Active Investing in the Age of Disruption. Evan L. Jones
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investor continues to learn and markets change. The core investment tenets we are discussing may not change, but any completely static process is not growing and evolving. We will discuss where to draw the line between a process that can evolve and become better over time, as opposed to one that is ever-changing and has no foundation.
My conviction in the core investment tenets described not only comes from 20 years of portfolio management experience but also from the opportunity to watch and interact with some of the world's best managers. The investment business is somewhat unusual in that understanding which decision was an error, even in hindsight, is not always readily apparent. It is possible to make the right decision and have a poor result. It is, also, possible to make the wrong decision and be handsomely paid. Some might not call being handsomely paid a wrong decision, but it may be a decision that nine times out of ten will cost you money; you just happened to be lucky in the timing of the investment.
Which experiences are beneficial lessons and which are red herrings?
Individual investment managers do not get the opportunity to analyze a huge dataset of decisions, because there may only be a handful of major decisions made each year.
The conclusions take time to become clear. Major periods of market stress are not very frequent, so the dataset of events to learn from is not large. For this reason, I am very appreciative of having learned not just from my own mistakes but also from watching and talking to the hundreds of global managers that DUMAC has partnered with in the 2010s. My dataset of decisions to analyze and consider has been 100 times what it would have been if I were to have solely managed my own fund and been confined to my experiences.
The next two chapters delve into more detail on the current market environment and the two forces challenging investment decisions today: central bank intervention and technology-driven disruption.
CHAPTER 2 GLOBAL CENTRAL BANK INTERVENTION
Unprecedented global central bank intervention
Fundamental investing overwhelmed by central bank intervention
Low rates and the US consumer
Unprecedented global central bank intervention
Global central bank policy after the 2008 financial crisis and the 2011 euro crisis has been analyzed in hundreds of books and by brilliant economists. The focus here is not on whether it was the right thing to do or could have been done better but on the effect quantitative easing and low rates has had on companies and investment managers' ability to outperform the market.
Global central banks have been actively involved in fueling the developed world economies (US, Europe, and Japan) for the past decade at a level that has never been seen before in history. The Federal Reserve (Fed), European Central Bank (ECB), and Bank of Japan (BoJ) have not worked in exact coordination, but they have followed similar paths. The effect has been that global central banks have been the number one driver of equity markets. The age-old maxim “Don't fight the Fed” has never been more apt than in recent history. US Federal Reserve governors are the new investment rock stars driving financial valuations to historic highs in the 2010s. Central banks globally have succeeded in lowering rates, ensuring credit accessibility, and raising the value of all financial assets without growth in inflation to date. Figure 2.1 depicts the growth in central bank assets of each of the three major developed world central banks in trillions of US dollars.
The magnitude of the asset growth is over 300% since 2007, and globally central banks have purchased over $15 trillion in assets, while GDP growth around the world has been stagnate. Each time one of the central banks has tried to ease off there has been a recessionary scare and they have jumped back in to support a fragile global economy. You can see by the solid line that the US has tried since 2015 to wean itself off the Federal Reserve support system, but as of the fourth quarter of 2019 slow growth and low inflation has the Federal Reserve once again supporting the markets with expected rate cuts and an increase in assets. Back in 2008, no one would have predicted that ten years after the 2008 financial crisis global central banks would hold this level of assets.
FIGURE 2.1 Global central bank assets—US Fed, Bank of Japan, and European Central Bank (2002 to November 2019)
Europe and Japan have not even attempted to slow levels of monetary support. Sovereign rates in these countries have been pushed into negative territory through the magnitude of central bank intervention, a feat that most investors and academics never thought could happen. In November 2019, an investor expected to pay the German government 0.35% and the Japanese government 0.15% to lend the government money for ten years. The ECB holds close to 20% of the sovereign debt of EU countries and has been buying as much as 90% of new issuance in certain months. Paying to lend a country money (buying sovereign bonds) or anyone for that matter does not make economic sense and blows up traditional quantitative models and risk analyses; yet is becoming a normal occurrence in developed world sovereign markets.
The Bank of Japan holds over 50% of all Japan sovereign debt outstanding and has led the quantitative easing experiment by also buying corporate bonds and equity ETFs. The BoJ began buying equity ETFs in 2010 to support the country's equity markets after the financial crisis. It continues to support the equity markets ten years later. In the years 2017, 2018, and 2019 the Japanese central bank bought an average of $50 billion of Japanese equity ETFs each year in an attempt to support the country's equity markets. In 2018, the balance sheet of the BoJ surpassed the country's GDP. The BoJ holds over $5 trillion in Japanese financial assets. The buying is not only unprecedented but also not sustainable.
Central banks would like to raise rates and return to some semblance of a normal rate environment, but they are up against two forces that are proving difficult. Inflation has been below normal levels despite zero percent rates, high asset prices, and large amounts of liquidity and capital in the economy. Globalization provided cheap labor and a large portion of the manufacturing base in the US and Europe moved overseas in the new century. This trend lowered prices and had a dampening effect on inflation. By 2015, the globalization trend had matured, but technology and demographics are now acting as key inflation-dampening forces. The US and Europe are debtor nations, and inflating away debt is the easiest and most comfortable path for debtors. Deflation would be a major problem for both government and consumer debt obligations. The Federal Reserve and all global central banks are very aware of the perils of deflation and the need for inflation. Even if the economy is growing nicely and unemployment levels are low, it would be difficult for central banks to return to historic interest rate levels, if inflation were not to move above 2.0%
History is inflationary; governments promise more than they can provide and they never want voters' assets to be worth less than before.
—Will Durant, historian
Unfortunately, developed economies are not growing at historic rates, if at all. This is another key driver that keeps central banks from raising rates. Neither Europe nor Japan is showing enough growth to even consider lowering support. Eurozone GDP growth has not hit 2.5% since before 2010 and future expectations are anemic at 1% to 2%. Japan has been even worse despite larger levels of support from the Bank of Japan. Growth rates in the developed world as a whole have been below 2% on average since 2010 and are forecasted to stay at these historically low levels.
So a lack of growth and inflation despite historically high levels of asset buying and low rates keeps the central banks from raising rates. Interest rates have remained below 2% globally with Europe and Japan rates below zero. Any time investors