Return OF Capital v Return ON capital
Anyone currently actively looking at financial and property markets with any sort of ‘logic filter’ is often left scratching their heads. How can we be seeing such sky high valuations in a fundamentally tepid economy and amid concerningly strong inflation?? The answer is simple – the free money environment is forcing investors there and simultaneously acting as a safety net. ‘Don’t fight the Fed’ combined with the ‘Fed has your back’ has become the only game in town.
That was certainly the case after the GFC when fears of inflation off the back of this new beast called QE were unfounded in the traditional sense, but saw asset inflation of an incredible order. Now, post COVID, where QE dwarfed that of the GFC response, inflation is most definitely real and this time both traditional AND asset based.
The eminently respected Mohamed A. El-Erian (President of Queens’ College, Cambridge University, and Chief Economic Advisor at Allianz, the corporate parent of PIMCO, where he previously served as CEO and co-CIO) was recently interviewed by Goldman Sachs and as usual had some very insightful views on this current set up. We provide some key excerpts below:
On the ‘transitory’ debate around inflation:
“I take issue with these characterizations because the whole point of transitory inflation is that it wouldn't last long enough to change behaviors on the ground. Yet wage-setting and price-setting behavior is already changing.”
“The underlying cause of the current surge in inflationary pressure is deficient aggregate supply relative to aggregate demand. Part of that will likely prove transitory as the pandemic continues to recede and factories in Asia ramp up production. But part of it will likely prove more persistent due to longer-term structural changes in the economy. Company after company is rewiring their supply chain to prioritize resilience over efficiency. US labor force participation is stuck at a low 61.6% even as unemployment benefits have expired, suggesting that people’s propensity to work may have changed. So, there are longer-term structural and secular elements to the rise in inflation. And I’m concerned that if the Fed doesn’t do enough to respond to these secular inflation trends, it risks deanchoring inflation expectations and causing unnecessary economic and social damage that would hit the most vulnerable segments of our society particularly hard.”
On the growing ‘policy mistake’ by the Fed view:
“Simply put, the Fed faces a choice between easing off the accelerator now or slamming on the brakes down the road. It should’ve starting easing its foot off the monetary stimulus accelerator months ago. I’ve argued for some time that it had a big window of opportunity to start tapering asset purchases in the spring, when growth was very strong and the collateral damage from maintaining emergency levels of liquidity in a non-emergency world was becoming apparent. But, inertia, inflation miscalculations and a new policy framework that was designed for a world of deficient aggregate demand rather than today’s world of deficient aggregate supply led them to wait until earlier this month to announce the start of tapering…. While it is now starting to act, it’s moving too slowly, as evidenced by the growing gap between its policy action and the rise in inflation expectations. So the Fed’s delayed and slow reaction to inflationary pressures has unfortunately increased the probability that it will have to slam on the brakes by raising rates very quickly after tapering and at a more aggressive pace than it would have if it had started to tighten policy earlier.”
And for a little bit of déjà vu for Aussies (as we discussed here) how’s this for sounding familiar:
“Even though the Fed is beginning to taper, it’s still buying tens of billions of dollars of securities every month, about a third of which are mortgage-backed securities. I don’t know a single person who believes the US housing market needs such broad-based policy stimulus. On the contrary, the housing market is so hot that an increasing number of Americans are being priced out of it. And the longer the emergency policy stance continues without an actual emergency, the greater the risk that the Fed does end up having to slam on the brakes and, in doing so, create unnecessary damage—i.e., a new recession.”
And finally the answer to how on earth shares can be so high, hitting both all time high prices and valuations, in such an economic environment:
“What’s happening in the equity market was recently captured perfectly by the legendary investor Leon Cooperman, who, when asked how he was positioned, responded that he's a “fully invested bear”. He's bearish on the fundamentals—with the view that valuations are too high—but he's fully invested in terms of technicals, and liquidity technicals in particular. The equity market is in a rational bubble; investors are fully aware asset prices are quite high, but they’re in a relative valuation paradigm in which it makes sense to be invested in equities rather than in other assets. The fixed income market is distorted and one-sided in terms of risk-return, dominated by technicals, and an unreliable diversifier in the current environment where its long-standing correlation with other financial assets has broken down. Many investors can’t invest in private credit, venture capital, or private equity, and are hesitant to delve into crypto. That leaves the equity market as the “cleanest dirty shirt” for investors. That works very well as long as the paradigm is a relative valuation one rather than an absolute valuation one, and markets will likely remain in this paradigm for a while. But investors need to respect that they’re riding a huge liquidity wave thanks to the Fed, and that wave will eventually break as monetary stimulus winds down. So investors should keep an eye on the risk of an abrupt shift from a relative valuation market mindset to an absolute valuation one, or an environment in which you stop worrying about the return on your capital and start worrying about the return of your capital. That’s a risk to watch because not only would it mean higher volatility, but also, and most critically, an undue hit to the real economy.”
Gold is often referred to as financial insurance for this very reason. Insurance sounds boring and infers a low return ON capital as it provides fantastic return OF capital. However the reality is far from that with gold providing one of the best investment returns over the last 15 years, and that is accounting for it not providing a yield. All tidal waves eventually crash. By all means ride the wave, but the trick is getting your portfolio balanced with the right assets BEFORE it crashes to ensure you have a sizeable return of capital in such an event.