As a child I was fascinated by the concept of a neutron star. A neutron star is the tiny but immensely dense thing that’s left after a massive star explodes. Imagine something eight times as massive as our sun packed into a 12 mile diameter sphere. Gravity compresses the surviving material so profoundly that its protons and electrons are squashed into neutrons. Just how dense ? A single teaspoon’s worth of a neutron star would weigh a billion tons. That presupposes you could actually get close enough to extract a teaspoon’s worth. In reality, the gravitational pressure would reduce your body to a very thin smear on the surface of the star. Very little escapes the gravitational force of a neutron star.
I never expected to encounter a neutron star but Messrs Bernanke and Yellen at the US Federal Reserve have been kind enough to engineer one for us. Like CERN it’s been something of an international collaboration – Messrs Carney and Draghi have also pitched in to do their bit. The hybrid of Quantative Easing (QE) and Zero Interest Rate Policy (ZIRP), our current monetary neutron star has succeeded in collapsing the yields of just about every financial asset. The tractor beam of ZIRP in particular is difficult to evade. Just ask Janet Yellen. After one of the most widely anticipated FOMC meetings in history, she has boldly decided to do precisely nothing.
Today’s investors are not exactly a lucky generation. Assuming they’ve survived two precipitous declines in stock markets in the course of a decade, they’re now faced with overpriced stocks, overpriced bonds, overpriced everything. The Economist cites a Deutsche Bank study pointing out that for 15 countries going back as far as 1800, the average prices of equities, bonds and residential property stand at an all-time high. In terms of investment yield, very little escapes the monetary policy neutron star.
Assuming prices matter, the implications for future returns are somewhat grave. “This is most obvious,” writes The Economist, “in the case of bonds: a yield of 2% means the nominal return if you hold the bond to maturity will be 2%. The real return may even be negative if inflation rises.” Gilt investors today dream of even 2% nominal returns: 5 year UK government paper struggles to reach a nominal yield of 1.3%. 5 year US Treasuries offer a munificent 1.4%.
“Worse still, there is always the chance that profits or valuations will return to their historical norms. If that happens, Deutsche reckons the average real return from equities over the next ten years will be negative. The same is true for Treasury bonds, European corporate bonds and American residential property.”
Deutsche are not alone – just more honest than most investment banks these days. The asset managers GMO recently published their own 7-year average annual real return asset class forecasts. For US large cap stocks, US small cap stocks, international small cap stocks, US bonds and international bonds, those annual return forecasts are all negative.
But not quite everything in the financial universe has seen its yield obliterated by the monetary policy tractor beam. Not quite all valuations are stratospheric. In a recent piece for the Financial Times (“The going gets tough for value managers”), columnist John Gapper suggests that QE “has lifted all boats in the equity markets”. With all due respect to Mr Gapper, that is simply not true. What is true is that to identify genuine value from today’s listed equity markets, you have to go further afield than most benchmarked and index-relative fund managers are either willing or able to. A case in point: the US accounts for fully 58% of the MSCI World Equity Index. Japan, by way of contrast, accounts for less than 9% of MSCI World. Yet over 40% of the Japanese stock market trades on a price / book ratio of less than one. It is objectively cheap – despite the fact that BoJ Governor Kuroda has himself been no slouch when it comes to stimulative monetary policy. And many Japanese companies remain disgustingly under-researched by a brokerage community still shell-shocked by a grinding, two-decade bear market. Question: would you rather look for bargains in a market recovering from 20 years of underperformance – or in a market that, on the basis of current overvaluation, now faces precisely that prospect ?
Absent some entirely magical economic developments, Janet Yellen looks set to be an unlucky Fed chairman. There is a growing risk that the fabric of the financial system may start to unravel during her tenure. Commenting on last week’s do-nothing FOMC meeting, Marcus Ashworth of Haitong Securities pointed out, fairly, that this is hardly progress in rebuilding market confidence in the Fed’s communications policy: now, after last Thursday,
“We are not just data-dependent but uncontrollable foreign economy-dependent.”
So there are some isolated pockets of value out there in stocks, but none whatsoever discernible to this observer from within the bond market – and doubtless plenty of skirmishes in the currency wars to follow. The Fed has managed to paint itself into an extraordinary corner. It has blown a pivotal opportunity to begin normalising interest rates and made its next attempt – if it ever even bothers – that much more problematic. The next flashpoint may not now be in stock markets themselves but in the international bond markets that dwarf them. Bonds, stocks, property – all in a bubble, and with the Fed having exhausted all its current and indeed feasible ammunition. Let’s not mention those $5 trillion of bonds the Fed happens to hold, the prices of which are only likely to appreciate further in an environment of entrenched deflation that will smash the economy in the process. Hardly a picture of progress on the part of our monetary central planners. Janet Yellen may yet go down in history as the very first person, and Fed governor, to have successfully squashed herself.