The price of money and the cost of capital
A combination of rising inflation, a renewed spike in interest rates and year-end rebalancing of equity portfolios, sent shock waves through global financial markets. With US equities up 100% over the last 5 years and on the back of a relatively calm 2021, with high expectations and high levels of leverage, markets were ill prepared. Initial declines on the back of increasing rate hike expectations triggered a wave of fear, de-leveraging and forced selling. A dismal press briefing from an ostensibly stressed and wavering FOMC Chairman Powell added nervousness. Bonds and equities declined further, and January ended up showing the worst start to the year for equities for more than a decade.
More balanced and sensible FOMC members helped to calm USD markets, where the latest move up in rates can best be attributed to strong macro data, such as the ISM manufacturing business confidence, GDP data and the Non-Farm Payroll. In Europe, the lack of credibility of the ECB’s process and predictions are reflected in the President and Governing Council’s expressed surprise that inflation came in at 5%, as opposed to a target of 2%, while they are still holding rates negative and buying government bonds. Independently of the institutional incompetence and lack of credibility on display at the world’s central banks, the key question remains how markets will weather the coming hiking cycle and the increased cost of capital. We continue to manage the risk levels of our portfolios based on the real time assessment of global market conditions provided by our algorithms, which for the time being remain positive. (Please see the last page of this publication.) Euro/USD has moved a lot, but changed very little since the euro was introduced. As mentioned during recent months and quarters, we expect the Fed to tighten this year and next and probably end up at 2%-3% perhaps around the middle of 2024. In such a scenario, we would expect long duration bonds
Figure 1: US Debt to GDP for the federal government, Households and the Non-financial sector
are close to 5%. For the next 12-18 months, therefore, we are expecting high yield to deliver positive absolute returns and to outperform high-grade bonds and US Agg, Euro Agg and Swiss indices (SBI AAA-BBB) by several percentage points (as they did in 2021). Figure 1 shows how the debt of the US federal government, households and corporates has increased over time. This debt burden is clearly manageable with US government bond yields at 1%, 2% or 3%. However, at 5% or 6%, the balance could tip and if the market senses that this is where we are heading credit spreads could widen, equity prices could fall (a lot) and a recession would hit. This potential cascade of self-reinforcing negative events is a key reason why we don’t expect that it will be allowed to happen. The first test of this kind of effects is likely to be in Europe where Italian and Spanish government bond yields have increased significantly on the basis of the clumsy communication from the ECB.
For now, markets remain sufficiently supported by fundamental factors to warrant maintaining positions in equities and high yield bonds. One reason is that much of what we have seen until now is fundamentally healthy, in the sense that money should have a price and capital should have a cost. We now know that US growth last year was the highest since 1984. It is possible that we have the highest inflation in decades because the Fed and ECB printed too much money and tightened too late at a time of expansionary fiscal policy. If this is true, inflation should now move down as growth is decelerating and financial conditions have tightened as corporate bonds and mortgage yield have moved up. If, on the other hand, the Fed and the ECB have broken the magic of low inflation, they will need to tighten a lot more. Should this happen, we are likely to change positions to defensive portfolio and the yield curve is likely to invert. For the time being, we are positioned as follows:
In our Systematic Equity Allocation strategy and the associated ACCI SA fund we hold 100% equities a position we have maintained since November 2020, and which is also expressed in our Euro and GBP growth mandates. As of the first of February, the Euro SEA strategy was up 24% YoY, the USD SEA strategy 16% and the ACCI SA fund in USD up 10% YoY.
Across our global fixed income opportunities portfolios, we maintain our short duration, high credit risk positioning. The USD strategy finished last year up 3% and was up 1% YoY as of first of February. The ACCI GFO fund in USD finished 2021 up 2% and was down 1% YoY as of 1st of February.
In our multi-asset strategies, we retain the full allocation to equities and the additional 30% allocation to high yield bonds. These portfolios delivered a return of 11-17% depending on risk level and base currency. The ACCI Diversified fund in USD was up 8% YoY as of 1st of January.
