Chautauqua Capital Management is a long-term, quality-growth global equity investor with a generally optimistic view. However, we are less so today. While potentially unpopular to point out market risks, we believe it is important that we be transparent about our market views and how we may be adjusting the portfolio.
To be clear, we do not possess the ability to predict a bear market. But from our perspective as enumerated in the following commentary, risks have increased, and the global financial markets appear to be at a heightened risk of a sell-off. Our concerns are around several factors, including the unwinding of extraordinary central bank policy, high valuations, investor compliancy, and heightened geopolitical risk.
We have already taken some measures to mitigate the negative impact of a potential market sell-off and provide us with greater liquidity to exploit the ensuing pricing anomalies and we may do more. In other words, it is our goal to participate in further upside and protect against the downside should the markets experience disorderly selling.
Background on Central Bank Policy
In the aftermath of the “Great Financial Crisis” borrowing and investing were subdued. In order to stimulate investing and spending, Central Bankers in the developed world embarked on monetary accommodation through interest rate reductions and asset purchases. Those tools are not revolutionary, but the magnitude and length of deployment of those programs are unprecedented. As a lender of last resort, Central Banks have historically been called upon in bank liquidity crises to avert subsequent bank failures by providing cheap capital to banks so they can withstand depositor withdrawals and resume lending to aid economic recovery. Typically, Central Banks set their benchmark rate low enough for member banks to borrow at a low rate on a temporary basis. The benchmark rate influences all other rates across the quality and duration spectrum. Under normal circumstances, government bonds form the basis for the “risk free rate” and should yield about 100 basis points (1%) more than the prevailing rate of inflation. Such historical perspective suggests the U.S. 10-year bond yield should be close to 3.0%, yet today it stands around 2.25%, a discount that is reflective of highly accommodative Central Bank policy.
Such abnormal monetary accommodation from the Central Banks can have a number of consequences. First, it can pull purchasing demand forward. Households may opt to replace a car earlier than they otherwise would because the cost of financing in a low rate environment is thought to be attractive and temporary. Second, monetary stimulus, as compared to fiscal stimulus, is deemed to be a blunt instrument and can aid those who are least in need by making the cost of money cheaper for everybody. On the other hand, fiscal stimulus in the form of tax incentives, for example for new industry development to assist people in a depressed region of the country, is a more precise tool. Third, as rates go lower the interest income from a bond and the dividend income of a stock becomes more valuable. As investors are willing to pay more for these valuable sources of income, asset prices go up. Existing investors experience price appreciation, but with the passage of time the potential for asset prices to continually appreciate comes under a high valuation strain. As yields on 10-year U.S treasury bonds have fallen from 14% to 2% over the past 35 years, investment returns have also fallen. This has been a multi-decade trend but abnormal accommodation has exacerbated what we see as a problem. Lower investment returns have negatively impacted pension plans (many of which have unfunded liabilities and require a higher investment return to compensate) and financial sector businesses such as banks and insurance companies (which need to earn a spread between their borrowing costs or premiums and their investment returns).