Interest rates are to asset prices what gravity is to the apple

“When there are low interest rates, there is a very low gravitational pull on asset prices…The most important item over time in valuation is obviously interest rates" 

- Warren Buffett.

Sensible Stanley

I have always found Stan Druckenmiller to be a sensible voice, in an often-emotional field of pursuit. With no clients save himself, he can be patient, seldom suffers FOMO (Fear of Missing Out) and starts from the position of capital preservation. He will strike, but only at a fat pitch. Patience is an enviable character trait, especially at the end of a credit cycle where opportunities exist to buy assets, cheaply. In a recent interview with Paul Tudor Jones, he talked about his views on markets, bonds, bitcoin and gold. He’s still long steepeners (focused more on the short end falling), he owns gold (“a 5,000-year-old brand”) and would buy bitcoin “if he was younger”. Of more interest were his comments re things being very different in a post QE world. He believes we need to challenge the idea that stocks always go up. They don’t. Especially if starting valuations are high. Price always matters and in a non-QE world where rates find a new equilibrium, so too must market multiples. As discussed previously, this was the biggest lesson of the ‘70s where US stocks went sideways from 1968 – 1982, but where multiples compressed from very high levels to under 10x. My suspicion, as is Druckenmiller’s, is that the S&P will be about the same level in ten years where it is today. Passive index investors will have taken a bath (and destroyed value in real terms) and active Buy (and Sell) investors, especially those with a propensity to carry active share bets in small caps or international markets will have done very well. After all, the UK and Japanese markets have already digested a sideways market for 20 years in the case of the UK and about 35 years in Japan. Valuations are now low and change is afoot. The future is NOT in the past. Unless by the past you mean that prior to 1982.

A pension pensioner crisis

The word “pension” originates from the Latin term “pensio,” which means “a payment.” The term came into English from the French “pension” in the 16th century and initially referred to a fixed, regular payment made under various conditions, such as to a retiree. It’s this idea of a regular, certain and predictable payments that allows workers to plan for their future and formed a core aspect defined benefit (DB) plans in the UK and elsewhere. As you know, defined contribution (DC) schemes don’t have this certainty, shifting the risk from the pension provider to pensioner. Accordingly, there’s a push by some to have them rebranded as retirement funds or later life-savings, for they fail the definition of fixed payment. Of course, you could buy an annuity with your savings pot, which would provide more ‘pension’ characteristics. But here's the rub. For those hoping to retire soon, you might find this pot has been decimated if you invested, as many have, into a default Lifestyle Fund, which allocated more to bonds as you approached retirement. Some of these have halved. Equities are up. Just saying.

Blame the game, not the player. The sin, not the sinner

It’s tempting to blame the players in a ‘crisis’ (and -50% is a crisis for some). But they are just playing by the rules of the game. Maybe we should question the game. And the spectators. Have we sat by and watched a system, led by accounting rules and regulations (think FRS17) with a myopic view of history, create a crisis for pensioners who now can’t afford to retire? Surely it’s time to question the rules of the game and the assumptions that underlie it. Assumptions such as that bonds are negatively correlated to equities (historically they are not), that bonds are ‘risk free’ and that they are optimal for matching purposes (see below)? At least let’s ask if there is a safer alternative, a more future-proofed asset class that is better value, unlevered, grows its coupon over time, generates income for the public purse and when it performs well, installs confidence in both corporates and consumers. If only there was an asset class like that. If only...

Why buy equities?

UK pension expert Henry Tapper posted a short article on his blog written by Con Keating entitled: Why Buy Equities? In a brief missive, Keating challenges the argument for using bonds to match pension liabilities. “This argument is rooted in the “Law of One Price” and that is a key ingredient in modern finance theory. It is, of course firmly based in what he refers to as ‘Model Land’…and that “reality is a very different world to "Model Land". For a pension fund investor he concludes “equity offers superior returns in all but the most unusual of circumstances” (my emphasis). And that using bonds for matching pension fund cash flows is a “very expensive and far from optimal way in which to deliver the returns needed for our pensioners to have a dignified retirement in the real world”. My only caveat: beware of starting valuations (which in the UK, Japan and Brazil could look very attractive!)

PS: re Bonds, seasonals and gold

While it might seem I’m beating-up on bonds again, we actually called time on their recent sell-off last week, at least the 10-year (for a trade only). With less gravitation pull, equities rallied. The question now is whether yields stay here and ignite a seasonal year-end rally in stocks. The only insight I can offer is that many allocators I know are tactically underweight equities, having positioned for recession as they entered 2023. As markets have rallied, that underweight has increased. Should they now look to rebalance into year end, seasonal patterns could support this, save of course any further geopolitical escalation. Back to bonds. Active bond investors must learn to exercise a new muscle; let’s call it selling discipline. This will, I believe, be a critical skill to identify, especially during a period of prolonged inflation and rates volatility. You may not make much money, in real terms, holding bonds to maturity but there will be times when price provides an opportunity – like it did recently. And of course there are higher compensatory yields in credit, which explains why absolute return fixed income managers are seeing plenty of interest (see above: lifestyle funds). For central banks, we still a believe a better reserve asset, in that it’s no one else’s liability, is gold. The Chinese seem to agree. Note China led record central bank buying in the first nine months of the year.

