Thoughts through the cycle: W3 December ’20

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Love in a cold climate – can you save in a zero-rate world?

  • The ‘bricks to clicks’ phenomenon which describes the shift in retail buying habits from high-street shopping to online purchasing is not new, but the restrictions imposed by the pandemic have accelerated the process. While headlines focus on the demise of Debenhams and the inexorable rise of Amazon, the lack of footfall on the high street, both as a cyclical and a structural issue, has much broader implications.
  • Given the decreed-from-on-high nature of lockdown and the arbitrary nature of restrictions and rules, it is only natural that government currently has a large hand to play in developments. For the high street, there has been a reprieve in the UK in the form of an extension on the commercial landlord eviction moratorium until the 31st December (‘UK extends ban on eviction of commercial tenants’, Financial Times, 09/12/2020).
  • The FT article suggests there is some confusion on owed rents and what is to be paid. The British Retail Consortium suggests that 80% of tenants have reached an agreement with their landlords on the status of money owed, while the trade body UKHospitality suggests only half of tenants have reached an agreement with landlords to defer or waive rents, with disagreement also on unpaid bills that have accrued this year. On the landlords’ side, the British Property Federation (BPF) is apparently happy that a firm date for the moratorium’s end has been established (don’t tell them about the Brexit deadlines..).
  • The amount of money owed is growing. UKHospitality estimates the figure to be £1.6bn by the end of 2020. With a harsh tiering system likely to continue into the new year and a growing realisation that the Covid-19 vaccines’ definition of ‘effective’ is somewhat wayward (apparently this does not mean people won’t die, nor that they won’t pass the virus on once vaccinated), then a return to normal feels like it is still someway off, at least until the warm weather reduces the virus’ potency.
  • In balance sheet terms, rent owed is a flow item. The stock aspect of the balance sheet is, if anything, more concerning. Not only has the high street taken a hit, but the WFH-phenomenon may yet prove to be a watershed in terms of work patterns with respect to offices and other professional working spaces. The two are linked – RWC’s own offices in Victoria, London, sit amidst a large new-build complex of shops, bars, restaurants and cafes. With fewer daily attendees in offices, the ecosystem of businesses surrounding could be permanently jeopardised. The value of commercial property will not escape a sharp lower revaluation.
  • Commercial property has become a key investment in terms of capital appreciation and income for a number of institutions, and any disturbance either to the flow or stock component of it will have consequences. There are of course the stories of absurd risk taking – the auditor KPMG has again in 2020 refused to sign off the accounts of Spelthorne Borough Council after it went on a £1.17bn commercial property spending spree financed by the Public Works Loan Board (PWLB). Local councils swinging the bat in the property market may ultimately be caused by funding cuts from central government, but it is nonetheless characteristic of a yield-searching mentality which is to be found in a low-rate world.
  • For much of the last 30-40 years, the classic 60/40 portfolio (60% equity and 40% bonds) has done a great job for pension funds and the like due to the negative correlation between the two asset classes. When equities roll over in a recession, central banks cut rates and bonds rally, partially offsetting the losses to equity. Cushty. Now there is a bit of a problem because rates are at zero and in some places negative, with little chance of any rate hikes any time soon (Chairman Jay Powell has gone on tape as saying the Fed ‘isn’t even thinking about thinking about hiking rates’). The graph below of the Barclays global aggregate of negative-yielding debt illustrates the problem well. The current total is now in excess of $18tn. Any new debt issued below zero guarantees a negative total return for the purchaser. Not ideal when your average pension fund has a target actuarial return of 7% per annum. The underfunding of pension funds and the overestimation of actuarial returns in the low-rate world will likely presage a social crisis far greater than the one of 2020. Money printing cannot fill this particular gap as these kinds of hand-outs would lead to instant inflation and would be largely self-defeating. What is to be done?

Source: Bloomberg, 14th December 2020.

  • If bonds yield nothing, can equities take up the slack? While some pension funds like Calpers in the US are advocating a gung-ho use of leverage to juice returns, many pension fund trustees are bound by (thankfully) strict rules on leverage with respect to fund allocation. In any case, US equities are very fully valued. The S&P 500 is trading on 26x forward earnings, a multiple rich even before one asks about earnings quality (Factset have found an average 32% differential between GAAP and non-GAAP earnings in recent US Q3 filings). The richness of the US equity market can easily be seen from the graph below which shows the classic Warren Buffett metric of total US equity market capitalisation as a percentage of GDP. It’s at an all-time high. Equities at 167% of US GDP is quite a thing.

Source: Bloomberg, 14th December 2020.

