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‘Peak finance’ could result in cheaper stocks and less rewarding finance careers

The combination of a rising fiscal deficit and tighter monetary policy in the United States is pushing the world’s risk- free rate upwards, thus reversing a 40-year trend of money become ever cheaper. Alongside adverse developments in global trade and politics, this could change the way we think about risk-reward trade-offs.

A 40-year trend in the world’s risk-free rate…   

In September 1981, the US 10-year government bond yield hit a post-World War 2 high of 15.4 percent. In September 2016, it touched a 50-year low of 1.6 percent.

This epic downward trend in the world’s risk-free rate has defined most of our careers. Had it not been for this downward trend, it is doubtful whether emerging market equities or private equity or real estate for that matter would be as big an asset class today as they have become.

In fact, in the broader scheme of things, the ‘financialisation’ of the global economy which has taken place in our lifetime has been underpinned by this epic bull run in US government bonds.

From 1.6 percent in August 2016, the US 10-year government bond yield has nearly doubled to 3.1 percent in mid-November 2018. Ex-poste, it is easy to attribute this to the US Federal Reserve’s strategy of ending quantitative easing, or QE, (which happened a year ago) and hiking interest rates. Over the last two years, the Fed has hiked the Fed Funds Rate by 2 percentage points.

However, if one looks forward, there is good reason to believe that the Fed Funds Rate and hence the US 10-year bond yield, will continue rising at a similar rate as: (a) the US job market – already overheated – starts showing pronounced wage inflation; (b) China – the world’s largest buyer of US government bonds (after the Fed) – reduces its purchases; and (c) the US budget deficit rises courtesy Trump’s tax cuts – the US budget deficit will be nearly $1 trillion in the financial year 2019, up 18 percent from a year ago.

There is another way to view the rise in the world’s risk-free rate — as a reflection of rising risk in the financial system. The perception that risk is rising could be fuelled by: (a) the fraying of the implicit understanding in the West that free trade between countries is a good thing; (b) the increasingly entrenched belief that the free market left to itself will result in a small group of people becoming super wealthy with everybody else left behind; and (c) the rising popularity of autocratic leaders in major economies across the world and implications it has for norms, which define liberal democratic politics.

Investment implications

Whatever be the reasons, the odds are in favour of the US 10-year bond yield continuing to rise over the next few years. If the US 10-year bond yield returns to the level of around 5 percent (which is where it was in 2007, before the Lehman-crisis struck) what effects could it have on India? There are five important effects to consider:

– If all we get is a rise in the risk-free rate in the US, then all we should get in India is India’s 10-year risk free rate rising by a similar amount (so India’s 10-year bond yield, currently at around 7-8 percent, should end up at around 9-10 percent, which is where it was before the NDA came to power). That implies a parallel shift upwards of the Capital Markets Line (CML) which is the risk-return trade-off that all of us use while weighing investments. If, on the other hand, risk appetite also wanes (say, because of a breakdown in global trade), then the CML tilts upwards as shown in the chart below.

– It follows from the above that not only will our discount rates go up (and thus exert downward pressure on asset prices), the riskier the asset, the sharper the drop in asset prices. Therefore, prices of private equity funded assets should fall more than, say, prices of large-cap stocks.

– Another way of putting this is the premium that investors will seek for taking extra risk looks likely to rise. So, for example, until a year ago, investors seemed happy to invest in small-cap stocks if the returns were one-third higher than large caps. Going forward the same investors might want small caps to give returns 50 percent higher than large caps.

– This, in turn, implies that assets which promise safety/certainty, for instance, premium commercial real estate in Mumbai, or well-run companies with strong ROCEs, predictable cash flows and formidable moats might actually get re-priced upwards as investors seek certainty. Continuing with this line of thought, one ends up feeling bullish about gold.

– Finally, the 40-year downward trend in the US 10-year bond yield has famously enriched many finance professionals the world over. The manager of a large privately run hospital in Mumbai will earn a fraction of what a manager of a large equity mutual fund in Mumbai will earn. The nurse in the same hospital will earn a fraction of what a junior sell-side analyst earns. If 2016 was ‘peak finance’, then the future earnings of finance professionals will face a reality check.