The Investment Pendulum

What will happen if the pendulum of the European Central Bank’s expansionary monetary policy stops swinging?

Introduction

“The mood swings of the market resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum ‘on average’, it actually spends very little of its time there, constantly swinging towards or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that will move back towards the midpoint sooner or later. In fact, it is the movement towards an extreme itself that supplies the energy for the swing back.”

– Howard Marks, 1991

 
 

As a child, the pendulum of my grandparents’ clock fascinated me. My grandfather used to give tension to the mainspring every night so the pendulum would continue to swing. One night, I asked him what would happen if he forgot to give tension to the mainspring. “The pendulum would stop,” he answered.

Many investors, including myself, are now asking what will happen when the European Central Bank’s expansionary monetary policy stops.

Negative Bond Yields

The current central bank monetary policy has, at the time of writing1, already driven nominal 10-year bond yields to negative territory in six EU countries – Germany, Denmark, Netherlands, Austria, Finland and France. So far, Spain and Portugal are still paying 40 and 45 basis points to issue long-term debt.1 However, I would not be surprised – should this monetary insanity continues for longer – if Iberian countries also join the ‘pay-me-to-borrow’ club. How distant seems that hot summer of 2012 when Spain was financing itself at 6.8% and Portugal at 9.1% (Figure 1)! For what it is worth, Portugal and Spain are still budgeting for a public deficit in 2019 (0.2%2 and 2.5%3 of the annual GDP, in the boom phase of the cycle!), while the stock of public debt remains stubbornly high at 122%4 and 97%5, respectively.

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Source: Bloomberg; as of 10 July 2019.

The lack of inflationary pressures is the perfect excuse to keep rates at low levels. However, Japan is a live example of how expansionary monetary policy failed to drive inflation. Instead, I believe Europe should focus on reforming and stimulating corporate investment, which creates jobs and drives growth. The real beneficiaries of this EU monetary fairy-tale have been private equity firms and highly levered companies. Almost no week goes by without another private equity (‘PE’) fund making an offer for a listed company using extreme leverage levels!

As a fundamental portfolio manager, I spend most of my days meeting management teams of European companies. So far, I have not come across even one management team that is investing in Europe because of the low interest-rate environment. On the contrary, companies are postponing investment decisions because of political uncertainty – arising from Brexit, nationalism and protectionism, among others – but also because of lack of reforms in Europe.

Telecoms and utilities are just two examples of the lethargy that this lack of long-term approach to regulation is driving. Telecoms’ investment in 5G is taking longer to ramp up, with companies instead involved in onerous spectrum auctions selfishly designed to maximise single country revenues.

European utilities prefer to invest in renewables in North America, where they can hedge power prices for much longer periods, avoiding the regulatory uncertainty of a non-coordinated European energy policy.

Then there is the perennial issue of Brussels’s red tape, not allowing European companies to compete in equal footing in the global market, supposedly to instigate competition. The latest high-profile example is striking: in Europe, Siemens’s and Alstom’s plan to create a rail champion was blocked by the EU regulators; in China, the merger between CNR and CSR to create CRRC (which operates a quasi-monopoly in the country) was not only allowed, but in fact promoted, by the government.

An Equity Bubble

Negative European bond yields are pumping up another remarkable bubble in equity markets, illustrated by the premium of growth relative to value and equity income stocks. The current premium of growth versus value in Europe has surpassed the dot-com high. ‘Older’ investors still remember, albeit necessary, how painful the bursting of the dot-com bubble was. In my mind, the pendulum will swing back as violently as it did back in the year 2000. Believe me: this time will not be different.

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Source: Bloomberg; as of 10 July 2019.

One interesting – and non-consensual – observation about this growth outperformance is that it is not supported by earnings. Indeed, since the second half of 2016, earnings of value stocks have been outperforming those of their growth peers, leaving the rally of growth equities to be explained by multiple expansion, which, in turn, is a reaction to lower rates. The market has clearly taken a view: the lower rates go, the highest the multiple growth stocks should trade at.

Figure 3. Growth Versus Value Relative Performance and Relative EPS in Europe

Source: Bloomberg; as of 10 July 2019.

Investment Opportunities

So, where do I find investment opportunities in the context of the current monetary and equity growth exuberance? My answer lies in the differential between equity and bond yields.

Across the sectors, the difference between the cost of financing for an individual company – depending on whether it chooses to tap the debt or the equity market – has never been so wide. A natural reaction to this would be European companies leveraging themselves up (to take advantage of the exceptional low cost of debt) and using the proceeds to buy back their own stock. Interestingly, this arbitrage opportunity is specific to Europe, with the gap between equity and bond yields at average levels in the US (Figure 4).

Figure 4. Spread Between Equity and Bond Yields

Source: Bloomberg; as of 10 July 2019.

Conclusion

So, if you believe that one day, inflation will come back to Europe or that the new ECB president Christine Lagarde will take measures towards a normalisation of the monetary policy, the pendulum will swing back. And not only will it swing back, but it will do so violently. And the biggest bubble that I have experienced in my investment life will burst.

 

 

1. As of 11 July 2017.
2. http://www.xinhuanet.com/english/2019-05/18/c_138067523.htm; as of 17 May 2019.
3. https://tradingeconomics.com/spain/government-budget; as of end-2018.
4. https://tradingeconomics.com/portugal/government-debt-to-gdp; as of end 2018.
5. https://countryeconomy.com/national-debt/spain; as of end 2018.