How the price of money and the cost of capital affects markets
We will address some of the more fundamental risk on the following pages and show why we do not think it will be possible, desirable, or even necessary, to hike beyond the 200-300bps we mentioned before. As the debt level goes up, tightening is more effective. In Figure 2 below, we show both the total debt level and the part held by the public. This is now much higher than it was in the three previous hiking cycles. Also, traditional
Figure 2: US Government debt to GDP since 1995
corporate debt (non-financial sector debt) has grown while US mortgage debt has been more stable. Both types of debt often take the form of bonds with long time to maturity and, therefore, with a high interest rate sensitivity (long duration). Most investment grade credit indices have close to 9-year duration in USD and most mortgages are for example 15 or 30-year bonds. This means that investors face larger losses when the yield on these bonds moves up and the nominal value of these bonds therefore “sells off”. On an individual level, many borrowers are shielded from the direct effect, but the borrowing price increases for new bond issues and therefore both for company financing, for new buyers and for people shifting up the value chain in the housing market. In economics, the time lag for the effect of monetary policy is often assumed to be 12-24 months. This is a convenient period in econometric modelling. Whether it is also a realistic assumption is more questionable. And here lies the reason, perhaps, for the apparent tendency for the ECB and the Fed to underestimate the long-term effects of their short-term policy and communication changes. The issue of duration and capital losses for those who hold these bonds is not likely to be a real problem in the US in the coming years, but the situation in Europe is more pressing. The largest holders of many of the southern European countries’ government bonds are financial institutions of these countries. Small and controlled increases in yield will help these institutions to become more profitable in their operating business. Larger upward moves of several percentage points, which some of the more “old fashioned” economists and market commentators sometimes talk or dream about, would undermine the capital based of these institutions at the same time as it would make it more difficult for the countries to service their debt.
Returning to the US and looking at the direct effects of borrowing, it is clear that debt cannot continue to grow forever. However, the dynamics by which debt actually grows is less straight forward. As shown in Figure 3, the US budget deficit as a share of GDP has grown very large in recent years due to special spending packages of record size and the decline in revenues in 2020. This has removed the fear that the US government bond market would cease to exist, as many economists speculated when the US ran budget surpluses around 1999-2000.
Figure 3: US Federal deficit as a share of GDP
growth of the deficit and the debt level has become the main concern. But of course, what you can afford to borrow depends on what you own in assets, what your income is and what it costs to borrow.
As shown in Figure 3, the deficit in 2021 was several percentage points lower than in 2020. Furthermore, as shown in Figure 4, the size of the Debt to GDP has declined in 2021. The reason is probably that despite the large deficit, which is a nominal figure, the growth of the economy in nominal terms has so to speak “overwhelmed” the growth of the debt. A critical component in any such debt dynamic is the interest rate cost and the pay back profile. If the US has credibility (in which it compares favourably to any other country), they can decide the pay-back profile by adding new debt when old debt expires. By having the central banks buy this debt, they can also keep interest rates under control, though this is at the risk of creating inflation. In 2020, there was a widespread belief that this type of inflation was far away out on the horizon. Now it looks as though we have reached this horizon. Even so, the cost can be controlled. And at the recently prevailing interest rate levels, the trend of the cost of servicing debt has been decreasing along with the declining interest rate level over the last decade. As shown by the light blue line in Figure 4, these interest rate costs are now close to 1.5% of GDP. With interest rates below 2% and nominal growth close to 10%, debt to GDP fell slightly and in the immediate future a very large deficit would be required to maintain or increase the ratio of Debt to GDP. To say it in a different way, assuming that growth and inflation moderate to a combined 5-6%, there is still room for a considerable deficit without creating a debt spiral.
Figure 4: US Federal Debt as share of GDP (Left scale), Cost of servicing Federal Debt (Right scale)
Should history repeat itself and the recovery leads to significant increases in tax revenues, of which we are seeing the first signs, the maximum sustainable deficit level will move up even higher. In any case, and independently of other developments, it is clear that at current interest rate levels the US is easily able to service the current debt. Should interest rates move swiftly back to levels around 5% seen in 2006-07, this would no longer be so obvious. And such a move would likely lead to mass bankruptcies, mass unemployment and, ultimately, deflation and a potentially a lasting depression. In this case, the Fed would again miss both of its mandates of price stability and full employment. It would also miss its original mandate of keeping the financial system stable. The task of the Fed and the ECB is therefore to balance the situation and use inflation and nominal growth to help ease the burden of the debt, while steering the economy through the current deceleration of growth. It is not easy, but it has been done before. A potentially optimistic interpretation of the last two years of experience and experiments is that while too much money was printed, at least it helped to ease the global debt burden.
