'Jam Tomorrow' Bubble Explodes
Monday, 12/06/2021 09:01
All about the time value of money...
FUND managers have had a good year so far,
writes John Stepek at MoneyWeek magazine.
But the threat both of higher inflation and of higher interest rates is hurting the valuations of the very longest-duration assets.
Markets are looking jittery. What's going to happen between now and the year-end? Will we get the traditional "Santa rally"?
Or will fund managers – having had a good year so far – decide that discretion is the better part of valour and take their money off the table?
Who cares? Most MoneyWeek readers are long-term investors. Even those with a shorter-term focus usually look beyond the next couple of weeks.
So let's look instead at what's going on underneath all the slightly scary headlines.
Because they all have something in common...
I've been talking for a while about the "long duration" bubble – or what I've called the "jam tomorrow" bubble.
Put simply, a long duration asset is one whose expected cash flows lie a long way into the future. It's typically used to refer to bonds. But if you aren't too pedantic then you can make it work for equities too.
Why does this matter?
It's all about the time value of money. £1,000 tomorrow is usually worth more than £1,000 in a year's time. That's because if I give you £1,000 tomorrow you can invest it and it'll (hopefully) have grown by this time next year.
Also, prices usually go up – that's inflation. So £1,000 won't buy you as much a year from now.
The question is: how much less is that £1,000 likely to be worth? Markets are forward-looking. The price you are willing to pay today for an asset should – in theory at least – reflect your estimates of the value of its future cash flows.
One thing affects that estimate like no other – interest rates. If you can put your money away today and earn 5%, say, accounting for inflation, then the gap between that future £1,000 and today's £1,000 is quite big.
But if that falls to 1%, the gap shrinks a lot. You don't mind waiting as much. Or put another way, when risk-free rates fall, the value of future money rises relative to today's money.
In turn, that pushes up the value of "long duration" assets relative to "short duration" assets (ones that are paying out cash today).
This is what lies at the heart of the disparity between growth and value stocks, among other things.
And what's happening now – and in fact has been happening for most of this year – is that the threat both of higher inflation and of higher interest rates is hurting the valuations of the very longest-duration assets. That is, the longest maturity bonds and the most speculative stocks.
As Eoin Treacy of FullerTreacyMoney.com points out, "the most interest-rate sensitive portions of the market are underperforming. For unprofitable companies with dim prospects of survival; without access to cheap abundant liquidity, even a modest tightening of credit conditions represents existential threats."
The ARK Innovation ETF peaked in February and has been struggling ever since – indeed, it's down more than 60% from the high. Holdings in said ETF include electric car maker Tesla and crypto exchange Coinbase. It's a similar story for ETFs tracking the performance of IPOs in the US, and also of Spacs (cash shells).
You could argue that the "jam tomorrow" bubble may have already burst. The tide is already going out, and we're starting to see who's been skinny-dipping all this time.
(This is a Warren Buffett quote reference, by the way, to those who are currently scratching their heads about the choice of analogy).
The question becomes – how far does this go? A lot of it boils down to who is most over stretched.
In 2008, the problem was that the most overstretched sector – US mortgage lending – was also systemically important. So when the tide went out on subprime home loans, it ended up going out on everybody, because the banks suddenly needed every spare penny themselves.
This time around, there are plenty of overstretched-looking areas, from all manner of funding for private companies to unproven tech companies (you need only look at SoftBank's share price to see this in action).
However, the potentially systemic areas are dominated by government debt. And I'm pretty sure that if we see a rapid spike higher in government borrowing costs, then central banks will be called upon to print more money.
That in turn is inflationary. Which is why I don't see a repeat of 2008 on the horizon. I think this cycle ends with inflationary fire rather than deflationary ice.
Anyway – position your portfolio accordingly. Look for short duration equities (a decent dividend is a good signal). Look for inflation hedges (gold is wobbly now but if inflation and financial repression are the end game here then it will pan out).
Oh and subscribe to MoneyWeek. We'll be talking about all this a lot more in the year to come.
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