FUND BOUTIQUES & PRIVATE LABEL FUNDS: Family Offices, Think Tanks, Economics & “Manias, Panics, and Crashes” (Interview – Martin Friedrich, Lansdowne Partners Austria GmbH)

Family offices, think tanks, and independent asset managers frequently have interesting economic “Maps” in the area of capital market strategy. Markus Hill spoke on behalf of FONDSBOUTIQUEN.DE with Martin Friedrich, Lansdowne Partners Austria GmbH, regarding connections between share prices, economic growth, and central bank policy. Additionally, the topics discussed were inflation and the importance of fiscal policy in coronavirus times. The interview was written as a follow-up to the lecture “Stock Puzzle of the Year 2020” (Organizer: CD Invest Consult GmbH, Vienna).

Hill: It seems like a mystery to many investors – the economy is constantly delivering new negative records, but stocks are rising. Have the central banks severed any connection between the stock market and reality?

Friedrich: We are not convinced by this argument. People are quick to blame, or credit, central banks with almost everything. In reality, we should first understand what is and what is not really different about the current situation. After all, before we can anticipate the future, we should first of all have an explanation for the present! So let us first understand what caused the stock market rally. The connection with between stocks and economic growth is often cited but frequently misunderstood. Yes, we can show that in the past, strong growth rates in economic activity have correlated with positive stock market returns; the opposite also holds. However, there is a catch to this “analysis”: it only works when looking backwards. In investing however, you have to plan ahead to make money – investment decisions are fundamentally about the future. So the question is, does the observed positive correlation hold up when compared with forward-looking returns? Unfortunately not! If you compare the GDP growth of the past year with the stock market returns of the next 12 months, the beautiful correlation just described is suddenly gone. Moreover, you cannot forecast equities based on an economic forecast, either, because there are simply too many surprises for that – see the special year 2020. So be careful with that. Instead, we see two other correlations:There is a certain correlation between the stock returns of the previous year and the economic growth of the following year. One can therefore very well derive an economic forecast from the shares.

a) Secondly, there is an observation – it doesn’t happen often, but if global GDP has really plummeted, then in the last 30 years we’ve not had a single case of negative stock returns in the following 12 months. So, deep recessions are really the time when you can buy stocks with the least risk. This has also proved true this year.

b) So what we conclude is the following: Central banks have helped to limit the duration of the recession to one quarter by providing liquidity and other measures. The fact that shares rise after a recession, on the other hand, is a completely normal thing.

Hill: Your explanations sounds plausible. Can you prove your conclusions with concrete examples?

Friedrich: Of course we can back our claim up. We looked at the Standard & Poors 500, before and during all the major recessions of the last 50 years. According to the research of the NBER (National Bureau of Economic Research), there have been exactly six recessions since 1970. We wanted to know, and asked ourselves two questions:

a) How many months before the beginning of the recession do stock prices start to fall? 

b) When do they rise again?

What we have seen is that the best time to buy has always been before the end of the recession – in fact always exactly when it seemed to be at its worst. Our analysis shows that while stocks begin to fall a good six months before the recession, when it comes to anticipating the new economic cycle, the market is much more short-sighted. On average, lows have been marked two to three months before the end of the recession. This, by the way, has been true well this year as well. So the stock rally is not really that surprising in principle, even though the current crisis is anything but normal. I think we can formulate the following hypothesis: If the economy started a new expansion cycle in the third quarter, then March 24th, 2020 was also the beginning of a new bull market in stocks! This is why I said in July already that we will not see the lows again.

Hill: What role did the central banks then play in this scenario?

Friedrich: The study of market panics – and we saw one in March on the world’s stock exchanges – leaves no doubt that in times of such emotional turmoil only the intervention of authorities is really able to stop the downward spiral. I recommend reading Charles Kindleberger’s classic “Manias, Panics, and Crashes”. This time, however, the authorities have really gone very far. The Fed has thus managed to dramatically reduce interest rates, up to very long maturities. For example, 10-year US yields fell from around 2.00% at the beginning of the year to 0.70%, and even 30-year yields came down from 2.40% to 1.20% in August.

Hill: So, the result of the central bank’s intervention influences stock markets?

Friedrich: Yes, and massively! As we have both talked about before, shares are financial instruments with a basically infinite term. And we can show that a drop in interest rates has a greater impact on their valuation than a temporary drop in profits due to the current recession. This is particularly the case with so-called growth stocks. It is therefore not surprising that technology and pharmaceutical companies have marked new highs in recent weeks, while on the other hand the cyclically exposed part of the market has been stuck in a sideways movement since April. Some use the term “K-shaped recovery” for this kind of dynamic. What is important to understand in this context is that the correlation between equities and bonds works both ways. Put simply, if interest rates rise again at some point, it will be unpleasant for investors in growth stocks.

