“Davidson” submits:
Current market conditions and misplaced investor pessimism make this topic worth revisiting. Continued revisits will likely prove valuable as global events play out. The value of hindsight is that it reveals the likely basis of significant market shifts the importance of which were not knowable at the time. Experience teaches that the most useful hindsight requires a look-back often encompassing decades.
Three(3) misperceptions that are key drivers of market psychology apply to the current topic.
- Central Bankers control interest rates-(not true)
- Emerging companies and emerging countries have the best returns-(not true)
- Market prices, the basis of Modern Portfolio Theory, reveal all one needs to know to invest-(not true)
The narrative begins with the enormous performance of Japanese market which evolved into the Nikkei 225 Index from $91 June 1950 to more than $39,000 Dec 1989. Few Western investors participated and only late in the 1980s did many become aware of ‘Japan Inc.’, an economy managed by a small group of politicians and corporations in Japan as some sort of miracle market. Hindsight revealed an excessive level of market manipulation by overly optimistic insiders which many still do not understand today. The performance convinced many to seek other Emerging Markets with similar potential for returns not available in traditional Western markets. The issue quickly became that Emerging Markets did not have the capital market infrastructure nor enough individual opportunities to absorb the capital that sought positions. The 1990s was a period of establishing the equity and fixed income trading capacity each market allowed and then gradually bringing sufficient number of formally private companies into newly created public markets.
Rapid Growth Of Emerging Markets
“Equity markets in LDCs expanded rapidly during the first three quarters of 1994… This growth marked the continuation of a trend, as the decade spanning 1983-93 had seen a 20-fold expansion in the total value of shares in the 25 emerging markets tracked by the World Bank’s International Finance Corporation. Expansion had been particularly vigorous in 1993, when U.S. investors buoyed overseas bourses by purchasing record amounts of foreign-equity shares.” . https://www.britannica.com/topic/emerging-equity-markets-566722/Global-Developments
The wide-spread belief of the corporate world at the beginning of the 1980s was that widening US global trade would spread democracy and world peace. Senior GE sales people at the time, believed that by expanding into foreign markets, those markets would adopt Western rules of business conduct and democratic culture. Modern Portfolio Theory incorporated new markets as fast as they emerged. What hindsight reveals is that as Emerging Market privately-held corporations gained liquidity, capital, now liquid, began to find its way back to the Western real estate and Sovereign Debt markets. This shift began slowly during a period of falling inflation and falling Sovereign Debt rates and can only be understood by the data we have today. The NAREIT index which covers the period from 1972-Present maintained a dividend level between 7%-9% till Jan 1993 when it traded to yield less than 6.60% for the 1st time in 21yrs. Real estate and Fixed Income have a history as culturally favored for those without extensive equity experience. This was the first evidence, not obvious at the time. that capital from Western investors seeking higher returns was in fact being returned to Western real estate and Sovereign Debt seen by Emerging Market investors as a safe haven. Western investment capital flow based on the belief that democratic principles followed was countered by native investor recognition that their own governments were confiscatory and not as safe as Western markets. In effect Western capital sent to Emerging Markets gained a different cultural perspective and boomeranged back to Western markets seeking safety. Modern Portfolio Theory using the history of the Nikkei as a base increasingly funneled capital to Emerging Markets. Modern Portfolio Theory is based on the Free Market in the US and has zero sensitivity to the anti-capital environments of Socialistic, Communist, autocratic or dictatorial governments. In recent years the flow of capital seeking safer markets has accelerated with growing global political turmoil. Rates in the US appeared to normalize with the 2008-2009 Great Recession, but as recovery accelerated so did capital shifting to Western markets with negative rates beginning to appear in 2012.
Negative rates began to threaten Sovereign debt when short-term Swiss securities traded with 0.0% yield in 2012. When Russia invaded Ukraine, all short-term European rates became negative. At the beginning of 2015, Swiss 10yr Sovereign Debt became negative with other countries following shortly. The US witnessed a surge in the US$ with 10yr Treasury rates falling close to the record lows of the ‘Cyprus Bank Scare” 2011. For the most part, capital shifts were explained by Russia’s actions and banking scares, but since then negative rates have persisted and confidence in understanding the reasons behind investor behavior have been laid at the doorstep of Central Bankers attempting to stimulate their economies. Central Bankers follow the rate trend. They do not set rates.
