Gold, Bonds, Tech: An Unholy Bull Market
Monday, 7/20/2020 09:01
Trinity of risk off, risk on spells trouble...
'RISK OFF' or so-called "safe haven" assets such as gold and government bonds have been doing well lately,
writes John Stepek, editor of MoneyWeek magazine.
But so have riskier tech stocks. That seems to defy common sense.
Gold has been doing well, poking its head above the $1800 an ounce mark for the first time in 11 years. Meanwhile, yields on government bonds remain solidly low or even negative.
Both of those things point to "risk-off" sentiment. In other words, investors running for what they perceive to be "safe" havens. Yet, while most stocks have had a mediocre time of late, tech stocks continue to soar to bubbly-looking levels. That's more of a "risk-on" trade.
What's going on? Believe it or not, there's a rational explanation for all this.
Tech stocks, gold, government bonds – one thing that all of these assets have in common is that they're all beneficiaries of a world in which interest rates are lower for longer.
Gold does well out of low interest rates, assuming that rates fall faster than inflation does (in other words, as long as "real" interest rates are falling). This is why it's not entirely accurate to say that gold benefits from inflation. Prices can be falling (we can be in deflation), but as long as interest rates are falling faster, gold can still do fine.
Government bonds (and high-grade corporate bonds) will do well out of low interest rates because they're seen as being safe and if – as an investor – you can't get a better rate elsewhere without taking lots more risk, then you'll just put up with it.
As for tech stocks – what they have in common with gold and government bonds is that they are also "long duration" assets (a "long duration" asset is one that takes a long time to pay you back, whereas a "short duration" asset pays you back within a short period of time).
In "normal" times (I put normal in inverted commas because increasingly it refers to a time period which is now more than a decade in the past), money today is considered significantly more than money a year from now.
So if you're looking at an asset which will pay you a year from now, you need to apply a discount rate to that future money. A high discount rate means that the future money is worth a lot less than money today. A low discount rate means there's less of a difference between the two (and a negative discount rate would mean that money in the future is in fact more valuable than money today).
Putting it even more simply, we have a default mental framework of the world in which a bird in the hand is worth two in the bush. But right now, that's not the case.
When interest rates and inflation are low, then it means that you aren't so worried about waiting for your money. The bird in the hand really isn't worth much more than the two in the bush. In fact, you'd rather wait for the two in the bush.
That broadly describes tech stocks. The business model there is that you spend loads of money today on building a network. Once everyone is in the network, they're trapped, and your profits explode higher, showering investors with cash (at least, that's the plan).
Electric-car maker Tesla is one example of this in progress (once everyone owns an electric car, Tesla will have the dominant market position and will be able to sell the owners downloadable upgrades, etc etc). Meanwhile, Amazon is an example of a company that has already succeeded at this to a great extent.
Older economy stocks – energy being perhaps the most pertinent example – might make money today (or at least produce cashflow), but they have a business model that will only ever grow at a certain rate. And with energy stocks, the current belief – which may be right – is that they face inevitable decline.
So you can buy a tech stock, which will produce a near-infinite sum of money at some point in the as-yet-undetermined future; or you can buy an energy stock which will produce a predictable amount of money today and a declining pile into the future.
If interest rates and inflation are high, you might well favour the latter. You'll take your jam today – the future is too uncertain. But if rates and inflation are low, the huge pile of money in the future from the tech stock is far more attractive than the little and declining pile of money you're getting today from the energy stock.
To be clear, I'm not making any judgement either way on which you should invest in. (It does feel that we're at extreme levels but we have been for some time). I'm just trying to explain what I think is going on in the market's head right now.
Markets are probably right to bet on interest rates staying low. That's almost a given – central banks won't let them rise if they can help it (it's called financial repression).
What they are perhaps overly confident about though, is the idea that inflation won't become a problem. And that's what would most likely drive a shift in regime. When might that happen? I don't know. But I am pretty sure that the coronavirus pandemic has brought the day closer.
We'll be writing a lot more about this in MoneyWeek magazine over the rest of this year. If you don't already subscribe, now's the time to do so.
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