Why everything is high and why it won’t last

When heads of the two largest funds in the world send clear warnings it is worth listening too.

Firstly the CIO of PIMCO, the world’s largest bond manager said recently in a Bloomberg interview “we have probably the riskiest credit market that we have ever had in terms of size, duration, quality and lack of liquidity……..We see it in the build up in corporate leverage, the decline in credit quality, and declining underwriting standards - all this late-cycle credit behaviour we began to see in 2005 and 2006."  Mr Mather went on to warn that the world’s central banks have just about run out of bullets…"The U.S. is about the only central bank that was able to normalize policy rates, but elsewhere, there is basically no monetary firepower left...  I think that’s what you’re seeing now in markets. People are starting to come to a more realistic outlook about the forward-looking growth prospects, as well as the power of central banks to pump up asset prices."

And then at the end of last week we had the head of the world’s biggest hedge fund, Bridgewater’s Ray Dalio, voice identical warnings.  Dalio spoke to the chart we keep sharing below of the seeming disconnect between the usually correlated sharemarket and bond yields.

bonds versus stocks

“I don’t see an inconsistency in the recent performance of stocks and bonds because stock values are fundamentally determined by the present value of expected cash flows. So, when the Fed shifted to a much easier stance, it made sense that both interest rates fell—which was good for bonds—and stock prices rose.

But the power to do this is limited. Think of central banks cutting interest rates and purchasing financial assets— Quantitative Easing (QE)—as shooting doses of stimulants into their economies and markets. The financial world is now awash with liquidity chasing investments because of all the rate cuts and especially the QE that put $15trn into the hands of investors since the Global Financial Crisis. The Fed and other central banks easing today will push more money and credit into financial assets, which will cause prices to rise but future expected returns to decline. In other words, it’s short-term bullish and long-term bearish because future expected returns will fall and central banks are running out of stimulants; interest rates are already very close to zero, and the Fed pushing more money into the system by printing it and buying financial assets will soon push the expected returns for equities and other assets as low as they can go. When we get to the point that stimulating via rate cuts and QE isn’t sufficient to offset market and economic weakness, market action will change.”

How soon he was asked? 

“Pretty close. There is now only a limited amount of stimulant left in the bottle, and the sooner we use it, the sooner it will run out. I’d say that there is about a one-to-three year supply left, depending mostly on domestic and international political outcomes and the policies that result from them. The Fed only has room to cut about 2%, which isn’t much because past recessions needed about 5% of cuts.”

We were again reminded last week of just how this plays out via companies using these ultra low interest rates to buy their own shares to keep the price high. Still near record highs reached earlier this year.

sp 500 buybacks

So weak are the fundamentals that BofAML’s latest earnings predictor, which has had an extraordinary success rate as shown below, has been predicting negative earnings since February of this year (which is now the case at -0.4%) and now has forward earnings at -4.6% for the coming year.  And yet shares are at all time highs….?

Earnings recession

Dalio famously called the GFC and Bridgewater came out of it better than most because they positioned themselves appropriately well before it happened.  No one gets the timing right.  A 1-3 year call like this means we could see this market fully unwind any time soon.  The world is not the US either and he warns that “But interest rates in Europe and Japan have no significant room to decline at the same time that printing money and buying financial assets will have very limited effects. So we’ll see “pushing on a string” in that part of the world.”

Ainslie’s trademark is “Balance your wealth in an unbalanced world”.  We understand it could well be Dalio’s longer term 3 years before we see a full financial crisis but it could also be tomorrow.  With respect to even the master, no one knows.  Importantly too, chasing that extra 10% left in the market over the next year could see you miss the top and see a 50% fall.  That’s what happened in 2008 and 2009 in the GFC.  This week may well be a significant one for being the week that the ASX200 reclaims the high last seen before that drop in October 2007.  That’s 12 years later to get back to even….

Let us leave you with Dalio’s closing comment in that interview…

“In my opinion, balancing risk in these ways [one of which was buying gold] is the most crucial thing an investor can do in the current environment.”