Hill: Some investors may interpret these relationships differently. Does this mean that you are now expecting the much talked about turnaround in interest rates?

Friedrich: For the sake of clarity, one has to distinguish two different aspects: In the near term, we have seen economic data has consistently registered above expectations for several months now. In interest rate markets, we have already seen a reaction to this. For example, market-based inflation expectations in Germany have risen from 0.4 % to 0.7 % since May. In the USA, they have risen even more, from 1.1 % to 1.7 %. However, I doubt this is already the beginning of a “major turnaround in interest rates” as some people claim. For this to happen, we would first need to see a longer-term rise in core inflation rates, and it is still too early for that.

Nonetheless: even a slight rise in interest rates could be enough to trigger a noticeable sector rotation in the equity sector. After all, we have seen price dynamics in the technology sector over the past six months that strongly reminds me of the developments in 1999. And we know how that turned out: Between March 2000 and September 2002, the Nasdaq-100 Index fell by over 80 % in real terms. However, history will probably not repeat exactly. In 2001, we had a recession, which today is probably already behind us. On the other hand, the corona-related surge in demand for FAANGM titles will create very difficult basis-effect, in my opinion. The earnings growth in 2021 compared to 2020 will perhaps be less than enough meet analysts’ sky-high expectations. On the other hand, I see much more upside potential in cyclically exposed parts of the stock market. Ironically, this could also mean that in 2021, US equities will perform significantly worse than European markets or Japan. Many emerging markets would also benefit from such a dynamic.

Hill: Let me return to your previous comment on core inflation rates. Why don’t you believe in a rise in inflation? What role does the current corona crisis and fiscal policy play here?

Friedrich: At this point we should make two distinctions: one, between the US and the euro area. And secondly, between the short- and long-term. Let’s start on our own doorstep: We just had negative inflation rates in the euro zone in September. At 0.2 %, the less volatile core inflation rate is also miles away from the ECB’s inflation target. In the USA we have a somewhat different situation, but here too, the figures are currently still below 2.0 %. The conclusion for the short term is that we are experiencing a deflationary shock from the recession in 2020. Leading indicators such as the ratio of the money supply MZM to GDP speak a clear language here. There are of course reasons to believe that we can stop this deflationary trend and that we will see higher inflation rates again sometime, probably from 2022 onwards. After all, the macroeconomic environment is strongly reflationary. In combination with a vaccine that would allow a sustainable opening of the economy, this can contribute to a really strong growth dynamic. Imagine putting the pedal to the metal with the handbrake on! That is roughly the state we are in. Solving the medical problem would be like releasing this handbrake!

Next, we need to talk about the role of fiscal policy. There is one aspect of the 2020 economic crisis that is really fundamentally different: it was decreed by governments from above, so to speak. That is why many people were – and still are – dependent on “helicopter money” to keep paying their bills. Without the many fiscal programs, the world would probably look very different today. Remember, central banks cannot create demand. They can only prevent liquidity shortages and reduce the cost of borrowing. Real demand, on the other hand, is created when the government spends money or sends it to citizens – and it doesn’t matter whether this is done through tax cuts or by mailing people checks. The longer-term danger is that such proactive fiscal policy is in the hands of politicians; this means that we are separated from potential abuse only by a very fine line now. And I’m not the only one who wonders whether fiscal programs will be cut back in time as soon as the economy recovers? If economic policy stumbles at that point, we will face additional demand while supply remains the same. And then there is the danger of a new spiral of price increases.

I would like to add that these medium-term risks are very likely to strike first in the US rather than in Europe. My fear, however, is that in the age of populism, other times may dawn here as well.

Hill: Many thanks for the interview.

Martin Friedrich is Head of Economic & Market Research and Portfolio Manager of the Lansdowne Endowment Fund. He joined Lansdowne Partners Austria in January 2019 from HQ Trust, one of the largest independent multi-family offices in Germany. Mr. Friedrich has been employed there since 2009, most recently as Head of Capital Market Analysis and Co-Chief Investment Officer. He also managed customer portfolios and was responsible for the investment process of LIQID, a Fintech company in Berlin. He was also active in the Wigmore Association. Wigmore is an innovative global cooperation of eight different single and multi-family offices.

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