No images? Click here   AFR: Hordes of investors ‘stuck’ in painfully over-valued assets An unusual period of excess liquidity has helped equities and risky assets, but it is now unwinding and adjustment will be painful. Christopher Joye, portfolio manager, Coolabah Capital Investments Over at the AFR I write there are big secular shifts in asset allocation under way as large institutional investors suddenly realise that they are massively overweight illiquid assets and equities. Every week we are reading new media reports of superannuation funds and sovereign investors seeking to get more exposure to the 5 per cent to 7 per cent interest rates on cash and investment-grade fixed-income. The problem, of course, is that many investors are stuck with excess holdings of illiquid assets. During the 15-year search for yield following the global financial crisis, most forgot about the cost of illiquidity – you have no ability to get out and hence no optionality to switch your asset allocation. You are stuck. It is actually much worse than that. You are stuck in over-valued assets, such as commercial real estate, that barely offer a return above cash and which need to decline by another 20 per cent to 35 per cent to adjust to the new world in which we live where the risk-free hurdle rate has risen to 5 per cent to 6 per cent. The problem is that the more illiquid an asset, the slower the painful price adjustment process. We are seeing this across the board in unlisted equities, property and illiquid credit. What exacerbates the illiquidity hazards is that we are in the midst of the worst default cycle since the global financial crisis – and it is only getting worse. A key sentiment coming out of central banks is that interest rates are not declining any time soon, and there is a real chance they could edge higher. Profligate approach With core inflation rates, and even more significantly demand-side services inflation, running at multiples of the central bank targets, they are not remotely close to mission accomplished. This is why at the looming Jackson Hole central banking conference we are likely to hear the chair of the US Federal Reserve, Jay Powell, tell us that his inflation fighting job is not complete. One of the biggest mistakes of the last inflation crisis is that the Fed eased rates too early in the mid-1970s. It was head-faked by an initial reduction in core inflation from double-digit levels to about 6 per cent, only to allow these price pressures to re-accelerate in the late 1970s and early 1980s to double-digit levels again.   The chances of history repeating are heightened by the fact that “Bidenomics” has bequeathed a huge budget deficit worth about 8 per cent of US GDP, which is among the loosest fiscal policy in the developed world. One observes an echo of this profligate approach to burning taxpayers’ hard-earned money in Australian states like Victoria where fiscal policy is completely divorced from practical reality. This column was shocked to learn that Victoria’s government thought it would be a fantastic idea to punt $2 billion of taxpayer cash on start-up companies – competing with private venture capital funds – at a time when the state is racking up the biggest public debts in history. This was similar to the recent decision to sell $7.9 billion of the taxpayer-owned VicRoads on the alleged promise to repay COVID debts—only for Victoria to do the opposite and speculate that money in global financial markets. Thankfully, sanity is returning to NSW where a new parliamentary report found that continuing to risk $15 billion of taxpayer cash in the state’s Debt Retirement Fund on equities and other risky asset classes is not a smart idea when the annual cost of NSW debt has skyrocketed from about 1.5 per cent a few years ago to 5 per cent today. The previous Liberal government managed to increase NSW’s public debt burden from less than $60 billion in 2018 to more than $165 billion at the time of writing. The recent NSW parliament report found that “the current policy settings of the Debt Retirement Fund (DRF) are not fit-for-purpose in today’s economic environment”. “The DRF is operating in a volatile economic environment and potentially putting the state’s overall fiscal outlook at risk. There are risks to the state’s budget and credit rating, and significantly, public confidence in the government if the current policy settings of the fund remain unchanged.” Turning point for equities Given Australians have unwittingly so much riding on the performance of equities, what is the outlook? Our latest research finds that cyclically adjusted price/earnings multiples do a decent job over the long-run of anticipating future US equity returns. And based on this relationship, the 10-year expected returns from the US equity market are the lowest they have been since just before the calamitous correction during the global financial crisis. The current cyclically adjusted US price/earnings multiple is north of 30 times compared to its long-run average of 17 times. And this implies that real annual returns from US equities over the next decade will be a miserly circa 2 per cent. Our chief macro strategist, Kieran Davies, updated the Fed’s model of the US equity risk premium, which compares the real earnings yield on US stocks (using forecast earnings) to the real 10-year government bond yield. On this basis, the equity risk premium is about 25 per cent lower than its median level since the early 1990s. As another approach, Davies emulated a 2003 model built by AQR’s Cliff Asness that posits that the US