  • Won’t it all get easier when lockdowns end and the wall of pent-up demand hits the market? Bond yields should rise right? There are a few things to be said about this. First, the US yield curve is steepening (US 2yr vs 10yr curve steepness has gone from around 50 bps in March to just under 80 bps at the time of writing). This can be interpreted as a recovery but this is not always the case and curve steepening can lead to solvency issues in highly indebted economies. When one looks at the components of the US yield curve, the picture is not as rosy.
  • The graph below shows US 5y5y inflation (5yr inflation in 5yrs time, blue) rising, while US 10yr real rates (yellow) are still deeply negative and falling. Rising inflation and negative or falling real rates is the textbook definition of stagflation. The sharp rise in US jobless claims on 10th December (853k vs. 725k est and 712k prior) is the sort of data point which also suggests a weak recovery. The picture in the UK is similar with negative real rates and rising inflation. Japan and Europe have negative real rates but low inflation, hence negative nominal rates. We believe that the problem for pension funds is the negative real rates, as these mean that capital invested in bonds is being destroyed and purchasing power lost. Negative real yields mean low growth, so any equity rally in these circumstances is likely to be a multiple expansion, not ‘real’ earnings growth. This is exactly what is happening now.

Source: Bloomberg, 14th December 2020.

  • So equities are at record valuations, rates are low, and real yields are negative. How do you actually save at a time like this? An article in a recent edition of the Financial Times’ section has a stab at answering this thorny question (‘Zero interest rates: what the UK can learn from Japan’, FT Money, 05/12/2020). Japan was the first country to experience the negative rate phenomenon decades ago. Japan has since hosted an excellent Rugby World Cup in 2019 and Hello Kitty land is still up and running, so there must be some useful tips here about surviving the low-rate world.
  • It turns out that the initial answer was carry trades, where one shorts low yielding currencies (often on a leveraged basis) and buys higher yielding currencies. That led to the early 2000s heyday of the yen carry trade and “Mrs Watanabe”, the archetypal Japanese housewife-turned-currency-investor. Most high street banks in Japan began to offer foreign currency deposits, with displays in their windows showing interest rates in dollars, euros, Swiss francs, sterling and other currencies.
  • The mass-deleveraging event of the global financial crisis wiped out much of the accrued returns from carry trades as the yen soared. The wisdom of relying on a leverage strategy as a long-term means for saving is also questionable from a risk point of view. What is relevant for today’s saver though is that the Japanese story of the noughties could only work when it was just Japan doing it (don’t forget the massive commodity bull market and furious Chinese GDP growth that was going on simultaneously). With the whole world now at zero rates, there isn’t so much of a yield pick-up to be had. In fact, the proof of this is quantitative easing, one consequence of which is often currency weakening (when you do enough), and therefore an unofficial currency war has developed. This is not a happy hunting ground for stable carry trades.
  • The FT Money article[1] goes on to talk about property. Japan had a mega-bubble here, and the multi-decade deflation of this meant housing was not a good option for investors. The discussion above about commercial property in the UK is not the same by any means, but when one has a fully valued asset which is starting to roll over, one ought not to hold too much confidence in it being the mainstay of one’s portfolio. For residential property in the UK, Rightmove is bullish for 2021, predicting that asking prices will rise 4%, but then again, it’s Rightmove’s job to be bullish on houses.
  • Japan has a deflationary mindset, and that could be characterised as one of loss-avoidance and risk-aversion. A protracted period of deflation or low rates in the UK could lead to a similar psychology setting in. The Japanese save a lot, although some do punt the stock market. The FTSE in the UK is certainly trading at a lower multiple than the S&P 500 and therefore has some attractions on a relative basis. The FT concludes that, “taking a risk on stocks is less risky than not investing”, and that in a low-rate world, UK investors may well draw the same conclusion. Sounds like there is no alternative.
  • The problem with this is that a low-rate world is one with low growth (especially if real rates are negative), and low growth means low earnings growth for corporates as well. Punting equities is fine but is not without its risk, as rising stocks are an expression of multiple expansion not underlying earnings growth. The massive retail call-buying which has characterised 2020 is looking eerily like that of 1999, and with IPO’s like Airbnb and Doordash flying on launch, the speculative mania is there to be seen.
  • The 2000 crash also marked the start of a 10yr commodity super cycle. Off the radar for now, commodities may in fact be the opportunity that investors should be looking for, and one which allows them to ditch over-valued equities and yield-less bonds. The greening of the global economy as a government-sponsored exercise, along with radical money printing as a means to pay for it, may just be the catalyst the commodity market needs. Hard assets for hard times, and an answer to the zero-rate saving question.

[1] ‘Zero interest rates: what the UK can learn from Japan’, FT Money, 05/12/2020.

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