WHAT IS CLEAR FROM OUR RESEARCH IS THAT THE “LONG TERM WAVE” STARTED ITS SUPPORTIVE TREND IN MARCH 2020, AS THE GLOBAL COST OF CAPITAL WAS EFFECTIVELY SET TO ZERO FOR THE FORESEEABLE FUTURE BY GOVERNMENT/CENTRAL BANK INTERVENTION.
rate being applied by the market to those cashflows at any point in time. Given those explicit outputs, we can then construct a stock level expected return forecast and an implied risk model of those expected returns to quantify both the risk and the reward for owning the asset.
Armed with this, we are then able to not only address the short-term risk/reward outlook but also determine the medium-term outlook for expected returns, the return on equity cycle and the longer-term outlook of the cost of capital cycle. Returning now to the prospects for 2021, we can put the information we have about all three of these cycles or “waves” in context as they combine to give us a quantifiable framework for investing.
What is clear from our research is that the “long term wave” started its supportive trend in March 2020, as the global cost of capital was effectively set to zero for the foreseeable future by Government/Central Bank intervention. This was the reason for the rally through the late spring/ early summer, as any asset with a positive return on capital was re-valued accordingly.
This has had the added consequence of not only removing the concept of the carry trade from the government yield curve – a major investment strategy of the past – but essentially removing the concept of a risk premium entirely, as credit risk was essentially absorbed by the authorities in the US. These structural developments will have longer term implications for investment flows into Government bond markets in general but for the purposes of understanding the underlying valuation trends for equities, the longer- term supportive trend is very much in place.
So as we approach year end, for Western economies and markets, it is the medium-term wave and the prospects for future cash flows that are now beginning to move centre stage. Investors will need to buy “cashflows” in 2021 and will want to have a clear view on both expected returns and the risk to those returns if they are to outperform. In the near term, despite the recent positive news-flow, the short-term wave relating to the uncertainty of those returns continues to dominate sentiment and drive market conditions. However, as we have seen in China, a reduction in uncertainty allows for a positive medium-term wave and the supportive longer-term wave driving returns. So as uncertainty declines – which it will - downside risks reduce and positive medium and longer-term valuation trends combine and support rising markets. The combination of a reduction in forecast uncertainty, persistent low interest rates and a boom in pent-up demand post Covid-19, provides for the prospect of a multi-wave reinforcement bull story for global equities. With the cost of capital effectively zero for those with access to it, capital will be used to buy cashflows in the form of expected returns greater than zero; supporting the view that the markets as a whole will rise. Obviously, the greater the return on cashflows and the more certain the returns, the greater the value that the markets will attach to them and, where leverage is available, this can become a self-reinforcing cycle. With any sustained reduction in uncertainty - improving Covid-19 conditions are an obvious trigger - investors should look to buy into the forecast cashflow winners of the low interest rate cycle, gear up and ride the wave.
Christopher Tinker E:
chris.tinker@libra-is.com T: +44(0) 20 3915 5621
8 | ADMISI - The Ghost In The Machine | Q4 Edition
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