There’s still plenty going on in finance-land although this last month really has just been the same as the prior one – inflation, interest rates, recessions, pauses and pivots…
As expected, the Federal Reserve chose to increase official rates by a further 0.75% at their July meeting. This follows on from last meeting’s 0.75% and is the fourth consecutive rate hike. This aggressive tightening – the most aggressive in decades – has taken official rates to the highest level since 2019 (!)
As I’ve been scanning the financial world, I’m constantly reminded about how amazing the journey has been for investors – not just the last two years but the last 25 years.
Here’s how the journey since 1995 looks like through the lens of the US S&P 500 index:
The 2008 global financial crisis and 2000 tech bubble are, in every sense, well in the past. In both cases, the market topped-out around 1,500. Plainly, that’s a long way from 4,800 where the market found itself at the end of 2021.
Measuring the return since before the GFC, the market went up around 3,300 points. If you calculate that out, the average annual return over around 13 years is a bit over 10%. Add in a couple of percent per year for dividends and maybe the return has been 12.5%. Very respectable but not incredible.
If we calculate returns from the March 2009 low of around 670, it’s been close to 18%. Add in a few dividends and someone that picked the bottom (and held on to the end of 2021) enjoyed returns close to 20% per year. Now that’s incredible! 13 years is a long time. It’s understandable that to many investors, a market relentlessly rising by 10+% per year is, well, “normal”… It’s all they have ever known.
The trouble we have is what this period of historically-outsized returns has done in terms of valuations. According to historically-informative, “revenue-based” valuation models, it looks something like this:
Now firstly, let me emphasise that this is not a share price index chart – it’s not supposed to rise over time as share prices rise. Whilst there’s technically no upper or lower boundaries, this is supposed to oscillate over time around some mid-point. Or, arguably, in an ideal world it shouldn’t – a horizontal like would mean valuations being largely unchanged. Note this wouldn’t mean static share prices – it would simply mean that prices are growing at a rate consistent with fundamentals (earnings growth).
Notice that the GFC took valuations to a level that might be described as “average” over the post-war period – we can probably even say “under-valued”. From there, valuations have surged – ending 2021 at the highest level ever.
That little red squiggle in the top right corner is roughly where we’re currently at. The falls during the first half of the year have unwound the frothiest bit of the bubble – valuations remain higher than every point prior to last year.
In summary, nothing has transpired in the past month to alter our investment stance. With valuations still extreme, corporate earnings under pressure from high inflation and a weak economy together with co-ordinated aggressive monetary tightening, it remains a time to be very defensive. Short-term rallies – perhaps months in duration – should be expected but, in our view, it will take some time to iron out the excesses.
Indeed, in the past, we’ve heard many a financial pundit emphasise that it takes many months for interest rate cuts to filter through the economy. True. And its logical that it will take a while for the full extent of rate rises to be felt.
It is very improbable that returns over this next 13 years will look anything like the last 13 years. One way to think of it is the last decade of great returns has “brought forward” future returns. This comes at a cost – future returns have to be lower than they would have otherwise been.
Looking back… looking forward
Reflecting on this journey always prompts me to reflect on my own journey in terms of my career. I won’t bore you with that although I do want to focus on one core aspect.
I was drawn into finance via a passion for finance. I’ve always had a desire to understand how the financial world works. In time, this evolved into what I often cite as the (unofficial) “motto” of Aviator – making sensible financial decisions based on a deep understanding of financial history and financial market operations.
A lot of people have been learning financial lessons lately:
Crypto investors have been learning that maybe crypto isn’t a one-way trip to fabulous wealth
Risk averse fixed-interest investors have been learning that capital losses are very possible on a supposedly low-risk portfolio
Builders have been learning that offering fixed price contracts can be very damaging to your business
NFT investors have learned that some of the things they paid a lot of money for in the past year might in fact be worthless
Home owners have been learning that interest rates can actually move up as well as down
Central bankers have learned that the rate of inflation can go up as well as down
When you think about it, all these people made the same mistake – they expected things to stay constant… for nothing to change…
Further, with regard to central banks, I’m sincerely hopeful that they have learned the lesson that excessively low rates are not good. There’s little doubt that extreme “easy money” policies have played a meaningful role in the blowing of the recent bubble although governments also have played a major role.
Inflation Lessons
Recent experiences have provided us a practical lesson on a rather controversial monetary concept. It’s rather esoteric, but being an area of significant interest to me I can’t resist reporting on it. Indulge me if you will…
In recent years, a fairly old monetary concept has been getting quite a lot of publicity among political and economics circles – the idea of “Modern Monetary Theory”.
