if this stream of consciousness is difficult to read on a mobile device).