A question that many people have is – how long can the equity markets keep soaring, how long can house prices keep increasing and how long can demand for negative yielding government bonds continue?
The answer to all of the above is probably (but not necessarily) indefinitely. In many ways we are living in very interesting times. This time it is different, why wouldn’t it be?
Prices are about demand and supply and in the current environment both demand is engineered to grow and supply is artificially constrained.
Demand – Engineered to grow
Asset Managers (the likes of Fidelity, Blackrock and others) are forced to invest irrespective of where the markets are. Asset managers globally have some $90 trillion in assets, and inflows are growing with new inflows now guaranteed to be at least $4 trillion a year. Why do we write guaranteed? Because governments are forcing people to invest indirectly in riskier assets by forcing private pensions and by artificially keeping interest rates low.
Take the UK for instance. In 2015, the government introduced mandatory employee and employer contributions for private pensions. Until four years ago, private pensions were entirely optional.
Currently, employees must contribute at least 5% of their pay into pensions and employers must contribute at least 3% of the employee pay over and above paying the employee. Private pension contributions in the UK are now set to be over £40 billion (or $52 billion) a year.
But the UK is not alone, most nations are now pushing private pensions by offering tax incentives or making it mandatory to have a private pension. Most private pension money inevitably gets invested in risky assets (mainly equities).
Governments globally too are investing pension money in riskier assets given the looming pension crisis in terms of an increasing pension deficit (due to years of underfunding), aging demographics and lower projected returns on government bonds.
Another aspect is the ultra-low interest rate environment. Savers in Europe and Japan are virtually getting nothing on savings in their bank. How do you sustain a living by the money you have saved if you are unlikely to earn any interest? You invest in riskier assets.
But it isn’t just governments and people indirectly investing in riskier assets. Even Central Banks are on it. Take the Swiss National Bank and the Bank of Japan as examples.
Both the Swiss National Bank and the Bank of Japan have negative interest rates (-0.75% for Switzerland and -0.10% for Japan) and both have done a lot of Quantitative Easing since 2013. Both have a balance sheet greater than the GDP of their respective countries with Bank of Japan’s balance sheet 105% of GDP of Japan and the Swiss National Bank with a balance sheet of 125% of GDP of Switzerland. What do they do with freshly printed money?
The Swiss National Bank has around $850 billion in foreign currency investments. Amongst its famous holdings are a $3 billion investment in Apple, another $3 billion investment in Microsoft, a further $2.5 billion investment in Amazon and a $1.5 billion investment in Facebook. It has been turning a profit on these investments.
The Bank of Japan has a target to buy 6 trillion Yen ($54 billion) worth of exchange traded funds (ETF) a year. It now holds almost 84% of all ETFs in Japan and is indirectly the largest shareholder in many large Japanese companies, almost about half of all large listed companies.
Central Banks don’t just manage monetary policy now, they are also major shareholders in private corporations pushing up asset prices.
There are other issues too. Take the bond market for instance. Fund managers have around $25 trillion to invest in bonds and since bonds mature and there are new inflows, they must invest up to $6 trillion a year in new bonds. Why is that a problem? Well, for instance if you have money in Euros to invest in bonds you have two options for shorter maturities (typically 2-year bonds), you can invest at a negative yield in the Euro currency denominated German government bond or you can invest in another currency (say US dollars) giving a positive yield in another country. Given currency fluctuations (the Euro is down 8.5% against the US dollar over the past year), investing in another currency carries a big currency risk. You can argue they can buy a currency hedge but that might yield even worse than investing in a negative yield Euro bond given the hedging costs. Selling negative yielding bonds is hardly a problem for governments now.
Constrained supply
There is too little choice for stocks. There are far fewer listed companies globally now then there were 20 years ago. 20 years ago, there were over 8000 stock market listed companies in the U.S., that number has halved by 2018.
Look at some valuations, Netflix is currently valued at around $163 billion. The company expects free cash flow of minus $3 billion to minus $4 billion in 2019 (yes, that is negative cash flow). It’s price to earnings ratio is over 100. Is this sustainable? Well, with competitors like Disney launching streaming services, it isn’t going to be an easy road ahead.
Tesla ended the day at a valuation of $40 billion (Ford is finally more valuable than Tesla again). General Motors (GM) until some time ago was valued at much less than Tesla too. Negative cash flow and losing money, yet Tesla was until a few months ago valued more than Ford and GM, both of whom sell far more vehicles than Tesla, have positive cash flows and are profitable.
Uber is going to list soon valuing the company at around $90 billion. But it is losing money, the more its revenue grows, bigger its losses. And it has warned that it might never make a profit. Yet, all this doesn’t matter so much. Once Uber is listed and is part of an index, money will be invested in it automatically.
Valuations don’t matter as supply is constrained. In the US the top 200 companies (exchange listed and private) account for around 90% of all corporate profits. Again, with very little choice, valuations are soaring especially for the very big listed companies. Microsoft joined the $1 trillion valuation club after Apple and Amazon.
Soaring forever?
Laws of gravity don’t necessarily apply to investments to the same extent. We are seeing a sustained rise in asset prices as everyone has indirectly become an investor. This doesn’t mean asset prices won’t fall in the short term – they will. We wouldn’t be surprised if prices fall significantly (about 20%) over the next 18 months. Money itself is losing its value which means asset prices will continue to rise in the long term making the value of outstanding debt (for governments, corporations and household) look far smaller. Hyperinflation ahead?