equity market’s earnings yield (or price/earnings multiple, flipped) is a function of bond yields and bond and equity market volatility. This analysis implies that price/earnings multiples should be more than 30 per cent lower than their current levels. One interesting feature of this year has been the bid for risk as manifest in the bounce in equities and house prices globally, among other things. Bridgewater has made the important point that an unusual dynamic in the last 12 months has been that while the US government deficit has exploded (and surprised in its size), net issuance of US government bonds has actually declined. Liquidity is the prize This is because the US treasury has consciously decided to issue short-term treasury bills rather than long-term bonds to fund the deficit combined with aggressively drawing down on the US government’s cash at hand. Bridgewater had assumed that there would be a large increase in net government bond supply with the Fed no longer buying US government bonds (and further allowing its bond holdings to mature via a “passive taper” of its balance sheet) while the US government was racking up enormous deficits. This would have in turn forced up bond yields and reduced the value of risky assets like equities. Instead, net government bond supply has declined, dampening the rise in yields. But there is only so long the US government can draw on cash and issue short-term paper while splurging massive amounts of money. And the US treasury recently surprised market participants with a significant increase in long-term bond issuance, which contributed to the spike in bond yields and poor equity market performance. Bridgewater believes this is a turning point for equities and other riskier asset classes. The second-order dynamic that many are missing is the asset-allocation shifts. In the same way that the global reach for risk and search for yield between 2008 and 2022 drove massive price inflation in listed and unlisted assets as investors exited cash, the unwinding of this dynamic as asset allocation pivots back to cash and bonds is likely to amplify the first-order cost of capital impacts. Here one unusual consequence of the net reduction in US government bond issuance as the Fed has commenced its hiking cycle has been net flows into both cash and equities as a result of excess liquidity attributable to the paucity of government bond supply coupled with the sheer magnitude of money being pumped into the US economy care of Bidenomics. But this is not tenable in the medium term and appears to now be inexorably reversing as liquidity is slowly drained from the system via normalised bond issuance and central banks shrinking their balance sheets. If there is one thing you should prize above all else right now, it is the liquidity of cash-like assets for their optionality, attractive yield, and the capacity to accurately revalue these holdings. Investors who have their money frozen in unlisted assets are learning the costs of the alternative.   For further information please contact us on 1300 901 711 info@coolabahcapital.com | www.coolabahcapital.com Disclaimer: Past performance does not assure future returns. All investments carry risks, including that the value of investments may vary, future returns may differ from past returns, and that your capital is not guaranteed. This information has been prepared by Coolabah Capital Investments (Retail) Pty Limited, a wholly owned subsidiary of Coolabah Capital Investments Pty Ltd. It is general information only and is not intended to provide you with financial advice. You should not rely on any information herein in making any investment decisions. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. The Product Disclosure Statement (PDS) and Target Market Determination (TMD) for the funds should be considered before deciding whether to acquire or hold units in it. A PDS and TMD for these products can be obtained by visiting www.coolabahcapital.com. Neither Coolabah Capital Investments (Retail) Pty Limited, Equity Trustees Limited nor its respective shareholders, directors and associated businesses assume any liability to investors in connection with any investment in the funds, or guarantees the performance of any obligations to investors, the performance of the funds or any particular rate of return. The repayment of capital is not guaranteed. Investments in the funds are not deposits or liabilities of any of the above-mentioned parties, nor of any Authorised Deposit-taking Institution. The funds are subject to investment risks, which could include delays in repayment and/or loss of income and capital invested. Past performance is not an indicator of nor assures any future returns or risks. Coolabah Capital Investments (Retail) Pty Limited (ACN 153 555 867) is an authorised representative (#000414337) of Coolabah Capital Institutional Investments Pty Ltd (AFSL 482238). Equity Trustees Ltd (AFSL 240975) is the Responsible Entity for these funds. Equity Trustees Ltd is a subsidiary of EQT Holdings Limited (ACN 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT). A Target Market Determination (TMD) is a document which is required to be made available from 5 October 2021. It describes who this financial product is likely to be appropriate for (i.e. the target market), and any conditions around how the product can be distributed to investors. It also describes the events or circumstances where the Target Market Determination for this financial product may need to be reviewed. 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