Wednesday , 22 May 2024

World’s Awash In Money: Its Implications & How to Invest Accordingly

[Bain projects that] if interest rates remain low then capital must go up the risk curve to earn income because although capital can sit idle, earning little for a while, it cannot do so for the long term.

[My comments: I agree.] With interest rates low for an extended period of time, capital must continue to go up the risk curve. It must do so because otherwise, pension funds will not be able to pay benefits, savers will not be able to earn on their money, and money managers will not get paid. Perhaps the last point is the most important. Active money managers of all types get paid by investors only because the investors believe that they can make more money for their capital. That forces managers, in their own interests, to take risks. Don’t take my word for it. Take a look at the brilliant speech by Federal Reserved Board Governor Jeremy Stein last week. He explains the mechanism through which the agency problem operates here almost to guarantee that in an extended low-interest-rate environment, investors will take greater risks. There is ample evidence that risk-taking has increased already. Some brokers go even further: They sell the illusion of higher returns with safety. Of course, safety is the illusion.

Capital can sit idle for short periods of time but [as Bain points out] over the long term, if short-term interest rates are low, it must take risks. They can be credit risks, interest rates risks or market risks – but risks must be taken.

3. Equities Will Benefit From The Risk-Taking

[Bain projects that] if capital must go up the risk curve, it must invest in junk bonds and equity, as well as fancier strategies that seek to take advantage of small arbitrage opportunities. Junk bonds will, therefore, suffer losses from time to time, and the arbitrage opportunities will be competed away by the smart people managing the money looking for the opportunities. That will leave equity as the most likely place for decent returns but those returns also will be competed away as world markets get frothier, simply because there is nowhere else for the money to go. That will lead to another crash when interest rates turn back up, probably as a result of a spike in inflation, or due to some other unsettling event.

[My comments:] The risks that capital will take will be various. Gold and real estate have obvious market risks, as do equities. Long-term bonds have obvious credit risk. Adding leverage increases whatever risks are taken, but also can add to returns. Many people and institutions will elect to take the leveraging risks because they are not as obvious. Of course, the leveraging risks add risk not only to the individual investor or institution, but to the entire financial system as well.

Equities, the asset class that I like to invest in, should benefit from the global rise of available capital. Gradually, it should result in higher valuations relative to traditional metrics. It is quite possible that we have seen that in action already, as the U.S. stock market has been elevated by many measures since 2010. Although that is unlikely to continue forever, additional investable liquidity in a continued low-interest-rate environment is bound to induce investors to seek returns that are less certain than historical metrics would suggest to be prudent in light of the accompanying risks….

Many investors make their asset allocation decisions emotionally, based on the most recent events in the markets. Many have essentially been out of the stock market since the lows of late 2008-early 2009, leaving one of the greatest bull markets in history for others to benefit from. Some of those investors are returning to the market this year. This may be a bad time to do so, despite my longer-term prognostication. Markets can be skittish for a variety of reasons, so the market may go down tomorrow and may continue to go down for a period of time. Good investors know that, and prepare for it mentally as well as by having money to invest when the market is down.

How out of historical kilter will the metrics go? I am a pretty fearless prognosticator, but even I will not venture any guesses.

4. Eventually, The Risks Will Come To Fruition

A time will come when, despite the world still being awash in liquidity, the overall level of risks being taken is going to spook market participants in all of the risky assets and strategies — probably all at one time. When that happens, there will be another great unwind. Probably it will look very different from 2007-2009, but its results may be similar. All the risky plays will collapse at once, and those who have leveraged their plays will be hurt the most.

5. When Is Eventually?

Eventually comes when there is a market shock. It may be inflation. It may be war. It may be the pricking of a bubble in some asset class that causes investors in all asset classes to feel potential contagion and therefore, actual contagion. Few investors will be able to predict when it is going to happen but…predict that it is not going to happen for awhile. In the meantime, the stock markets will meander up and down, but secularly up, and those who elect to sit on the sidelines are likely to have low returns unless they decide to take other risks, such as high leverage, a great deal of interest rate or liquidity risk, or get lucky with an alternative asset class.

The Lesson

The lesson is that:

  • owning risk assets (not highly leveraged) for the near, and probably intermediate, term looks like it will be fine.
  • In the long term, however, the day will come when the chickens come home to roost.

Sensible investors therefore, will design their portfolios to take advantage of the relative risk-on period that is likely to continue, while covering their downsides where possible….

Editor’s Note: The author’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.


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