Low US interest rates continue to impact risk asset prices
Disappointing economic growth offers a silver lining in that it discourages central banks from becoming less accommodative, despite jawboning to the contrary. The US Federal Reserve (Fed) continues to keep interest rates low with negligible tapering of its quantitative easing (QE) policy. This effort clearly hasn’t had a significant economic impact, but it has continued to elevate the price level of risk assets around the globe. The chart below gives rise to our observation that the Fed has been the biggest driver of the stock market in recent years.
Declining yields cause investors to assume additional risk
With yields remaining artificially low, we observe that the zero interest rate policy is perverting capital allocation decisions. Money continues to flow around the globe in a quest for yield, instigating a continued rise in risk assets. Many investors who have been accustomed to the lower risk of high-grade bonds and Treasuries are now looking for alternatives. The first six months of this year provide the best example of this, when global stock markets, high-yield bonds, gold, oil and long-dated Treasury bonds all increased in value simultaneously, which is a real rarity. As yields have declined, the expectations and spending needs of investors appear to have remained constant, leading them to assume additional risk in various asset classes around the world. Many past bull market rallies have been greed-based, but this one seems more need-based.
Accommodative monetary policy in the US unlikely to end soon
Slow growth, low inflation and fear of deflation are plaguing most developed economies and it’s unlikely that the current easy money regime will end soon. For it to end, the Fed would first have to slow and then stop buying, and then liquidate or roll the assets they’ve purchased. It therefore appears that we have a long way to go before the Fed is less accommodative, unless their hand is forced. The US is increasingly on its own in financing its deficits, with foreigners having largely stepped out of the US Treasury market. If the US needs financing assistance from their trading partners, they may need higher interest rates to get the partners to buy more Treasuries. Or, the Fed could always reverse course on the QE taper and continue to self-finance. Or they could shrink the current account balance, which will require less funding, with either exports and the economy growing, or imports and the economy shrinking. That’s a lot of “oars” needed to keep the boat moving – which begs some degree of caution.
Investment opportunities are scarce
We believe the economy can only ascertain what is possible at some point, rather than predicting what will happen when. With a healthy dose of scepticism and an appreciation of our fallibility, we understand that things can always go wrong (including our own projections). However, we are still happy to commit capital to new or existing investments as long as they offer an attractive risk/reward ratio, even after taking into account bad news that brings about a reasonable worst-case scenario.
Investing today feels a bit like dancing the limbo – how low can you go? With interest rates, volatility, and short interest all near lows, it’s no surprise that opportunities are scarce, as we can see in the following two charts, which show that valuations are above normal historical figures.
Source: First Pacific Advisors
Be patient – look to the future for wealth creation
If you were to conclude that there isn’t much trading at low valuations, you would be correct. With many stocks hitting new highs, the number of stocks trading at lower price earnings ratios is low. We continue to trust that long-term thinking will pay dividends in the form of good returns and allow us to avoid the frequent mistakes commonly associated with the need for immediate gratification. Patient investors have created great family fortunes over time in diverse industries by disregarding present performance in an effort to create future wealth.