Whilst there’s plenty of nuances to the concept, there’s several core aspects, which can crudely be described as follows:
Government debt/deficits don’t matter, therefore
A government can spend as much as it desires, however
Inflation is the main restraint facing governments with respect to spending
The theory got a lot of airplay in the years following the global financial crisis as nations sought to rebuild economies. It got some more airplay in recent low growth, low inflation years as a possible way of governments doing more for the people. Indeed, we saw a number of prominent U.S. politicians floating the idea of using MMT – even stating “doing MMT” – as a means of funding big government spending initiatives.
In simple terms, MMT is based around an assertion that in the modern monetary world where (most) nations have their very own floating “fiat” currency, nations don’t face any kind of solvency restraint – at least with respect to debts denominated in their own currency. Currency isn’t “backed” by anything such as gold. Therefore, unlike days gone by, a nation isn’t restrained by factors such as gold reserves. They can borrow and spend as much as they want!
Of course, this doesn’t sit very well with most people. “Nonsense!”… “How can that be possible?”
But there’s a very important reason why it may be possible – a nation isn’t an individual or business.
We all grow up learning that we are restrained in what we can spend. Whilst we can spend more than our income, we need to go into debt to do so.
We also learn that we are restrained in what we can borrow. If we get ourselves into too much debt, we might not be able to service our debts and face the risk of bankruptcy.
We know these things to be true. They are true. But a nation isn’t an individual.
Through the complex beast that is the modern monetary system, a federal government such as the U.S.A. and Australia can always harness the banking system to obtain funds – in other words, to sell new debt. It’s hard to explain this simplistically but hopefully this helps:
“Running a deficit” means the government spending more than it takes in in taxes
If the government hasn’t “drained money” from the economy in taxes, the money is there sloshing around in the banking system.
These “excess funds” sloshing around create their own demand for new government debt – the banks are eager to park it somewhere where it earns a low (no) risk return.
Or perhaps think about it this way – what happens if the government pays off all its debt? There’s no longer a federal government bond market, right? Government deficits are responsible for creating a valuable source of risk-free “assets” for the private sector in the form of government bonds. Now, of course that’s not to say “more is always better”.
Although a detailed explanation would run many pages, trust me when I say that, in a purely mechanical sense, a sovereign nation with its own currency simply cannot ever “run out of money” – they technically have no spending restraint.
So if you’re accepting of this, we can move on to that other MMT theoretical assertion – inflation is the main restraint facing governments with respect to spending.
Well, it might surprise you to learn that many nations just “did MMT”. We therefore have a case to study.
Note that you didn’t “miss anything” – there wasn’t any formal announcement about governments “doing MMT”. But realise that the fiscal response to Covid adopted by many nations was, for all intents and purposes, “MMT”.
As we’ve covered off on previously, many nations responded to Covid with significant government support programs. In the case of nations including the USA and Australia, the response was massive – programs pushing 20% of GDP.
And realise that this was all debt-funded. Nations didn’t massively raise taxes to offset the spending.
Massive debt-funded government spending programs… At its heart, this is “MMT”.
Academic Economists’ Dream
This exceptional period in economic history has been a dream for economists – there’s been so much to study. Indeed, we’ve seen plenty of research already compiled on inflation and the Covid fiscal response. Even some from the Federal Reserve.
Fed researchers released a report during July titled “Fiscal policy and excess inflation during Covid-19: a cross-country view”. It included the following:
Their conclusions are similar to other researchers – whilst it is impossible to definitively calculate, it is evident that the significant spending response during Covid has juiced inflation.
It’s also notable what didn’t happen…
Bond markets didn’t “break” – nations including the USA and Australia were easily able to sell all the new bonds they required to balance the spending.
The US dollar didn’t crash. In fact, it’s only gone up, which is causing pain and disruption to many emerging market economies:
This period has brought many lessons. I do hope that the lessons you have learned have been “informative” rather than “painful”…
This document contains information which is the copyright of Aviator Capital Pty Ltd (AFSL 432803) or relevant third party. Any views expressed in this transmission are those of the individual, except where the individual specifically states them to be the views of Aviator Capital Pty Ltd. Except as required by law, Aviator Capital Pty Ltd does not represent, warrant and/or guarantee that the integrity of this document has been maintained nor is free of errors, interception or interference. You should not copy, disclose or distribute this document without the authority of Aviator Capital Pty Ltd. Aviator Capital Pty Ltd does not accept any liability for any investment decisions made on the basis of this information. This information is intended to provide general information only, without taking into account any particular person’s objectives, financial situation, taxation or needs. It does not constitute financial advice and should not be taken as such. Aviator Capital Pty Ltd urges you to obtain professional advice before proceeding with any financial investment.