An equally simple view of how the Fed and the ECB could improve their performance is the optimistic hope that if Powell and Lagarde shift their focus from their fumbling re-interpretation of their mandate to the narrower but also more useful goal of living up to their mandates, life might be easier and central banks more useful for the general population.
In order to secure an equilibrium of debt and interest rates, an additional flexible variable in the equation is growth. The more actual growth we see in coming years, the more rates will need to go up and the better the world will be able to afford higher rates. This will be an uncertain and volatile process. To put it in more practical terms, those of us whom want to harvest risk premiums, will likely have to live with some realized risk and volatility. Right now, we remain fully exposed to such upside potential and risk.
Figure 5: US Government 2-year, 5-year and 10-year bond yield were around 5% in 2006-07
A final and important regional difference to note is that in Europe it is often highlighted as a success of Europe over the US, employment in Europe is back above levels seen before the pandemic. In the US, GDP is well above previous levels, but employment is not. Clearly, if the issue is economic potential, the US compares better because it currently produces more with fewer employed. Looking at profitable growth in the future, this is probably also the case. Historically, growth is linked to productivity. So, while European equities trade on lower multiples according to a static measurement of price to earnings, the earnings potential, which is part of the price paid when buying equity (the right to future earnings), is also likely to be higher in the US.
It is our belief that the above considerations are important for long term and short-term movements in markets, even if they have an air about them of theoretical posturing. We therefore repeat the more practical observation that if you bought the S&P 500 just before the taper tantrum in 2013 and held on to these equities as the Fed hiked from late 2015 and only sold when yields peaked in late 2018, you would have obtained a solid total return of 170%. Holding onto such a position until today would only have further increased these returns. In addition to this simple example of equity markets remaining firm in spite of the Fed tightening in the previous cycle, the following observations further add support to our overweight of equities and high yield bonds and, possibly, even justify adding to such investments:
2021 was the strongest year for US growth since 1984. Real GDP growth was close to 6% and nominal growth 9-10% (using the GDP deflator). It is natural that such strong growth should lead to inflation. As growth slows down, inflation should follow and also decline.
The US earnings are much stronger than expected just 3 or 6 months ago. While Peloton, Netflix and Meta (Facebook) clearly have problems with their growth, S&P 500 earnings are up 25% year on year. Price to earnings multiples have decreased and the S&P 500 now trades at 19.9 times expected earnings for 2022 (based on Refinitiv/IBES data from Friday, 4th Feb).
Fed Chairman Powell made it clear that the economy is in better shape than when the Fed started hiking last time, implying that faster hikes could be needed. This is priced in. US 2-year, 5-year and 10-year yields are at levels close to where they were at the end of 2016, a year after the Fed started hiking.
Yield levels for corporates have moved up more than 1% over recent months. This creates a positive situation in which the Fed has tightened but credit remains affordable for companies while it is more attractive for investors than at any time in the last 6 months.
The US and the world economies remain supported by companies willing and ready to invest and consume in both US and Europe; they are experiencing solid job markets and increasing wealth, which will drive consumption.
The Chinese PMI`S came out at low levels, giving the authorities further incentives to restructure the real-estate sector and the Chinese Central Bank has incentives to provided additional liquidity.
Covid cases have spiked dramatically in several countries, including Denmark, Norway, Sweden and Switzerland. ICO hospitalization and deaths have not increased very much. Denmark and Sweden have now decided to abandon restrictions. Some think that governments in Scandinavia don’t know or don’t care about their populations. It is more likely in our opinion that things are improving significantly and rapidly. Politicians in many countries are unsure how to change direction, ease fears and scale back restrictions quickly.
In the event that renewed uncertainty from the Fed and the ECB, a simple policy mistake in the form of excessive tightening, or other factors lead to the current risk reductions across markets moving into a self-fulfilling tightening of financial conditions, we stand ready to protect the invested capital by reducing equity and high yield positions decisively. In that case, what will matter most to markets will be the context in which the Fed hikes. If inflation rolls over soon and trends down below 3% over the coming year or two, everything will be easier to deal with for the Fed and for equity markets.
Mads N. S. Pedersen, Managing Partner and CIO