Active Investing in the Age of Disruption. Evan L. Jones
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rates to be rising they flee the markets and growth slows even further forcing global banks to reconsider any rate raises. This is a rate environment that was never anticipated, especially with US unemployment levels below 4% and the US stock market reaching all-time highs (3,100+ on the S&P 500 in November 2019). There is no historic data on this level of central bank intervention, so derivative effects are not known in the intermediate or long term. Despite (or because of) this, equity and bond markets remain unperturbed, demonstrating the lowest volatility levels in history. The 2010s will be remembered for central bank intervention driving the lowest rates in history and the equity markets demonstrating the lowest levels of volatility.
[On 0% interest rates] I can't figure out how it's going to end. I just know it's going to end badly.
—Stanley Druckenmiller, investor
Can central banks unwind their asset purchases over the next decade?
A complete unwind or a return to central bank asset levels pre-2008 will either never take place or at least not occur for decades. There is no way that the Fed, ECB, and BOJ can sell a majority of their assets back into the market in any intermediate time frame.
[In July 2014] I hope we can all agree that once-in-a-century emergency measures are no longer necessary five years into an economic recovery.
—Stanley Druckenmiller, investor
Not unwinding the central bank asset growth does not mean rates will always be close to zero, but historical interest rate levels will not be seen for many years. Looking at the 20-year history of the Federal Funds rate in Figure 2.2, rates have been 4%, 5%, and even 6% at certain periods. A Federal Funds rate at 5% is impossible to imagine today. The hope central bankers hold is that a small amount of growth in GDP and inflation over many years, while holding assets flat, can right size their balance sheet. Federal Reserve increases in 2016 and 2017 were quickly reversed as the economy demonstrated its fragility and capital markets started to drop.
If the central banks can simply maintain assets at $15 trillion, potentially the developed world economies can grow (and inflate) into a scenario where $15 trillion does not look that extreme. It is a delicately balanced scale. Investors have remained confident and taken on more risk, and to date the US Federal Reserve has maintained continual support of the markets.
Inflating the value of financial assets has been the one goal that the Fed has been able to master. Low rates and promises to promote growth at any cost has supported financial markets and consumer confidence in general, but it has had a derivative effect. Financial asset growth has created the greatest wealth divide since the 1920s. If you own financial assets, you are prosperous and if you do not own financial assets you have been left behind. Figure 2.3 shows a graph of the S&P 500 and the Federal Reserve assets since 2001. It would be hard to dispute the causation of Fed intervention and equity performance. The Fed tried to raise rates in 2017 and 2018, because unemployment dropped below 5% and the economy seemed to be expanding, but the equity markets stalled, scaring the Fed into cutting rates once again in 2019 and renewing asset growth.
FIGURE 2.2 US Federal Funds rate (1998 to November 2019)
FIGURE 2.3 Federal Reserve assets and the S&P 500 Index (2001 to November 2019)
Fundamental investing overwhelmed by central bank intervention
For a fundamental investment manager this is evidence that macro news and events are driving markets, not fundamental business results. In the 2020s, the markets can progress down two different paths. The first is a continuation of the 2010s, which will be a struggle for active investing, as we have discussed. The second path would be more ominous, as investors lose confidence in central banks. There seems to be little indication that a third option of growth and normalcy will arise. The path of global economies rebounding significantly allowing central banks to stop their intervention has little supportive data. Central banks have taken on the incredible responsibility of stabilizing and supporting financial markets for the next decade.
A macro-driven market, as the Fed has created through constant intervention, takes the emphasis away from fundamental investing. At the core of any investment strategy that outperforms the market is investing based on future expectations of cash flows produced by a company. A security selection thesis can be articulated by managers in many different ways. Investing in a business may be based on operating margin growth, entering new markets, facing weaker competition, creating a technological advantage, or having an elite management team, but they equate to expecting stronger cash flows in the future than the market expects today. Central bank intervention has materially lowered the relationship of fundamental company security selection and equity performance. Multiples are more volatile than earnings, so if multiples are going to be driven by outside factors, cash flows will have less explanatory effect.
[In January 2015] Earnings don't move the overall market, it's the Federal Reserve Board… Focus on the central banks and focus on the movement of liquidity… It's liquidity that moves markets.
—Stanley Druckenmiller, investor
Diligently studying a company's operations to understand future growth does not add the same value to future equity performance when a central bank dictates the markets and low rates make all stocks go up due to higher valuation multiples. An additional driver of valuation multiples today is technological disruption. Certain sectors of the S&P 500 have been decimated by actual or perceived future disruption and are trading at historically low multiples balancing the historically high multiples of other rate-sensitive sectors. Retailers' valuations have been destroyed by Amazon's success, energy producers have been destroyed by supply gluts created by fracking disruption, and health care services trade at all-time lows due to regulation concerns and technology company threats to the established industry leaders. This confluence of cheap, easy money and disruption is the challenge pressuring active managers. If we focus on S&P 500 sectors that are rate sensitive and have not seen large-scale technological disruption, we can see the massive effect on valuations from low rates.
When capital is in oversupply, investors compete for deals by accepting low returns and a slender margin for error.
—Howard Marks, investor
Utilities are one of the most rate-sensitive sectors and to date have not been negatively influenced by technological disruption. Figure 2.4 shows price-to-earnings (P/E) multiples in the 2010s. Multiples have grown over 60%. Utilities are historically a cost of capital return sector, where very few investment managers spend much time due to the slow-paced, regulation-influenced business model. Low rates have made it a top-performing sector.
During the same time frame that P/E ratios rose, utilities had incredibly easy access to capital at very low rates due to investor demand for their debt. From 2010 to 2019, the S&P 500 utilities sector created negative-free cash flow every year and increased dividends every year. Figure 2.5 illustrates the upward dividend per share trend and the downward free cash flow trend. All dividends during the last