The global market is in uncharted territory – which is why we should be afraid … very afraid
Never in history have interest rates been so low, share prices been so high and debts been so massive. When the inevitable crash comes, it will be like an earthquake, a tsunami, or a category 5 typhoon
One thing that they did teach me at Harvard Business School was the incredible power of 80 or so fertile minds working on a single problem. The other thing I learned was how a group can nevertheless collectively miss the big point, the proverbial elephant in the room.
My recent finance class in Boston was unique; everyone was highly experienced and current – no students here. The insights were powerful, for no one in the room was less than 25 years from their Harvard MBA. This was grass roots thinking on the US economy by some of the best-educated brains with the whitest hair in the business.
The professor opened the class with a chart indicating the movement of US interest rates over the last century – we are at the lowest ever. He had a chart of UK interest rates over the last 200 years – the lowest ever. He even had a chart that went back 5,000 years (including Sidney Homer and Richard Sylla’s work on the history of interest rates) – we plough the bottom. Never in the course of human history has so little been paid, by so many, on so much debt.
He then showed a chart of share prices – the highest ever. Then a chart of price to earnings ratios – the third highest ever (but the spike we are on is not finished yet). This is unknown territory.
We were asked to solve a simple formula computing the likely annual share price rise of equities over the next 10 years. This was the sum of the dividend yield (the dividend per share paid divided by the current share price); the annual earnings growth of the share market; and the expected change of the price to earnings ratio.
Plugging in numbers was easy. The current US dividend yield is circa 2 per cent; the earnings growth is say around 3 per cent (conservatively and in real terms); and let us assume no price to earnings multiple expansion occurs. As long as that happens we should get a return from the stock market of around 5 per cent per year over the next 10 years. Not too bad. Job done.
The sagaciously greying heads nodded there were multiple problems around. How are unfounded pension funds going to keep paying out to increasingly healthy, ageing pensioners when they do not have the cash?
Or perversely that many other institutions, investors and funds have too much cash, lent generously by the world’s central banks? They need to keep investing to find a decent return in a bottom-scraping yield environment. If you are in Europe, rates are negative so investors pay the government to keep their own money in case the returns get even worse.
One further mantra from the US-centred group was that everyone expected the US dollar to remain strong – for the next 10 years. Both of these factors made anything but US stocks look like a loser!
Every comment in the class pointed out exceptionals such as low rates, high markets, massive debt, historically low inflation, negative interest rates. It points to an unsustainable, dysfunctional global economy. There is no new normal any more – it is all abnormal, and that is not a good place to be.
The only exit strategy that is somewhat palatable is for inflation to erode the debt mountain – but inflation means higher rates and imploding economies. No one wants to be irresponsible for that.
The big elephant in the room was left unspoken. Surely the next crash will be coming within the next 10 years, maybe the next three.
The happy prospect of a moderately steady state of 5 per cent return will be abruptly cut, like a knife through warm butter.
This market will not move in a straight line forever but will be subject to a major discontinuity; like an earthquake, a tsunami, a category 5 typhoon.
These dysfunctional market elements that we discussed portend a financial market crash that will blow these calculations out of the water. What is happening in the markets is uncharted and has shattered any real understanding of modern economics.
Low interest rates did protect the markets during the global financial crisis but that short-term fix has inhibited long term, robust economic growth that requires spending money in the hands of the ordinary consumer. Easy money has instead accelerated technological development, which has destroyed the value of labour, keeping cash in the hands of the controllers of capital rather than trickling down.
Regardless of how the global economy will get out of this fix, it will make for some interesting classes in a few years’ time.
Richard Harris is a veteran investment manager, banker, writer and broadcaster – and financial expert witness. www.portshelter.com