The Breakdown - How Stocks, Bitcoin and Other Investments Fare in a 0% Interest Rate World

Episode Date: October 18, 2020

On this week’s Long Reads Sunday, NLW reads: “Capital Allocation & Risk Asset Ramifications in a 0% Interest Rate World” The piece examines how different asset classes – from stocks to bonds to bitcoin and beyond – fare in the context of a world where the Federal Reserve is determined to keep interest rates at or near zero for years to come.

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by crypto.com, nexo.io, and elliptic, and produced and distributed by CoinDess. What's going on, guys? It is Sunday, October 18th, and that means it's time for Long Read Sunday. And I'm really excited about this one. This is a selection from John Street Capital, and you may remember I referenced something that John Street Capital wrote a couple months ago when I did my primer on SPACs. They were one of the voices talking about why a Coinbase SPAC might make sense. Today we're going to read a piece

called Capital Allocation and Risk Asset Remifications in a Zero Interest Rate World, which is a mouthful, but that zero interest rate world and what happens because of it is really the topic. So without any further ado, let's dive in. QE Infinity turned your savings account into your checking account, the bond market into your savings account, the equity market, the venture market into the equity market, while given rise to the crypto market as the new venture market. On a recent podcast, we spoke about the public and private markets, the current macro environment and implications for risk asset allocation. Some asked for the SparkNotes version of what was discussed and why it's relevant, which is attempted below. Macro-backer.

In a world post-financial crisis, we have seen a structural move lower in global rates with an estimated $17 trillion of negative yielding debt. The COVID-19 pandemic has only accelerated this trend due to the unprecedented global fiscal and monetary stimulus with central bank's balance sheets expanding by $5.5 trillion year-to-date from $16 trillion to $21.5 trillion, that's 34% increase, representing the biggest move since the depths of the great financial crisis in 2008. If we look across the global yield, the story is the same with the average 10-year yield across the U.S., Canada, UK, Germany, France, Italy, Japan, and Australia at 0.37%.

As you can see, the global central bank reaction has had implications across the yield curve. Investment firms such as BlackRock, Fidelity, and JPMorgan asset management have recently had to waive fees on the $5 trillion of assets held in money market funds to keep yields that investors earn from dropping below zero. With the seven-day net yield for the average money fund hitting 0.05% in July down from 1.31% at the end of 2019. The top-rated tier of the high-yield bond market now offers an effective yield of 3.8%. And the effective yield on the entire junk bond market as measured by the Ice Bank of America High Yield Index is at 5.4%. Fed Chair Jerome Powell recently said that the Fed was, quote, not even thinking about thinking about raising rates.

Concurrent with the Fed's desire to keep rates low, they have also recently released a document on the longer-run goals in monetary policy strategy, in which they note that, quote, the committee seeks to achieve inflation that averages 2% over time, and therefore judges that following periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time. This commitment from the Fed to look to ramp inflation, coupled with lower rates, puts the onus on investors to reassess portfolio allocation and search for alternative sources of return. Why do yields matter? While QE Infinity has created a generation of dip buyers and the belief

that stocks only go higher, risk matters, and riskier investments should have higher expected returns than safer investments. This should be pretty intuitive. If you were to write a check in an angel round for a startup you believe you can 100x your money, because there's a significantly higher probability that it goes to zero, you therefore size your investment. accordingly. Alternatively, if you were going to invest in WMT stock, while there have been a number of 20 to 30% pullbacks over the trailing 20 years, you'd probably expect your investment to compound at a high single-digit rate of return, and aren't all that concerned about it going to zero. If you were to invest in WMT bonds, you might be earning 2.5% today, but view that as effectively

risk-free on par with sovereign debt. NYU Professor Oswald Demodarin is known as the dean of evaluation, and has written a series of papers on equity risk premiums, ERP. Damodarin writes that the expected return on any investment can be written as the sum of the risk-free rate and a risk premium to compensate for the risk. In explaining why equity risk premiums matter, he highlights, the equity risk premium reflects fundamental judgments we make about how much risk we see in an economy slash market and what price we attach to that risk. In the process, it affects the expected return on every risky investment and the value that we estimate for that investment. He notes implications on expected returns and discount rates. Damodaran acknowledges those

