Building on fault lines - Angles & Perspectives Q1 2023

The bigger point is not necessarily predicting what the next area of fragility will be, but rather that significant parts of the financial system are ‘built in the wrong place’ and will prove unable to weather sustained higher rates and tighter liquidity.

The biggest monetary policy experiment ever is going to have unintended consequences
What are the long-term implications of more than a decade of zero interest rate policy in most developed economies, and nearly 25 years of zero or negative rates in Japan? This question has deeply concerned us, not just because of its importance for investment positioning in the years ahead, but also because very few market participants appeared to share our sense of unease.

That appears to be gradually changing. With the rise in interest rates and increase in macro volatility, some pockets of risk are being exposed. Two large ‘fault lines’ have already been revealed. The gilts sell-off in the UK triggered the liability-driven investment (LDI) crisis amongst defined benefit pension funds in 2022. US regional banks are currently in the spotlight, their business franchises being pressured by both the substantial declines in the value of their hold-to-maturity investment portfolios and their difficulties in retaining deposits when money market investments offer more attractive rates.

Ignoring history in the hunt for yield
We believe that these events are most likely just symptoms of the deeper underlying problem built up over the long period of low rates and suppressed economic volatility. In particular, in the decade-plus hunt for yield, very substantial duration risk has been accumulated across the financial system. We liken this to building cities on a fault line or in a flood zone because the last disaster was so long ago, its consequences have been forgotten.

Which fault lines could be revealed next? Three areas stand out as having elevated risk:

• Japanese banks, especially regionals and Shinkin banks, have huge bond and collateralised loan obligation (CLO) portfolios, with the Bank of Japan (BoJ) still needing to end yield curve control (YCC) and normalise the curve.

• The private debt and private equity markets typically involve large amounts of floating rate leverage, have grown to a massive size and are opaquely valued.

• Commercial real estate, in particular the office sector, is also highly leveraged and suffering from spiralling vacancies, yet capitalisation rates used for valuations are still very low.

Main Street has been doing just fine despite higher rates
The US Federal Reserve (the Fed) has been attempting to correct its misdiagnosis of the inflationary environment in 2021 and 2022 by rapidly raising interest rates. While inflation was a key concern for the median voter (driven primarily by higher gasoline and food prices), the Fed has had strong political support for its actions so far.

That the real economy has held up so well despite the rate hikes to date has surprised many market participants, as the prevailing view was that after a couple of hikes a deep recession would ensue. US households in particular remain in a strong position, with low unemployment, rapidly growing wages, record funds on deposit (now earning significant interest) and the vast majority of their debt being fixed rate mortgages, which are unaffected by the hikes. Indeed, well-known hedge fund manager David Einhorn (Invest Like the Best Podcast, 27 March 2023) estimates for each 100 basis points (bps) of hikes, disposable household income increases by US$400 billion!

Policymakers constrained in their inflation fight
We see three important reasons why policymakers across the developed world will fail to reduce inflation sustainably to levels below their targets:

• Firstly, the financial economy is not in as resilient a position as the real economy, as illustrated by the proverbial fault lines described above. The current level of rates has already exposed financial sector vulnerabilities, and further hikes may trigger a much bigger and more systemic event. This means policymakers will be forced to reverse course and prioritise maintaining financial stability over fighting inflation.

• Secondly, we are in a period of secular inflation. The important drivers of inflation include tight labour markets and low productivity, a lack of investment in the ‘old economy’ sectors over the past decade, and a growing fiscal dominance in policy choices.

• Thirdly, the political will to prioritise fighting inflation quickly evaporates when the cost is a deep recession or financial sector upheaval.

Most developed market policymakers have never experienced this environment and have taken the wrong lessons from the narratives about the last major secular inflation period, the 1970s.

Killing demand does not solve secular inflation
This is not a normal cycle with excess demand driven by credit extension causing higher prices. The cyclical remedy that is normally so effective (i.e. raising interest rates) actually makes secular inflation pressures worse by reducing much-needed investment spending. The correct policy actions include encouraging investment in supply-constrained sectors and incentivising capital expenditure (capex) spending to improve labour productivity while easing immigration barriers.

Expect macro volatility and put aside the secular stagnation playbook
At the intersection of policymakers’ actions and massive financial fragility lies macro volatility. Most developed market participants are not familiar with this kind of environment. They cut their teeth in the era of secular stagnation, where macro factors had muted, if any, market impact. Emerging markets, largely ignored for the past decade, have provided a much better training ground for the volatile macro environment that faces investors in the years ahead.

What this means for portfolios
The old sources of diversification and protection have proven ineffective during 2022, and we expect this to continue. A backward-looking and volatility-driven risk process will push investors towards assets built right on our fault lines. Long duration assets, including long-dated developed market (DM) bonds and growth stocks – (the ‘go to’ assets in the secular stagnation world), look particularly ill-suited to weather the macro volatility ahead. We would urge investors to think about risk more holistically and avoid the knee-jerk reaction of buying the previous regime’s winners during the periods of inflation suppression.

This is an environment that favours short duration assets, where risk mitigation comes from very low ratings, low leverage and the prospect of receiving a significant portion of your purchase cost back in capital returns within a couple of years. The old economy is traditionally viewed as very macro-sensitive, so investors anticipating weaker growth sell counters associated with it aggressively. This is likely to cause very volatile performance, but also provide generational opportunities to increase holdings in fundamentally advantaged companies at deeply discounted ratings.