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Lessons Learned
Lessons Learned
There’s still plenty going on in finance-land although this last month really has just been the same as the prior one – inflation, interest rates, recessions, pauses and pivots…
As expected, the Federal Reserve chose to increase official rates by a further 0.75% at their July meeting. This follows on from last meeting’s 0.75% and is the fourth consecutive rate hike. This aggressive tightening – the most aggressive in decades – has taken official rates to the highest level since 2019 (!)
As I’ve been scanning the financial world, I’m constantly reminded about how amazing the journey has been for investors – not just the last two years but the last 25 years.
Here’s how the journey since 1995 looks like through the lens of the US S&P 500 index:
The 2008 global financial crisis and 2000 tech bubble are, in every sense, well in the past. In both cases, the market topped-out around 1,500. Plainly, that’s a long way from 4,800 where the market found itself at the end of 2021.
Measuring the return since before the GFC, the market went up around 3,300 points. If you calculate that out, the average annual return over around 13 years is a bit over 10%. Add in a couple of percent per year for dividends and maybe the return has been 12.5%. Very respectable but not incredible.
If we calculate returns from the March 2009 low of around 670, it’s been close to 18%. Add in a few dividends and someone that picked the bottom (and held on to the end of 2021) enjoyed returns close to 20% per year. Now that’s incredible! 13 years is a long time. It’s understandable that to many investors, a market relentlessly rising by 10+% per year is, well, “normal”… It’s all they have ever known.
The trouble we have is what this period of historically-outsized returns has done in terms of valuations. According to historically-informative, “revenue-based” valuation models, it looks something like this:
Now firstly, let me emphasise that this is not a share price index chart – it’s not supposed to rise over time as share prices rise. Whilst there’s technically no upper or lower boundaries, this is supposed to oscillate over time around some mid-point. Or, arguably, in an ideal world it shouldn’t – a horizontal like would mean valuations being largely unchanged. Note this wouldn’t mean static share prices – it would simply mean that prices are growing at a rate consistent with fundamentals (earnings growth).
Notice that the GFC took valuations to a level that might be described as “average” over the post-war period – we can probably even say “under-valued”. From there, valuations have surged – ending 2021 at the highest level ever.
That little red squiggle in the top right corner is roughly where we’re currently at. The falls during the first half of the year have unwound the frothiest bit of the bubble – valuations remain higher than every point prior to last year.
In summary, nothing has transpired in the past month to alter our investment stance. With valuations still extreme, corporate earnings under pressure from high inflation and a weak economy together with co-ordinated aggressive monetary tightening, it remains a time to be very defensive. Short-term rallies – perhaps months in duration – should be expected but, in our view, it will take some time to iron out the excesses.
Indeed, in the past, we’ve heard many a financial pundit emphasise that it takes many months for interest rate cuts to filter through the economy. True. And its logical that it will take a while for the full extent of rate rises to be felt.
It is very improbable that returns over this next 13 years will look anything like the last 13 years. One way to think of it is the last decade of great returns has “brought forward” future returns. This comes at a cost – future returns have to be lower than they would have otherwise been.
Looking back… looking forward
Reflecting on this journey always prompts me to reflect on my own journey in terms of my career. I won’t bore you with that although I do want to focus on one core aspect.
I was drawn into finance via a passion for finance. I’ve always had a desire to understand how the financial world works. In time, this evolved into what I often cite as the (unofficial) “motto” of Aviator – making sensible financial decisions based on a deep understanding of financial history and financial market operations.
A lot of people have been learning financial lessons lately:
When you think about it, all these people made the same mistake – they expected things to stay constant… for nothing to change…
Further, with regard to central banks, I’m sincerely hopeful that they have learned the lesson that excessively low rates are not good. There’s little doubt that extreme “easy money” policies have played a meaningful role in the blowing of the recent bubble although governments also have played a major role.
Inflation Lessons
Recent experiences have provided us a practical lesson on a rather controversial monetary concept. It’s rather esoteric, but being an area of significant interest to me I can’t resist reporting on it. Indulge me if you will…
In recent years, a fairly old monetary concept has been getting quite a lot of publicity among political and economics circles – the idea of “Modern Monetary Theory”.
Whilst there’s plenty of nuances to the concept, there’s several core aspects, which can crudely be described as follows:
Government debt/deficits don’t matter, therefore
A government can spend as much as it desires, however
Inflation is the main restraint facing governments with respect to spending
The theory got a lot of airplay in the years following the global financial crisis as nations sought to rebuild economies. It got some more airplay in recent low growth, low inflation years as a possible way of governments doing more for the people. Indeed, we saw a number of prominent U.S. politicians floating the idea of using MMT – even stating “doing MMT” – as a means of funding big government spending initiatives.
