Playing chicken with a crocodile

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Articles by Alexander

Alexander Chartres

Fund Manager

12 July 2019

Einstein quipped that ‘the definition of insanity is doing the same thing over and over and expecting different results’. Someone needs to tell the US Federal Reserve.

For thirty years, America’s central bank has cut interest rates to fresh lows every time markets or the economy wobbled. Progressively lower rates encouraged recovery through credit-fuelled spending and asset price booms. The result? Spectacular bubbles. And spectacular busts.

This month’s chart plots the net wealth of US households – everything they own less everything they owe (green) – against US economic growth since 1992 (blue). Together, they form ‘the crocodile jaws’.

Household net wealth is a good proxy for US asset valuations. Over the long run, financial asset values can only increase as fast as underlying economic growth, upon which they are based. In the easy money era, however, financial asset valuations have repeatedly become detached from economic reality.

First came the dot.com bubble, focused on loss-making internet stocks like pets.com. No prizes for guessing what the Fed’s response was when it burst: cut rates to new lows.

Next came 2008’s credit crisis, prompted by the bursting of America’s sub-prime housing bubble and excessive borrowing in the global banking system. The Fed’s response? Cut rates to zero and print trillions of dollars to buy assets (QE), driving prices up and yields down.

Today, the crocodile jaws have never been wider. A decade of ultra-low rates has forced income-starved investors out of cash and into riskier assets – the so-called ‘reach for yield’.

The ripple effect of this has seen even traditionally ‘safe’ investments such as government bonds trade at record highs. Germany’s ten year bonds yield less than zero. In other words, investors are paying Germany to hold its debt!

The bottom line: we may now be in an ‘everything bubble’.

During the dot.com and US subprime bubbles, there were clear assets to avoid: internet stocks or housing/financial companies, respectively. Now, obvious hiding places are few and far between. Unless nominal economic growth (blue) accelerates dramatically to catch-up with asset prices (green) – requiring materially higher inflation – markets are once again heading for a bust.

The chart offers no certainty on timing and markets may yet have plenty left to run – especially if central banks add yet more stimulus. The question is, do you want to play chicken with the crocodile?

Investors seeking to preserve capital must now look beyond conventional assets. In our view, the traditional safe havens aren’t safe. At Ruffer, we think that powerful derivative protections are an essential part of an all-weather portfolio’s defences. Akin to insurance policies, during good times these are a drag on performance. But they might also be the only port in the storm when the everything bubble bursts. We think it’s a price worth paying.

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Playing chicken with a crocodile