Watch your language

Language matters. How we speak drives how we think. How we think drives what we do, or choose not to do. Recently we are being forced to question certain maxims. Are bonds really ‘safe’, do US stocks ‘always go up’, is PE truly a diversifier and are commodities too speculative? I think we’ve found answers to some of these, certainly those relating to bonds and PE. But are there any better alternatives?

A better Alternative

Yes, there might well be an Alternative asset class. One not reliant on leverage or information asymmetry to generate returns. One not displaying late cycle dynamics or a satiated investor base. In fact it’s facing historically low institutional and retail participation, is good value relative to history, has genuine inflation protection, generates cash-covered coupons (known as dividends) and having faced years of regulatory scrutiny, is experiencing a lighter more accommodative touch and potentially, positive tax reforms. It’s called the UK (and Japanese) equity market. Both stand at the juncture of several of the largest (potential) mean-reversion trades I’ve seen if years: from ethereal to material, expensive to cheap and private to public. Let’s start a movement. A cult, perhaps? The cult of equity.

Reviving an equity ‘movement’ through competition

Quite a lot of talk in the UK press this week about the upcoming Edinburgh Reforms (intended by the UK Government to drive growth and competitiveness in UK financial services) and what that means for UK assets. Some suggestions may not work as intended. Others touch on things we’ve discussed here previously: from returning ISA tax breaks to domestic shares, creating a sovereign wealth fund to invest directly in UK Plc and improving financial literacy. We’ve already seen a more competitive renumeration regime (removing bonus caps), easier listing requirements and upcoming reforms of MIFID II to promote research participation and market sponsorship. But we need to be braver. I think we need to reform FRS17, align tax treatment of retail owners of UK shares to the same as mutual funds, increase the tax-free allowance on gains and then go find a champion to wave the flag for UK equity. Someone like George Ross Goobey.

But to really turbo-change interest in the stock-market over time, start with the young. We should create a stock market competition in Schools and Universities that combines leaning and gaming. Incite human nature. Find corporates, fund managers (I’ve already spoken to a couple), banks, brokers, exchanges, VC networks, consultants, researchers, quangos (Innovate UK), universities, etc. to sponsor, put up prize money, internships, tuition, scholarships. And for the platform, leverage The Small Cap Research Platform the government wants to build – this could increase its ‘surface area’ on Day 1 and help create the desired network effect. Provide research access and tools to enable all students to pick stocks. It taps into competitive desires, FOMO, and connects brands with wealth generation – directly. Drive a sense of community, even tribalism around local companies and increase knowledge of investing and of corporates themselves. Fund it through selling the data (assuming you could) to some of the growing numbers of AI firms, including perhaps those who visited the UK this week – as I’m sure it’s a treasure trove for sociologists, election campaigners and fund managers. Equity ownership is about the future, so what better place to start than with those who will create it? Yes, change needs a champion. It also needs the youth.

A champion like George

When George Goobey started work at the Imperial Tobacco pension fund in 1947, the prevailing asset class of choice was fixed income. He felt the yield on government debt failed to compensate, in real terms, for inflation. And being fixed, it would destroy value over time (for what good is getting your money back if it’s lost its purchasing power?) Rather, equities – which were higher-yielding and with growth potential – offered a much better chance of delivering above-inflation returns. After some persuasion (involving a second-hand Bentley, a rushed golf-club membership and hilarious propaganda campaign) the trustees allowed him to do what no other fund had done: sell all their gilts and replace them with equities (for more on this read John Plender’s book). This change in thinking became so popular that it led to the Trustee Investment Act of 1961, allowing general trust funds to invest up to half their money in equities. By 1963, every professional money manager was climbing aboard the bandwagon. The market and economy soared. By the early ‘70s professional managers owned nearly half of all listed share capital in the UK and Goobey was considered the inspiration for the ‘cult of equity’. Could history rhyme? I’m not sure but one thing is certain. Imperial’s pension fund in 1947 sounds a lot like many UK pension funds today. All we now need is a George.

And finally. Seeing as some of you care…

To all those gurus, therapists and life coaches who say “Life is not just about peaks and valleys, about wins and losses. Life is about the journey…”

Well, I say to you as a New Zealander: codswallop! Sometimes life is about winning the Rugby Union World Cup. We didn’t last weekend.