Editor’s Note: Carrier Management did a great profile on Informed. Please give it a look here.
People sometimes forget they are living in a special period of history until many years later when they can look back on its consequences.
The past 15 years have been a remarkable experiment in monetary policy, commonly referred to as “Quantitative Easing” but known academically as financial repression.
Financial repression is when central banks intentionally suppress interest rates below market demand in order to spur economic activity. It tends to have side effects like increased wealth disparity and high returns for risk assets and also leads to bubbles as opportunists use cheap leverage to amplify returns.
The beginning of the Fed rate hiking cycle last year arguably ended financial repression, but the market wasn’t signing off in full until now. Finally, the two year Treasury has surpassed the pre-financial crisis level of 4.9%. With that, I think we can officially declare the end of an era.
What does this mean going forward? A lot. If your investing experience is confined to the last 15 years, you are now a babe in the woods. Your experience is worthless, maybe even a detriment.
All the trading instincts you have were fostered by easy money and cheap leverage. Growth doesn’t always beat value. Momentum can be negative, not just positive. Multiples don’t always expand.
Risk taking is now dangerous, not a free lunch. Bad companies will be allowed to fail. Cost of capital is a real thing to consider when making an investment.
Wall Street vs. Main Street
Financial repression benefited two parties – job seekers and investors. Keeping interest rates around zero for an extended period of time boosted hiring and let investors increase leverage with little default risk.
However, it also led to an extended period of slow economic growth as future growth was pulled forward to avoid recessions. Instead of having 3% trend growth with occasional recessions, the Fed chose 2% growth with less variability.
Thus, living standards rose slowly while the investor class benefited from the “risk on” environment and made outsized returns leading to tensions between the “working class” and the “elites” over growing wealth disparity.
Also, while employment was high, wage growth was low. This allowed corporations to expand margins to repeated new record highs. This also fueled stock prices.
Going forward, the pendulum is swinging back towards Main Street. Wages are accelerating. This will pressure profit margins and slow earnings growth. That’s bad for stocks.
Higher interest rates are bad for stocks. There will also be more uncertainty. That is also bad for valuations.
But for workers, things are looking up. The tight labor supply means that even increasing layoffs won’t be too painful and 3-5% raises will be the new normal.
There will be new waves of automation to try to reduce demand for labor, but overall, it’s an improving environment for the average family.
The New Paradigm
But it will not be a risk on world. Momentum will be as likely to be negative as positive. Valuation will matter more to stock returns. Predictability will matter much, much more. There will be no meme stocks.
Investing will more closely resemble the 90s where the “steady eddies” and large brands see ongoing multiple expansion, but slowly. There will be big premiums paid for consistent organic growth and stable margins.
If you can deliver 10% earnings and a point of multiple expansion per year, you’ll be boring but beautiful.
Note, this is not an environment favorable to hedge funds. Hedge funds require constant price movement to trade and cheap leverage to juice their small alpha into a larger total return.
A world of grind it out a little bit each month does not serve them well. That requires tying up capital for too long.
There is also less opportunity for factor neutral returns. Style investing will return to vogue, whether it be traditional ones like value and small cap or hiding in “industry leaders” or “growth financials” or “GARP”.
This is also the end of the private equity era. No more cheap debt to fund deals. PE will have to return to its roots of operational improvement to drive returns.
Activists, on the other hand, are likely to enter a golden era. There will be plenty of companies that will realize they have far too many people and their margins are on the downslope. There are a lot of Salesforce’s out there that are going to hit walls.
The Fiscal Mess
Government debt hasn’t mattered for a long time – worldwide, not just in the US. Many smart investors have had careers ended waiting for Japan’s debt to matter.
However, in this era of financial repression, where government was supposed to reduce debt costs to improve its balance sheet, we had the opposite happen.
In 2008, debt/GDP was 60%. Now, it’s 120%. Think about that for a second. That sort of massive stimulus spending should have produced massive above trend GDP growth. Instead, we mostly struggled to do 2%. Talk about a low return on capital!
Japan is even worse. They crossed 100% in 1998 and now are > 250%! The UK went from 40% in ’08 to 100% now. China went from 30% to 80%. There was a worldwide destruction of wealth by governments spending to little benefit.
The main reason to believe inflation will remain with us for years is governments need to devalue their currencies to pay back debt with cheaper paper. You should also expect to see higher taxes.
We are entering an era where governments will need to focus on reducing deficits to keep inflation from getting too far out of hand. Maybe there is a reason to own bitcoin after all!
This also means central banks globally will be less able to come to the rescue when there is a stress. The days of no default risk in credit are done.
Insurance Implications
What does this new era mean for insurers?
The obvious concern is going to be loss trend pressure. A zero rate world certainly suppressed trend. Full employment with modest wage gains was a boon for worker’s comp.
On the other hand, there was arguably some correlation between asset price gains and nuclear verdict awards. Also, litigation funding benefited from easy money (though it may still be in demand if it truly proves uncorrelated).
Comp looks like the one area most at risk. Not only will claims go up if unemployment bumps up, but wage growth creates more exposure (I know insurers get audit premiums, but there can be periods of mismatch).
The severity problems we’ve seen in auto are likely to show up in parts of commercial. For example, what happens to the cost of cleaning up an industrial explosion or finding replacement parts for old machinery that is damaged?
How many underwriters have thought about the potential cost of BI when revenues are accelerating due to inflation? Or properly adjusting for commodity exposure to current market prices?
And obviously, inflation is bad for claims that take a long time to settle. Defense cost budgets are probably too low if they’re assuming 2% inflation instead of 5%.
While returns on fixed income will rise, investors prefer lower combined ratios along with shortfalls in investment income to beats on NII accompanied by higher CRs (higher NII eventually feeds into lower pricing).
However, in a world where debt is more expensive, the value of cheap insurance float rises. I’ll have more to say on this next time.
On the distribution side, the bubble in brokerage valuations would be at high risk in a slower organic environment with higher financing costs.
The Risk of Shocks
The final thing worth a brief mention is inflationary periods are more vulnerable to shocks. The risk of financial crisis rises during delevering periods and also during currency devaluations.
Commodity prices are prone to large swings. Economic stress tends to lead to political strain or foreign conflicts. There will likely be trade wars.
I am not trying to make specific predictions of what could go wrong. The broader point is the way one looks at risk needs to evolve.
It’s not all about the Fed anymore and it’s certainly not about deflation or tech bubbles. That era is over and you need to prepare for new challenges.