A valuable lesson

How much value added comes from riding the interest rate curve versus more sustainable improvements?

What a week! On 9 February, the Dow Jones Industrial Average bounced back by 300 points, capping off its worst week in two years. At the height of the Great Correction, earlier in the week, the Dow nose-dived by 4.6 percent in a single day – its worst in six years – triggering a global sell-off and such a massive spike in the CBOE Volatility Index (the VIX, which tracks stock market volatility) it made Bitcoin’s recent wild swings look, well, tamer than the VIX, according to SEC chairman Jay Clayton.

Inevitably, this kind of roller-coaster ride has prompted a hefty dose of soul-searching. Was last week just a correction or a full-blown crash? The former, most pundits agree. Why was the sell-off so violent? Blame the machines for starting it, writes the Washington Post, though “the freak-out that followed was man-made”. And, finally, did the stock market make a “big mistake”, as President Donald Trump tweeted, in reacting negatively to seemingly good news in the real economy, namely, a 2.9 percent US wage increase? That’s debateable.

Investors are nervous – and rightly so, because, after years of quantitative easing, “you have a market where somebody changed the rules of the game”, as the New Mexico Educational Retirement Board’s Mark Canavan told us last year.

Higher wages in a low-unemployment economy raise the spectre of higher inflation which, in turn, boosts the chances of further rate hikes. After years of cheap liquidity, investors are starting to ask themselves how much of the value created by markets is durable, and how much of it is a function of the current environment. Faced with the prospect of interest rates increasing, they decided the stock market was overvalued and acted accordingly.

The expected impact of higher interest rates on infrastructure is not linear, but there’s little doubt the asset class has done very well out of the current low-interest-rate environment. For a start, it’s benefitted from a massive influx of new investors looking for yield; it’s gained depth, thanks to a flourishing private infrastructure debt market; and it’s allowed responsible investors to de-risk their assets by locking in cheap, long-term debt.

It’s also given the asset class a healthy boost in valuations.

There’s nothing inherently wrong with increased valuations. As JPMorgan Asset Management’s Anton Pil told us last year, it’d be “disappointing” if the asset class never went up in value. “The question is, when values have been rising, have they been rising because of discount factors or the underlying business dynamics? I’m a lot less interested in assets that have gone up simply because you’ve changed the discount factor.”

The problem, as one LP put it to us during the Great Correction, is that “a lot of the ‘value’ fund managers have added has been because of multiple expansion or discount-rate compression”. Some managers would no doubt dispute that (though one readily admitted the industry had benefitted from a “windfall gain”) and it’s also worth pointing out, as AMP Capital did in a 2016 note, that “unlisted infrastructure valuers […] concerned about the longevity of the ultra-low bond-yield environment […] have tended to embed an additional ‘alpha factor’ in discount rates”, thus moderating a rise in valuations.

But if one accepts that a non-negligible amount of value added comes from discount-rate compression then, as the LP told us, one has to ask if the discount rate on, say, regulated assets purchased in this environment will be appropriate in 10 years’ time?

The larger question, of course, is how prepared managers truly are for what could turn out to be “a rapid tightening of monetary policy, not just in the US”, on the back of “a strong synchronised global recovery […] with unemployment in a number of important economies reaching low levels,” as the Financial Times Martin Wolf put it. And that’s discounting any Black Swans.

“Nowadays, everyone is a hero,” our LP quipped. Yes, but who will still be a hero tomorrow?