In simple terms, MMT is based around an assertion that in the modern monetary world where (most) nations have their very own floating “fiat” currency, nations don’t face any kind of solvency restraint – at least with respect to debts denominated in their own currency. Currency isn’t “backed” by anything such as gold. Therefore, unlike days gone by, a nation isn’t restrained by factors such as gold reserves. They can borrow and spend as much as they want!
Of course, this doesn’t sit very well with most people. “Nonsense!”… “How can that be possible?”
But there’s a very important reason why it may be possible – a nation isn’t an individual or business.
We all grow up learning that we are restrained in what we can spend. Whilst we can spend more than our income, we need to go into debt to do so.
We also learn that we are restrained in what we can borrow. If we get ourselves into too much debt, we might not be able to service our debts and face the risk of bankruptcy.
We know these things to be true. They are true. But a nation isn’t an individual.
Through the complex beast that is the modern monetary system, a federal government such as the U.S.A. and Australia can always harness the banking system to obtain funds – in other words, to sell new debt. It’s hard to explain this simplistically but hopefully this helps:
“Running a deficit” means the government spending more than it takes in in taxes
If the government hasn’t “drained money” from the economy in taxes, the money is there sloshing around in the banking system.
These “excess funds” sloshing around create their own demand for new government debt – the banks are eager to park it somewhere where it earns a low (no) risk return.
Or perhaps think about it this way – what happens if the government pays off all its debt? There’s no longer a federal government bond market, right? Government deficits are responsible for creating a valuable source of risk-free “assets” for the private sector in the form of government bonds. Now, of course that’s not to say “more is always better”.
Although a detailed explanation would run many pages, trust me when I say that, in a purely mechanical sense, a sovereign nation with its own currency simply cannot ever “run out of money” – they technically have no spending restraint.
So if you’re accepting of this, we can move on to that other MMT theoretical assertion – inflation is the main restraint facing governments with respect to spending.
Well, it might surprise you to learn that many nations just “did MMT”. We therefore have a
case to study.
Note that you didn’t “miss anything” – there wasn’t any formal announcement about governments “doing MMT”. But realise that the fiscal response to Covid adopted by many nations was, for all intents and purposes, “MMT”.
As we’ve covered off on previously, many nations responded to Covid with significant government support programs. In the case of nations including the USA and Australia, the response was massive – programs pushing 20% of GDP.
And realise that this was all debt-funded. Nations didn’t massively raise taxes to offset the spending.
Massive debt-funded government spending programs… At its heart, this is “MMT”.
Academic Economists’ Dream
This exceptional period in economic history has been a dream for economists – there’s been so much to study. Indeed, we’ve seen plenty of research already compiled on inflation and the Covid fiscal response. Even some from the Federal Reserve.
Fed researchers released a report during July titled “Fiscal policy and excess inflation during Covid-19: a cross-country view”. It included the following:
Their conclusions are similar to other researchers – whilst it is impossible to definitively calculate, it is evident that the significant spending response during Covid has juiced inflation.
It’s also notable what didn’t happen…
Bond markets didn’t “break” – nations including the USA and Australia were easily able to sell all the new bonds they required to balance the spending.
The US dollar didn’t crash. In fact, it’s only gone up, which is causing pain and disruption to many emerging market economies:
This period has brought many lessons. I do hope that the lessons you have learned have been “informative” rather than “painful”…
This document contains information which is the copyright of Aviator Capital Pty Ltd (AFSL 432803) or relevant third party. Any views expressed in this transmission are those of the individual, except where the individual specifically states them to be the views of Aviator Capital Pty Ltd. Except as required by law, Aviator Capital Pty Ltd does not represent, warrant and/or guarantee that the integrity of this document has been maintained nor is free of errors, interception or interference. You should not copy, disclose or distribute this document without the authority of Aviator Capital Pty Ltd. Aviator Capital Pty Ltd does not accept any liability for any investment decisions made on the basis of this information. This information is intended to provide general information only, without taking into account any particular person’s objectives, financial situation, taxation or needs. It does not constitute financial advice and should not be taken as such. Aviator Capital Pty Ltd urges you to obtain professional advice before proceeding with any financial investment.
Register your interest in this Fund
Lorem ipsum dolor sit amet, consectetur adipiscing elit. Ut elit tellus, luctus nec ullamcorper mattis, pulvinar dapibus leo.