not in the midst of valuation might not care about ERP, but should due to wide-reaching effects, including the amount set aside by both corporations and governments to meet future pension fund and health care obligations are determined by their expectations of returns from investing in equity markets, i.e., their views on the equity risk premium. Assuming that the equity risk premium is 6%, that will lead to far less being set aside each year to cover future obligations than assuming a premium of 4%. If the actual premium delivered by equity markets is only 2%, the fund's assets will be insufficient to meet its liabilities, leading to fund shortfalls which have to be met by raising taxes for governments or reducing profits for corporations. In some cases, the pension benefits can be put at

risk if plan administrators are unrealistically high equity risk premiums and set aside too little each year. Business investments in new assets and capacity is determined by whether the businesses think they can generate higher returns on those investments than the cost they can attach to the capital in that investment. If equity risk premiums increase, the cost of equity and capital will have to increase with them, leading to less overall investment in the economy and lower economic growth. Regulated monopolies, such as utility companies, are often restricted in terms of the prices that they charge for their products and services. The regulatory commissions that determine reasonable prices based on the assumption that these companies have to earn a fair rate of return for their equity

investors. To come up with this fair rate of return, they need estimates of equity risk premiums. Using higher equity risk premiums will translate into higher prices for the customers in those companies. Judgments about how much you should save for your retirement or health care and where you should invest your savings are clearly affected by how much return you think you can make on your investments. Being over-optimistic about equity risk premium, will lead you to save too little to meet future needs and to overinvest in risky asset classes. Demadorin compiled summary statistics for U.S. stocks, T-bills, and T-bonds from 1928 to 2018. While U.S. equities have delivered much higher returns than treasuries over this period,

they've also been more volatile, as evidenced both by the higher standard deviation in returns and by the extremes in the distribution. He takes a first shot at estimating a risk premium by taking the differences between the average returns on stocks and the average returns on treasuries, yielding a risk premium of 7.93% for stocks over T bills and 6.26% for stocks over T bonds. S&P 500 valuation regimes over time. A lot of market pundits talk about markets at all-time high valuations looking at it on a pure PE basis without factoring in equity risk premium. When looking at equity risk premium, the market is still in light to slightly cheap versus historical averages. There's also a

a number of structural reasons that support higher multiples than in decades past, including the fact that it's never been easier to index slash diversify, which inherently lowers the risk associated with any single equity position. Given the proliferation of ETFs and globalization of mega-cap businesses leading to geographic diversification, the market can support higher multiples. The composition of broad market indices has changed with the top five stocks in the S&P 500 all technology stocks for the first time, which have historically supported higher multiples as a result of growth rates, margin profiles, and financials, industrials, energy, conglomerates, which historically were larger percentages of the indices.

Finally, technology progress has more broadly led to structurally higher margins, which, all else equal, increases profitability again supporting higher multiples. Capital allocators At the most fundamental level, capital allocation decisions are predicated upon investable assets, expected inflows, slash outflows, and risk-return objectives. These core characteristics vary considerably when you're dealing with pension plans that have a significant retiree base with an ever-shinking employee base versus an endowment with billions of dollars and minimal operating expenditure required, a high net worth individual and prime earning of their career,

a middle-class individual near retirement, or a recent college graduate. Regardless of what bucket an entity or individual falls within this, move in rates has a profound impact on allocation decisions. This episode is brought to you by Crypto.com. the crypto super app that lets you buy, earn, and spend crypto all in one place and earn up to 8.5% per year on your Bitcoin. Download the crypto.com app now to see the interest rates you could be earning on BTC and more than 20 other coins.

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Protect your customers. Manage your risk. Scale your business. Visit elliptic.co slash coin desk to talk to a cryptocompliance expert today. That's elliptic.com slash coin desk. Pensions. Pension funds manage 4.5 trillion of assets, so what they do has an impact on markets.

Estimates for unfunded pension liabilities in the U.S. range from $1.6 to $6 trillion, depending on the method and assumptions used. There are three primary levers these organizations can utilize to close that gap, including one, contribute more to the plan, two, cut payouts to beneficiaries, or three, generate higher returns. Since the first two have significant controversy, there's a push to increase returns. Pew showed an analysis of average assumed rates of return for pensions versus the 30-year treasury and implied risk premium. Notably, the assumed return has drifted from 8% to 7.2% despite the 30-year going from 8% to now less than 1.5%. How are pensions supposed to generate higher returns in a lower interest rate environment?

