What is The Solution When The Biggest Credit Bubble of All Time Bursts?
Skerritts View – August 2017
We said at the end of our last piece that we would address this question this time. So, what do you do when the level of global debt has stretched so far that it becomes impossible to pay it back without the Central Banks stepping in to do it for you?
Why, after a brief pause for reflection, you borrow more, of course. According to the table below, global debt has never been as high as it is today. What may the consequences be for us all?
Why do equity markets continue to test all-time highs against a backdrop which tests many a fundamentalists credulity? If you think about it, this is as it should be in a successful capitalist economy so, in some ways, should come as no surprise. But then things are not exactly normal are they?
Firstly, the bailouts of the Financial Crisis in 2008 effectively shifted the debt burden from the private to the public sector. This has created a cycle that is very hard to break.
According to Canaccord [US Equity Research July 2017], US pensions have become the dominant global investor, requiring a 7.5% per annum return in order to fund public pensions liabilities due to previous losses and underfunding. This has led to more aggressive credit funds launching (over 1,200 in the past year and a half), which buy eye-watering amounts of corporate bonds. CEOs join the circle in trying to keep share prices high, to reward their stock options, by using the massive cash inflows through the debt market to buy back their shares.
The investors who focus upon fundamentals can’t match this behaviour with their traditional analytic methodology and are ready to sell at the drop of a hat, leading to more frequent market corrections (we touch on this later). But, as this is primarily a credit-led equity bull market, the credit cycle will come to an end, as always, and when cycles end this tends to be bad news for equities. In a classic “God giveth with one hand and taketh with the other” statement, Canaccord predict that “this cycle is likely to persist for some time” (hooray!) but “it is likely going to end with more systemic risk than the prior cycle did, potentially leading to a more intense crisis than was seen in 2008” (yikes!).
They conclude that the credit bull market will persist for between 3 to 5 years.
Further good news could be found in a recent BCA report in which the author gave his opinion that, despite some short term volatility, we can expect markets to largely proceed in an upward direction until at least the second half of 2018, at which time some darker clouds may be gathering which could signal the onset of a global growth slowdown. This would have the potential of developing into a global recession. At that point, current profit forecasts (and thus equity valuations) could come into serious question with “perhaps a 20%-30% correction as a consequence”.
The good news in this is, of course, that such a problem may not be imminent (as many investors appear to fear).
Even more investors appear to have been lulled into a sense of complacency however, if we listen to their views on volatility at present. Two common beliefs can be misinterpreted or forgotten. First, equity markets tend to advance gradually then sell-off suddenly. Second, observed volatility is not a measure of riskiness.
The first point leads to the second.
If we take the first point, the Eurostoxx 50 is at the same level now as it was in mid-2008, effectively going nowhere in that time. Of course, the true picture is far more revealing and there have been 55% up weeks in this time, and only 45% down weeks. Thus, by definition, the average up week has been less positive than the down weeks have been negative. Indeed, the best week saw a gain of 11.5%, whereas the worst week saw a loss of 25.1%.
In other words, equity markets amble up the hill, but jump off the cliff to get back down.
This pattern reflects itself in the volatility measure though, as sharp moves in either direction increases the observed volatility. So when the equity market advances, as now, in a prolonged reasonably gentle manner, the observed volatility is low. The longer this pattern continues, the lower it gets (see graph), but the biggest risk of all is that investors (and computer-driven algorithms) think that lower observed volatility equals lower risk. This is absolutely not the case. In fact, if anything, it could be the exact opposite.
Annoyingly, no one knows. It’s a bit like driving at night across Beachy Head, off-road and with no lights on. You know the danger is there; you’re not sure where the danger actually lies; but keep driving around for long enough and the likelihood is you’ll drive off the cliff eventually.
We manage our funds with one eye on the cliff edge. Are we one year, three years, five years away? We can’t tell, but we think it is better to be cautious than blindly reckless and treat information that comes our way with suspicion. If, like us, you believe in this being a relatively new era in which the newest set of rules have yet to be written, we will treat the old rules and measures warily. Like free lunches, there are no such things as low risk equities.
BCA Research August 2017
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