Deflationary Pressures and the Markets (Part 2)
In a previous post, I drew the parallels between the deflationary pressures of today’s technological advancements and those of the Second Industrial Revolution. The latter era produced a twenty-year period of sustained deflation commonly referred to as the Great Deflation. If the comparison is accepted, an interesting question arises: “How do you value assets in a zero, or negative, interest rate environment”?
In a deflationary environment where nominal interest rates approach or dip below zero, the relationship between value and cash flow falters. Traditionally, investors could calculate a value based on an expected revenue stream. However, as risk-adjusted rates approach zero an inflection point occurs and the cash flow an investment generates no longer determines its price. At its extreme, this phenomenon forces all investors to chase momentum, solely hoping to earn a return by selling an asset at a price higher than originally purchased. We saw hints of this scenario played out in 2016. The real estate markets in Switzerland, Sweden and Japan all increased substantially as interest rates dipped below zero.
The following are some thoughts on how negative rates might impact the major asset classes — e.g. debt, equity and real estate.
Investment Grade and High Yield Debt
The Great Recession was largely a byproduct of the divergence between the financial and real economy exacerbated by record levels of indebtedness. The coordinated easing of central bank monetary policy since the Great Recession has added unprecedented liquidity to the financial system in hopes of facilitating lending while generating manageable levels of inflation. Growth and inflation are the cures for over-indebtedness. Unfortunately, for the reasons noted earlier, accommodative monetary policy has proven ineffective in stimulating the real economy. However, the low interest rate environment has enabled one form of growth, the growth in debt. The total U.S. indebtedness continues to rise unbounded.
The impact of deflationary pressures on rising corporate debt (see graph below) will be somewhat binary. As the initial benefit of lower interest rates wane, investors will become more scrutinous of the impact that pricing pressures have on corporate profits and sustainability. Companies with strong debt servicing capabilities will see the value of their existing debt rise as rates drop further and they will be able to easily refinance their debt. Conversely, firms that do not generate sufficient cash-flow to service their debt will find that their cost of debt remains stubbornly high and they will struggle to issue new debt or refinance existing debt. Shifting investor sentiment as to where a particular company lies on this spectrum may result in significant credit spread volatility with companies that suddenly falter suffering sharp increases in their cost of capital.
Equity
Many prognosticators cite excessive equity market valuations based on historical price-to-earnings (P/E) ratios. The current S&P 500 trailing P/E ratio exceeds twenty-five (25). Historical norms hover closer to fifteen (15). This increase in the broad market P/E ratio can be attributed, in part, to the persistent fall in the discount rate applied to earnings or dividends. In a scenario where discount rates approach zero, traditional market pricing metrics will lose their meaning. As P/E ratios continue to soar, many value-oriented investors will avoid participating in the market. However, sustained upward momentum will test their convictions as they lag industry benchmarks. Compounding their dilemma is the continued dominance of passive management that results in index or benchmark constituents indiscriminately rising, regardless of valuation. As conventional pricing metrics lose meaning, stocks that falter will see violent downside volatility. In this environment, earnings and cash flow stability should be valued, although applying mathematical rigor to such beliefs will prove difficult. Active managers will continue to chase momentum and will need to adeptly manage downside exposure when companies fail to meet earnings and growth expectations. In a deflationary environment, a potential complicating matter will be the contraction of profit margins and growing burden of bloated corporate indebtedness.
Real Estate
As with the equity markets, near zero or negative discount rates will cause havoc with cash flow related property pricing metrics. In an environment where the opportunity cost of capital and the cost to borrow money become negligible, investors will continue to accept lower and lower cash flow returns as property prices spiral higher. As we have seen in many Asian economies, this market dynamic often culminates with an inflow of speculative investors willing to forgo current yields in the hope of capturing future price appreciation. The price volatility that traditionally accompanies speculative markets will be exacerbated by the opaque and illiquid nature of the real estate market. Astute investors will need to anticipate bouts of price volatility brought on by a temporary slack in tenant demand or exogenous factors. Prolonged periods of duress that result in a persistent state of negative cash flow will test speculators’ endurance and flush out weak players. As we saw during the 2008/9 Financial Crisis, a potential risk to a volatile real estate market is that naive lenders may ultimately bear a portion of speculative investment losses and contract lending at a time when the market needs it most. Aggressive investors may aggravate this issue by gaming institutions that do not require sufficient amounts of equity in comparison to the potential price volatility of an underlying asset.
An interesting dynamic that the current interest rate environment brings to the real estate market is the potential for price convexity. If interest rates drop as anticipated, yield-starved investors could spark a speculative investment wave and, if interest rates rise, the residual equity component of a real estate investment — i.e. the value of the property greater than its financing — should increase commensurate with inflation. Such convexity exists solely as interest rate hover near the zero-rate inflection point.
What resonates from this assessment of investing in a deflationary environment is the importance of stable cash flows and the potential for extreme price volatility for investments that cannot provide consistent yields. A microcosm of this affect occurred in mining stocks during 2015 and 2016. As the price of commodities plummeted during 2015, the burden of servicing existing debt and the cost of new capital for heavily indebted miners became prohibitive resulting in contracted equity valuations. As commodity prices rebounded in 2016, the equity of these miners exhibited option like returns, significantly outperforming their healthier peers.
The challenge for active managers, especially larger institutional investors, will be finding enough sub-sectors of opportunity to add meaningful alpha to a portfolio. As the enthusiasm for President Trump’s policies eventually wanes and the Federal Reserve mimics the policy errors of 1937–38, the economy’s structural deflationary bias will reemerge. As dropping investment discount rates propelling passive benchmarks higher, institutional investors will once again chase and crowd momentum trades. Unfortunately, it is statistically unlikely for a single manager to consistently pick the few “winners” that outperform their benchmarks. For the broader industry, there is no evidence that active managers can outperform the benchmarks. For institutional managers, the most prudent investment strategy as deflationary pressures return will be to passively invest in benchmarks and look to generate alpha at the margins. Alpha generating opportunities will exist in investments where cash flow yields are on the cusp of improving or faltering. In deflationary markets, cash flow will be king and the ability to properly assess cash yields will be the driving source of outperformance.
Thomas T. Halikias
Originally published on SeekingAlpha.com on March 24th, 2017