They need to move out the risk curve with a higher allocation to alternatives. A recent report from Morgan Stanley highlighted that pension funds took their allocation to alternative assets up from 7% in 1990 to 29% in 2019, with close to 40% of institutional investors planning to increase that exposure. Endowments. Endowments control more than 600 billion of assets, and while smaller than pension funds still very significant as it pertains to their capital allocation decisions, David Swenson and Yale really pioneered the modern endowment model or the Yale model. This relies on a heavy allocation to alternative assets while simultaneously avoiding asset classes such as fixed income or commodities. Per their last update, Yale's endowment returned 11.4% per annum over the 20 years ending June 30th,

2019, exceeding broad market results for domestic stocks, which returned 6.4% annually, and for domestic bonds, which returned 4.9% annually. Endowments at large have taken their alternative asset allocation from 6% in 1990 to 53% in 2019. At present, smaller endowments still have a smaller allocation to alternative assets due to lack of liquidity, as liquidity venues for LP's stakes become more prominent, as well as direct single asset exposure, we would expect to see that tail continue to trend higher as well. 60-40 portfolio. For retail investors that have a 401k or even discretionary accounts, there's been talk for decades

about the 60-40 portfolio popularized by Jack Vogel, and for good reason, as it's had an outstanding track record over the past 50 years. 82% positive rolling one-year returns, 93% positive rolling three-year returns, 99.4% positive rolling five-year returns. Fell 20% or more in a year, just one time, gained 20% of it. or more in a year 10 times, average annual return of 10.7%. Vertus Investment Partners highlights these returns were driven not just by stocks, but also by bonds, which had an average annual return of 7.5% from 1976 to 2019. The average 10-year yield over this time was 6.2%. Today is 0.7%, which is why it's impossible for forward returns to

match those of the past. There are an estimated 28.7 trillion in retirement assets, inclusive of 1.5 trillion in target date funds. If you start to see a shift in that allocation, which we believe you must, that's a significant amount of capital to be reallocated and potentially prop up risk assets. Asset inflows. This has resulted in significant inflows into hedge funds, PE firms, and buyout funds over the past 45 years, up 470x over that time period. Remifications for asset classes and strategies. What does this mean for risk assets over the next couple of years? Bonds. The U.S. bond market is in an almost four-decade bull market, and for the better part of the last decade, industry pundits have been calling for it to end. With the Fed not thinking about raising interest rates

and liquidity that needs to come out of the bond market in search for higher returns elsewhere, we'd have a minimal to near zero allocation to bonds at this time. Equities. There should be a continued bid for U.S. equities as a result of this backdrop. You'll see capital inflows out of fixed income into equities with lower interest rates and higher ERPs supportive of this. Stanley Druckenmiller has noted that liquidity is the most important driver for the market. Beside the ramifications of monetary stimulus, you should see significant inflows out of fixed income into equities all else equal, driving equity prices higher. While Drucken Miller also commented that he believes risk and reward at current levels is

maybe the worst he's seen in his career, he also notes how quick he is to change his mind and his portfolio. For those with a longer-term horizon, 10-plus years willing to dollar-cost average and be patient, now is as good a time as any to start and continue deploying in public markets. Not all equities are created equal, with the market bifurcating between small-cap, mid-cap, and large-cap across value, core blend, and growth, while the team at Arc argues that innovation deserves a strategic allocation. Historical studies demonstrate that value has outperformed growth over long time periods.

The team at Touchstone Investments has noted that historically style leadership, changes have occurred near the end of an economic cycle, which did not occur in the COVID-driven downturn in their expectations that this reverses as the market rebounds. The outperformance of growth stocks year-to-date is most evident when looking at Bessemer's emerging cloud index. Now, perhaps the subsector of growth is not representative of the entire market, given the specific macro tailwinds associated with many of the companies as a result of the enhanced rate of digitization. In our view, you will continue to see growth outperform value, as investors are discounting future cash flows at lower interest rates, while going out the risk curve even within

