Cracks in the new orthodoxy

After a decade of unbroken economic growth, at least in the world’s strongest economy, the US, you start to speculate as to whether something has fundamentally changed in the nature of economic cycles. It’s always dangerous to think ‘this time it’s different’ but it is equally dangerous to ignore structural change and constantly live in the past.

In the era post-GFC, policymakers have used a wide range of new monetary tools, all with the explicit or implicit goal of manipulating asset prices and avoiding credit and investment cycles. Prior to this, the economy was prone to a regular series of booms and busts driven by excessive investment and borrowing, which ultimately unwound as markets moved between fear and greed. We have now gone ten years during which we have seen only mild cycles at worst and on the occasions where credit or equity markets have attempted to discount an economic cycle, policymakers have come to the rescue with further rounds of QE type ‘free money’. We might criticise this overt manipulation of asset prices as against the principles of a free market, but it is hard to deny that we have experienced a long and sustained period of growth.

So, maybe it is possible to argue that the policy is working at reducing the impact of credit and investment cycles of economic growth. There have been unintended consequences however, in terms of incentives and capital allocation with the capital investment, and hence, productivity cycles being muted and debt levels in the economy becoming ever more elevated. It is also arguable that the policy has led to perverse incentives such as companies borrowing money to buy back shares, replacing equity with debt, rather than investing for growth, or investors being happy to hold bonds with negative real yields somehow considering a certain negative real return as an attractive investment.

As investors, our challenge is to invest money rationally when we do not, for now, know what rational is anymore. If we assume that the new monetary system can avoid or at least temper cycles going forward, then maybe it is rational to own the bonds of highly leveraged businesses at very low yields. The problem arises if we are wrong, the downside implied in a reversion to the old normal is simply huge now. The same observation can be made in venture capital markets and the growthiest of growth equities. If cheap money remains available forever and the stock market can avoid anything more than the occasional correction, then maybe the valuations applied to mega cap growth darlings can be sustained, but what happens in the alternative scenario? Many of these companies are dependent on continuous funding with cheap money for their very existence, without it they would quickly unravel as they have no underlying profitability.

This brings us to recent events, a huge proportion of recent US new equity listing has been of loss making businesses, where future success is expected to justify the valuation. However, recently new issues have been falling to discounts implying that the stock market is taking a much less rosy view. The worry is that even with ever more QE, asset markets can only be stretched so far.

Our approach to navigate this environment is to avoid the extremes of high debt levels or high valuations as this is where the worst losses will be if the new monetary system eventually does fail to prevent a credit or investment cycle. This does not mean we cannot find attractive investment opportunities which do not require adherence to the new orthodoxy just in case the market does eventually wake up.


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Source for information: Miton as at 17/04/2019 unless otherwise stated.

The views expressed are those of the fund manager at the time of writing and are subject to change without notice. They are not necessarily the views of Miton and do not constitute investment advice.

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