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#24 — ZIRP, inflation, QE and other animals...


June 20th, 2017

By Andrew Craig

Reading time: ~ 11 minutes

In my last article, I referred to two reasons for the concerted equity market strength of recent years: First, the impact of certain very real structural changes on companies – primarily technological development and related globalisation. Secondly, the impact of what has been going on in the bond market – that is to say - the impact of interest rates, real inflation and government policy in this area all over the world.

In that article – I dealt with the first of these themes. Today I address the second.

Let’s begin with “ZIRP”. As some readers may already be aware, this stands for “Zero Interest Rate Policy” – something that governments all over the world have had in place for several years. This reality is very important for the discussion of where stock markets are at present.

If we go back to the above chart of the Shiller / CAPE ratio and compare today’s ‘high’ “crash-danger” valuation of around 30x to times in the past when the market crashed from similar levels – we should probably think about whether we are “comparing apples with apples”.

There is one very important reason why a 30x ratio today may not be the same as a 30x ratio in 1987: Interest rates.

The graph below shows us one kind of interest rate (known as the ten-year bond yield) going back to 1980 for Germany, the EU, the UK and the USA.

Source: ECB

You can see just what an astonishing fall there has been in interest rates all over the world in the last thirty-five or so years.

The important thing to understand here is that the lower interest rates are, all other things being equal, the higher share prices can and should be in theory and, (if the evidence of history is anything to go by), in practice too.

To say that the stock market today is going to crash because it is as expensive as it was in 1987 before that crash but to ignore the 10% or more difference in interest rates is to miss a very key piece of the puzzle. You are not comparing apples with apples.

Indirectly, we have already seen that lower interest rates increase a company’s earnings: They are able to borrow and invest more cheaply and, as has been prevalent in recent years, buy back their own shares too. Both of these factors will drive earnings upwards – and the stock market, all else being equal - as the level of the stock market is a function of earnings.

Low interest rates & bond yields = more demand for shares

More directly, low interest rates are basically the same thing as low yields on bonds. The lower the yields available to investors in the bond market and the lower the interest rates available on savings accounts, the more likely an investor is to own shares. This is because the higher potential returns from shares become significantly more attractive in relative terms.

In 1987, if you could earn 10% or more a year on your post office savings account (as I did with my paper-round money – making me thousands of pounds by the time I got to university ;-) ), why go to the bother and risk of investing in the stock market?

In 2017, however, when interest rates and bond yields are basically zero (and actually negative in real terms – i.e. after accounting for inflation) – you would, arguably, have to be stupid not to invest in the stock market. If you’re keeping your money in cash ISAs or most bond market funds - with inflation where it is you are actually guaranteeing to yourself the loss of your wealth in real terms every year. This reality is particularly strong at the moment.

Many retirees have to be in shares

A related point concerns the fact that the vast majority of people in the world have made insufficient provision for their retirement financially. In 1987 – if you had managed to build a pension pot of, say, £500,000 by the time you retired, with interest rates at around 10% - you could just sit on that pension pot earning about £50,000 a year – i.e. more than likely enough income to live on for the rest of your life. Today – with annuity rates at more like 3% - that £500,000 pot will only pay you about £15,000 a year of income – nowhere near enough to live on.

Millions of baby-boomers now at or near retirement just don’t have enough to live on if they are only able to make returns of 3% (or even less). For many of these people – and for the financial advisers and investment funds they use – the answer has been to chase higher returns by investing in the stock market – that is to say shares rather than bonds.

A tidal wave of money

It is very hard to quantify the impact of this theme. What is clear, however, is that there are trillions of dollars around the world in the bond market and / or in cash or precious metals, paying investors zero or, more frequently, negative real returns. At the same time, there are basically only a few thousand good quality companies listed on stock markets in the entire world for those trillions of dollars to switch into – assuming a decent chunk of that money continues to go that way.

On top of amazing developments in technology, it is zero or even negative interest rates through various mechanisms (corporate buy-backs and asset allocation from cash and bonds into equities), then, which have driven stock markets all over the world to their current levels. Remember too that these interest rates are largely a function of government policy all over the world – primarily Quantitative Easing (QE). Whilst this continues (which it seems likely it must, given authorities in Japan, Europe and the US have left themselves basically no choice in the matter), this theme could run and run.

Given just what a tidal wave of money this could continue to be – it seems entirely possible that there may be yet more upside for shares – more than many commentators realise if they’re using traditional models of equity valuation. Ultimately – when there is lots of money moving into any asset, that asset will continue to appreciate in price. Valuation can continue to be a less important consideration than sheer volume of fund flows into a relative scarce asset (quality companies) and although the asset in question is certainly expensive - set against historical averages – it will quite simply continue to get more expensive. As John Maynard Keynes famously put it:

“The market can remain irrational longer than you can remain solvent…”

Ultimately companies are not rubber bands. Rather than “snap” they might be a great deal more stretchy than we realise. The fact that Apple is the world’s first $800 billion company with Google et al. not far behind, is indicative of this very fact.

