Global Insights

Navigating the markets in an upside-down world

By driving the real cost of capital into negative territory, major central banks have broken a cornerstone of capitalism – one that determines how assets are valued and capital allocated. In today’s unanchored world, investors need to challenge long-held orthodoxies and rethink their allocations. Read the summary of Michael Power’s talk at Global Insights 2022.

Jun 8, 2022

3 minutes

Michael Power
By driving the real cost of capital into negative territory, major central banks have broken a cornerstone of capitalism – one that determines how assets are valued and capital allocated. In today’s unanchored world, investors need to challenge long-held orthodoxies and rethink their allocations. Read the summary of Michael Power’s talk at Global Insights 2022.

The fast view

Fundamental principles of modern finance no longer hold

  • Modern finance was built on the assumption that taking risk should cost money in real terms.
  • Due to ultra-loose monetary policy, this fundamental principle has been broken. Real (inflation-adjusted) yields have been negative in much of the world for several years.
  • The pandemic and Russia’s invasion of Ukraine have exacerbated the issue, and persistent inflation has become an even more serious threat.

A race against time in uncharted territory

  • The US Federal Reserve (Fed) is in a race against time to tame inflation before recession hits. With markets implying that it will take five years for US inflation to fall to 2.5%, failure is a distinct possibility.
  • If recession arrives first, the Fed may be obliged to cut rates and the Fed Funds rate would have to stay too low to tame inflation, with real yields remaining negative. Medium- to long-term US inflation expectations could become ‘unanchored’, raising serious questions for financial markets.
  • For one thing, this could put the US economy in the opposite of a ‘goldilocks situation’ – one characterised by low growth, weak employment and untamed inflation.
  • The Fed and many of its global peers are severely constrained: debt levels have risen so dramatically since 2010 that significant hikes in interest rates would make debt-servicing unaffordable.

The foundation of asset valuations has broken

  • As Allison Schrager of Bloomberg notes: “The risk-free rate is the foundation of asset pricing; if it's askew, so are markets.”
  • The risk-free rate is the key ingredient in the most important measure in capitalism, the weighted average cost of capital (WACC). Today, calculating WACC is not just extremely challenging, it may be theoretically impossible.
  • The equity risk premium – the return above the risk-free rate offered by stocks – is now below 2%, a post-Global Financial Crisis low. The equity market has become untethered from fundamentals. So, while equities remain investible, investors need to find a new way of assessing them.

Investors should brush up on ‘geoeconomics’

  • A further challenge for today’s investors is the rise in geopolitical tensions. While intangible in nature, this is something that we need to somehow make measurable; welcome to ‘geoeconomics’.
  • The world is moving from a single sphere of influence (the US-led international order) to multiple spheres of influence. In parallel, there are now multiple ‘atmospheres of capital’ for investors to navigate.
  • It is possible to invest in multiple atmospheres, to cross over from one to another and return. But extra risk might be entailed, so extra reward for that cross-over risk might be sought.

Navigation points for global investor
Investors need new approaches to navigate this upside-down world and its fluid geopolitical and geoeconomic divides. Here are some of the factors we think investors need to consider.

  • While headlines suggest the Chinese renminbi has crashed, it’s more relevant to look at the currency against the US Dollar Index (DXY). That’s what the People’s Bank of China has its eye on as it determines how competitive China’s exports are relative to its biggest competitors: Germany and Japan.
  • Today, investors in the US dollar ‘atmosphere’ face a dilemma: a negative real yield on the bond and cash market and an equity market valued off a negative real WACC. This makes it challenging to value these asset classes using fundamentals. Chinese markets do not face these issues and China’s government bonds pay investors a positive real yield.
  • While the US and other developed economies face problematic inflation, in China and many of its regional peers, inflation remains at manageable levels, creating a big difference in these two atmospheres of capital.
  • In recent years, China has recycled a significant proportion of its external surplus into strategic reserves of commodities. This is one reason why commodity prices have risen so much. Since 2020, the inverse relationship between the US dollar and commodities appears to have broken.
  • Recent geopolitical events, including the nationalisation of Russian FX reserves, may speed up the decline of the US dollar as a reserve currency.

 

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Authored by

Michael Power
Global Strategist

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