David Jane, manager of Miton’s multi-asset fund range, explains why the eight-year bull run since the financial crisis has been loathed rather than loved.
The current bull market is often described as ‘the most hated bull market in history’, with many calling it artificial, or a bubble, right from the start. But what are the reasons for this negative sentiment and how should we react?
The principal reason why the bears have been negative mostly stems from a disagreement with central banks’ quantitative easing (QE) and negative interest rate policy (NIRP) programmes. These have caused interest rates to become very low in both absolute and real terms, which in turn has led to the revaluation of all risk asset classes, to a lesser or greater degree. Whether you consider it the right policy or not seems irrelevant: it’s that the policy and the effect of the policy was predictable.
Of course, were the policy to change and interest rates to become ‘normal’, valuations of equities and bonds would be very different in the future, but policy makers appear to be extremely wary of the destabilising effect this would have. At present, US policy makers, while further advanced in their tightening cycle, have little reason to become aggressive and rates remain accommodating. Therefore, it doesn’t appear that the interest rate cycle is about to end the bull market just yet.
Latter stages of the cyle
However, what does seem increasingly evident is that we’re in the latter stages of the cycle. It’s been a worry for a long time that central bank policy was primarily finding its way into financial markets, rather than stimulating the real economy, and that this would ultimately result in capital misallocation and capital destruction. This is a classic feature of markets, where in the highly optimistic later stages investors make decisions which they ultimately come to regret.
There are numerous examples in the euro denominated bond markets where negative government yields have led to high yield bonds with absurdly low yields. A recent example, which famous short investor Muddy Waters has been highlighting, is French supermarket chain Casino whose bonds maturing in 2019 yield 4.5 basis points. This is effectively a zero return to lend money to a company which, despite incredibly low financing costs, can only cover its interest two and a half times. It takes but a moment’s thought to realise that if interest rates rose materially this is not a company that will find life easy. Investors seem happy to accept a measly return right now in exchange for accepting the risk which in a bond is all to the downside.
It isn’t just European high yield where investors are sowing the seeds of future disappointment. More and more bond issues are being launched with weak or no covenants to protect investors, and PIK (payment in kind) bonds have made a reappearance. These bonds typically pay interest with more bonds, as the company is too stretched to actually pay cash interest, despite incredibly low interest rates.
A couple of recent bond issues caught our eyes, Tesla and Netflix. We have owned both these companies’ equity in the past as they’re excellent growth stories with huge potential, however, bond investors benefit from none of that, they simply get all the downside if the company fails to succeed. Both these companies have never generated a cent of cash flow to pay the interest on their bonds, it has to be paid from future bond and equity capital issuance. Let’s just hope conditions remain as favourable as they have been recently or they will have to make profits to pay their interest.
Signs of excess in both bond and equity markets
It isn’t just bond markets where there are signs of excess. A number of recent new equity issues have shown that this market has also been a little too willing to finance businesses on hope rather than substance. Snapchat’s IPO is a good example, now trading at less than half the price it achieved in its first week on the market, as competing with the incumbent tech giants has proven harder than expected.
Another example of excess could be Softbank’s huge fund raising to make technology investments. History will judge how successful a Japanese mobile phone company will be at running a US$93bn technology fund, but the fee structure alone should have waved a red flag for investors. Having made a fortune from its investment in Alibaba, investors must believe the company has the golden touch and are prepared to accept a very disadvantageous fee structure (in which outside investors provide the leverage which the manager benefits from).
Preparing for a range of scenarios
As multi asset investors, we seek to invest in ways that allow for a range of scenarios, and would avoid situations which look good now but, should conditions change, might go badly wrong. There are plenty of opportunities which are attractive, but might be resilient in a less favourable environment. A particular worry for us in this environment remains liquidity, as this is your ultimate fall-back position if conditions change. Illiquid situations with material downside risk are a particular source of concern, hence we are getting more conscious of our position sizes.
We would not seek to call the top of the market as this phase can persist for several years, particularly as monetary policy, although tightening, remains highly accommodative. However, experience guides us to be alert to the potential errors that we might come to regret in the future and avoid situations, which when conditions do change, could go very wrong. It’s the decisions we make now which will determine not only how we do near term, but importantly how we fare when the market does ultimately turn.”
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