The rise and rise of Exchange Traded Funds

I would go further and argue that this reality has been supercharged by another structural factor – the rise and rise of “passive” investments and most particularly Exchange Traded Funds (ETFs). All over the world, increasing numbers of people are taking more of an interest in investing (a good thing). Many such folks have heard that 90% of active funds underperform the market and that passive funds (which track said market) are cheap.

The result has been an unprecedented and record breaking explosion in investment into ETFs. The leading player in this space, Vanguard, has grown its assets under management to $4.2 trillion (thousand, thousand, million) by April 2017 from $1 trillion seven years ago. Vanguard have gathered more assets in the last few years than the nine next largest investment companies combined.

One of the key things about passive investing is that the majority of this money goes into funds that are what is known as ‘market cap weighted’. If you put £100,000 into a FTSE tracker, for example, you don’t end up with £1,000 in each of the 100 companies in the FTSE. You end up with about £10,000 in Shell, £7,000, in HSBC, £5,000 in BP, £4,000 in GlaxoSmithKline and only £100-200 in a number of the smallest members of the index (EasyJet, Hargreaves Lansdown, Hikma Pharmaceuticals, Worldpay Group and so on).

If Vanguard, or indeed another big passive investment fund, takes in £1 billion into a FTSE 100 or S&P 500 tracker fund, it must then buy up £1 billion worth of shares and do so in proportion to the relative size of the companies in that index.
This means that:

“Vanguard’s traders funnel as much as $2 billion a day into stocks like Apple, Microsoft and Amazon, as well as thousands of smaller companies that the firm’s fleet of funds track. That is 20 times the amount that Vanguard was investing on a daily basis in 2009…”

Source: NYTimes

Whilst investors all over the world are making increasing use of passive investment vehicles which want to put money into quality companies, this theme can and will run.

I think it is worth repeating another key point here – the fact that a number of central banks are actually directly buying into equities too. I’ve written on this subject before but on top of their enormous QE programmes, many of the world’s central banks are buying shares directly.

No doubt they are doing so because the folk in charge at those institutions have considered all the points I’ve made above and realise that the only way they have a chance of making a real return is to play the game just like everyone else. Whatever their reasoning, the fact that they are committing yet more billions to that relatively small number of quality companies is another reason this theme could continue to run – at least until they stop doing this!

…and finally – a little thing called “denouement” / going parabolic

The last point I think it is worth making concerns the fact that most bull markets end with a bang rather than a whimper – by which I mean that what tends to happen in the last few months, weeks and then days of a bull market before it goes into a sharp reversal and falls off a cliff, is that the market goes up massively – and usually beyond everyone’s wildest expectations.

Below are two charts of the gold price to show just how crazy and powerful this can be. When President Nixon took America off the gold standard in 1971, the price of gold was $35. By 1980 it had gone up twenty-four fold but just look at how and when that price performance came. Only two years before the 1980 denouement, in 1978 the price was ranging between about $150 and $200.

That is a great uplift from $35 to be sure but look what happens in the end of a bull market. Everyone suddenly rushes in and the price goes crazy.

Gold started 1980 at just over $500 an oz and most market commentators would have told you how ridiculously over-priced it was at that level but three months later it was north of $800. This is what often happens at the end of bull markets. It is a function of the self-fulfilling reality of “the madness of crowds” – where an increasing number of people rush in for fear of losing out and where everyone you meet is telling you that it is time to buy the asset in question (and the smart money is taking their profits).

If you think this is a one-off and the gold bull market top of 1980 was a freak event, think again. Look at what happened to the NASDAQ index in the dot.com peak of 2000.

Lots of sensible folk would have been saying it was overvalued and a sell all through 1999 given how well it had performed by then, but look how crazy it went in the last year.

Or just look at Bitcoin – which has done the very same thing twice in the last five years.

History provides us with plenty of examples then that that overvalued markets tend to get a great deal more overvalued before they crash.

Perhaps that is what is going on right now but I just don’t think that any of the major world share indices look steep enough to imply they have yet gone into the final parabolic phase and I'm still finding that I'm often the only person in the room who invests in the stock-market at nearly all of the social events I go to - at least the ones that are unrelated to my work. Before the dot.com crash of 2000 pretty much everywhere you went, people would be talking about the shares they were buying and selling. We are nowhere near that today.

ARRRGHHHH – This all too confusing and conflicting – what can we actually DO?

Over the last several articles and in various other pieces I’ve written in recent years, I have laid out a number of arguments for why the market may be due a massive correction and then still more in the last two articles for why it may yet have a tonne more upside.

What a fence-sitting pain I am and no doubt this is potentially very annoying for a number of readers ;-)…

In my defence I will simply say this: First, in my view there are simply too many variables and too many unknowns in the world and, by extension, in financial markets for anyone to be able to say that they can predict with any degree of certainty where markets are going or when they will go there. However, secondly, and more importantly, it doesn’t really matter to your ability to succeed in investment because of two wonderful things: Diversification and a simple and elegant technique called trend following.

In my next article I will explain how you can use trend following in particular to ride the tiger’s tail of this stock market denouement without fearing that you’re going to get taken to the cleaners when the proverbial hits the fan…