MSCI recently added Chinese markets to the recommended indices for institutional portfolios. Capital has been flowing into Chinese securities for some time the addition of Chinese securities to MSCI indices has accelerated Western capital inflows. Unfortunately the activity following Modern Portfolio Theory comes on the heels of Xi Jinping’s elevation to Chinese leadership(Nov 2012) and a sharp turn away from what was believed to be a path towards Democratic principles. Investors began to shift capital out of China Jan 2014 causing the Yuan/US$ exchange rate to weaken. Concurrently 10yr Treasury rates have declined with each bout of Yuan weakness and real estate prices have continued to rise. These correlations have only become tighter in recent days as the daily data in Yuan vs Hong Kong$/US$ Exchange vs 10yr Treasury Rate demonstrates.
Western investors continue to be perplexed by negative rates. It should now be obvious that significant global capital shifts have occurred due to geopolitical events. While negative rates appear detrimental to the Western financial system and illogical to Western investors, from the perspective of Emerging Market investors the returns have been quite positive. Capital is fungible with many circuitous routes available. There is no reliable means to track it. The most useful means we have is to watch currency exchange rates and the most likely investments for capital seeking safety from confiscatory governments. That China has reached a comparable capitalization rate to the US and executed a tight turn away from Free Markets makes viewing the movement of capital relatively simple. From the Chinese point of view, those who were early movers have gained not only ~15% from the favorable currency exchange rate shift(Yuan vs US$) which occurred since 2014, but accrued additional gains in Western and US real estate and Sovereign and US Treasury securities. They even have capital gains as rates fell. China’s actions have provided visibility on drivers of global capital but capital has been flowing to the US since the early 1990s especially so as various countries turned more autocratic. Where ever a currency exchange rate has weakened vs the US$, one will find weakened individual protections to private property. The list of countries includes Turkey, Iran, Venezuela, Brazil, Russia, Mexico and even the Eurozone recently.
Dec 2018 saw negative rates on ~$8Trillion of Sovereign Debt. By Aug 30, 2019 negative yielding debt had grown to more than $17Trillion. It should come as no surprise that the Yuan’s weakness has been a large part of this unusual period of negative rates. China and Emerging Markets did not create the bulk of the capital which has caused these imbalances. Much of that capital originated in Western markets seeking diversification and higher returns. Once that capital entered these markets, enough was recycled back to Western markets to create the condition we see today.
What’s next? Forecasting the future has always been the hard part. The considerable imbalances seen today make this even more difficult, but how US companies have responded thus far and the positive government initiatives recently and in process offer a positive outcome for US only focused investors.
- Low rates means low cost of financing debt
- US has implemented considerable expertise in ‘lean mfg’ to counter deleterious impact US$ strength has on exports
- US remains on trend extend the current expansion the next few years-employment, retail sales, personal income continue to record new highs and etc
- US is the only Free Market and culturally the most innovative/creative globally-this will continue to outpace every other country
- Current government initiatives working towards no tariffs and other countries paying an equal share for US intellectual property(in the past much US creativity has been given away)
For decades the US has born the development cost of many innovative developments and once proved shared products globally at much lower cost having already recouped R&D costs through introductory pricing to our own population. This is most evident in key pharmaceuticals which cost as much as 90% more in the US than in other countries. Policies which require prices to be the same globally are being considered. The issue is fairness. US citizens should pay the same for innovation as any other consumer.
In my opinion, what could be next is a shift out of negative rates to dividend paying equities. This has already occurred to REITS and utility issues, but left on the sidelines are many healthy companies with exceptional long-term operating histories and growing dividends in the 3%-5% range. In my opinion, those who have been comfortable with Fixed Income and Real Estate will branch into solidly managed companies currently selling at large discounts. The shift higher for US equity prices could be substantial.
Be patient. Be US focused. Low rates and a terrific economy with tons of innovation is a good place to be invested.
