This month is the ten year anniversary of the beginning of the credit crisis in June 2007. Whilst things got a lot worse over the next 21 months into the lows of March 2009, asset prices have risen a long way since then. If you want to understand why asset prices have done so well since then there’s three drivers you need to grasp.
Firstly, governments responded to reduced private sector demand by stepping up stimulus spending. That’s slowed a little in more recent years but government debt to GDP now is way above where it was 10 years ago and is still rising. In a normal market that growth in debt would have seen the interest rates paid by governments increase but that hasn’t happened.
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The second key driver and the reason that interest rates have fallen so far is the actions of central banks. By sending reserve rates to zero and below, and by printing far more money than was needed to cover the increase in government debt, central banks killed the normal incentives to save and invest. Why bother engaging in productive business activities when it is far easier to speculate through borrowing money and buying existing assets.
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Thirdly, yield chasing by investors has allowed global debt levels to increase. The combination of low rates and lack of supply of government debt (see no.2) saw investors pushed out to riskier asset classes. This enabled the boom in high yield debt, emerging market debt and consumer debt at interest rates well below historical levels. Companies have used additional debt to buy back their own stock and buyout competitors pushing stock prices up. Consumers used the additional debt to push up property prices and fund consumer spending. The graphic below from Morgan Creekshows how investors have had to change their portfolios to meet return targets.
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Those drivers have worked well for eight years, but each of the three drivers is now at risk of reversing. Government debt in some countries is at levels where it is tough to see the country ever repaying their debts. In many cases, the outright debt levels can appear reasonable but the addition of pension deficits means effective debt levels are unsustainable. Central banks are starting to raise rates and reduce money printing in the US and are talking about going in that direction in Europe. Finally, the stimulus provided by credit growth is now becoming a headwind as repayments reduce future consumption. The graph below from UBS shows how global credit is now growing at a slower rate than it has, pointing to economic growth rates being lower than they have been.
For investors, the gap between what is expected and what is likely to occur is widening. A recent survey by Legg Mason found that investors expect 8.6% annual returns, which is about what historical returns have been. The updated return forecast from GMO below shows there’s nowhere to go to get this.
If nothing else it is fun to chronicle the irrational exuberance that current markets bring. Cryptocurrencies have boomed this year but experienced wild volatility this month. The second biggest cryptocurrency, Ethereum, has been called a bigger bubble than tulips after rising 3500% in six months. The CAPE ratio of the S&P 500 above 30, a level only surpassed in the lead up to the great depression and the tech wreck, is quite tame by comparison.
In credit new money is pouring into leveraged loans and private debt at a time when covenants are falling away in the US, Asia and Europe. Edward Altman sees high yield conditions as bad as they were in 2007 but Bloomberg has five reasons not to be worried about high yield debt. Emerging market credit spreads are the lowest since 2007 and weaker countries are growing their share of the outstanding debt. Does risky debt + low margins = credit bubble?
I can’t finish this section without highlighting some positive economic news during the month. The US is seeing strong growth in income tax withheld this year, although it has started to trend down. German business confidence is at the highest level in 26 years. Britain has recorded its best factory orders in nearly 30 years. It’s not all bad out there!
Guest post from Jonathan Rochford, CFA, Portfolio Manager, Narrow Road Capital Pty Ltd