the equity asset classes itself chasing returns. We think tech stocks, particularly those with high recurring revenue, will continue to do well. Buyout. With elevated public market valuations, buyout math becomes trickier, as private equity firms have to acquire companies at higher entry multiples. That's said, with a boom in assets under management, as well as annual investment, you haven't seen a slowdown in deal activity. And the median EV EBIDA multiple has generally followed the S&P higher, as P-E firms have the expectation they'll be able to sell for an even higher multiple down the road, with the loan exception being the last tech bubble. Given the cost of debt and elevated multiples, it wouldn't surprise us to see even greater leverage applied to companies as a means

to try to improve IRR. This is where a softer economic backdrop can cause potential problems if there's a material or in even some cases a modest slowdown in these highly levered businesses. Given the economic damage caused by the COVID-19 crisis, we think some of the smaller bio-firm's focused on the lower-middle market will perform incredibly well over the next couple of years due to the entry multiples at businesses that today are going concerns. Venture Capital We're seeing a blurring of the lines of public and private markets with an ever-increasing number of crossover funds.

Initially, this was largely relegated to hedge funds, but now, long-only asset managers such T. Roe Price, Fidelity, Wellington, Franklin Templeton, etc., are frequent participants in late-stage venture. Not only are we seeing new entrants into late-stage venture, but we're also seeing the proliferation of what some are calling SPACs 3.0, looking to take its place, with people like Chamath, Reed Hoffman and Mark Pinkis, and Mickey Malka all coming to market with SPACs. In the 690 million Reinvent Technology Partner SPAC that Hoffman and Pinkus are looking to bring to market, they highlight that they are excited to be a new kind of VC partner at the table for one of the many tech companies set to go public over the next few years,

and to help it maintain a growth mindset, be bold, and go for it in the face of pressure to deliver quarterly results. In our opinion, the 3.3 billion K-KAC deal for QuantumScape will be looked at as the poster child for this trend. Despite the fact that QuantumScape isn't projecting any revenue until 2024, they were able to raise 700 million as part of the deal. They had a who's-who of backers from Kleiner, Lightspeed, Bill Gates, Kossela and strategic backing from Volkswagen, with John Doer and Vinod Kossla on the board.

They could have remained private and given the revenue trajectory, it was probably more appropriate to do so. But given the market appetite for EV companies and QS's position in the market as the only lithium metal solid estate battery, with automotive OEM validation, they were able to build a fortress balance sheet and raise more capital than they otherwise would have been able to privately or in an IPO. As late-stage valuations get bid up due to new competition and larger fund sizes, we think returns will disappoint in the near term. This, however, leads to an opportunity in the early

stage part of the market due to the capital chasing late-stage deals and perhaps earlier exits, such as those occurred at the pre-tech bubble. One of the most attractive parts of seed and Series A venture, regardless of the macro environment, they can only be bid up so much. If a company goes on to IPO or sell in a meaningful way, those differences are negligible. Bitcoin In our piece entitled Bitcoin in the Macro Environment, we highlighted growth in the Fed's balance, sheet, M2, and savings rate as ripe conditions for BTC. Bitcoin has a plethora of both macro and micro-catalysts that are relevant in the zero-interest world, many of which Paul Tudor Jones discussed in his May letter entitled the Great Monetary Inflation, where he outlined assets

to own as inflation hedges in which he identified gold, the yield curve, NASDAQ 100, and Bitcoin as some of the assets most likely to outperform. What else? We think this macro backdrop leads to the financialization of everything. While we wrote about the various potential areas of growth at detail, sports teams, memorabilia, diamonds, helox, income sharing agreements, etc., were most excited about companies like Pipe that are creating an entirely new asset class out of subscription revenue, isolating the contracts from the equity debt themselves. While the Fed, inflation, and target yields may seem to be an afterthought for growth VCs, the financial markets are one interconnected web growing more so by the day.

So I'm not going to do a full breakdown, but I really liked the individual investable asset classes breakdown, right? How each of these different investments are likely to fare in this larger macro context. And this point that he makes at the end that while many of these folks don't necessarily see their business, especially on the VC side, as connected to things like interest rates, they are actually all connected if you take this historical view. I think we're still just beginning to try to understand what the implications are of a zero interest rate or even negative interest rate world. And so how different investments fare in that context is going to be a phenomenally important conversation. So hopefully you enjoyed this piece. I know I did,

and I appreciate you listening. Until tomorrow, guys, be safe and take care of each other. Peace.