William McNarland, CFA
In North America, the ‘Big One’ often describes an expected earthquake rated at above eight on the Richter scale that is supposed to happen along the San Andreas Fault line. This event would be especially devastating to people who live on the west coast of North America.
Being new to living in Vancouver, I decided to research how likely this will happen in my lifetime. Based on my research, it has a 20% likelihood of coming in the next fifty years. At this level of probability, I don't give it much thought.
I have heard this term used in finance as well when people describe the next shock to the financial system and few that we have experienced before. I feel the next ‘Big One’ in finance has 100% chance of happening in the coming decade and I want to prepare for it. In my career, there have been three events that people have referred to as being the ‘Big One,’ and I do not believe they were as large as the one that is coming.
"I feel the next ‘Big One’ in finance has 100% chance of happening in the coming decade and I want to prepare for it."
The Asian Financial crisis of 1997 was not felt globally and was more centered on emerging economies and only had significant effects later on Japan, Korea, and Russia only. I do not consider the dot.com bust of 2000 as being significant as it only focused on the technology sector and it was mostly just investors who were affected. In comparison, the devaluation of the Thai Baht or Philippine Peso was much more significant to the average person in the 1997 financial crisis. The ‘Great Recession’ of 2009 was a ‘Big One’ and is fresh in most of our minds. But as big as it was, I believe that the next coming ‘Big One’ will be even more disastrous and the effect will take a decade to return to normalize.
The first tremor of the coming ‘Big One’ was felt just recently after the election of US President Donald Trump. The tremor was the shockingly rapid increase in interest rates. As an example, the 10-Year US Treasury moved up from its 52 Week low of 1.32% to 2.49%. In the two days after the election, over $1 Trillion USD was wiped out in the global bond markets. I believe we all have to recognize this tremor as an early warning sign and consider how to prepare our assets so as not to be affected. Like everyone else, I do not know when rates will rise, but recognize that it is extremely likely over the next ten years.
Let's consider the effect of higher interest rates on public fixed income, developed real estate, oil and gold, and private fixed income.
1. Public Fixed Income
Bond funds should come with a warning label! Based on the guidance of National Instrument 81-102, public mutual funds come with a low risk classification for investors. Based on the gradual fall of interest rates over the last three decades, they have been a haven for investors. Based on the direction of the NI, these bond funds are usually rated a low risk in their fund fact sheets. But what happens to these bond funds if interest rates rise by 1%, 2%, or 3% in the next year or two? The loss is easy to calculate using the fund's duration, average gross yield, and management fee. Below I take one of the Canadian ‘Big Six’ banks flagship Canadian Bond Fund and calculate the expected loss when interest rates increase. As you would note in the chart below, double-digit potential losses are at least medium and if not, high risk. I am baffled how, using the guidance in the NI, an issuer can provide their opinion that bond funds are low risk when we see the effect rising interest rates would have on their performance.
2. Developed Real Estate
Many private equity offerings use real estate professionals who help with selecting underlying properties to provide investment returns to investors. Beta and Alpha are the two components that combine to produce investor returns. The alpha represents the return that was powered by the management skill; the beta was the return attributed to the change in the overall market conditions. For offerings like REITs, there were significant beta returns that came from falling capitalization rates and falling mortgage servicing expenses. The beta returns in the future will provide a headwind to investment managers as cap rates traditionally are very highly correlated to interest rates, and mortgage servicing costs are expected to rise. The chart below shows this strong historical correlation. In these future environments, it is imperative that investors choose managers that can produce alpha returns by actively increasing the net operating income of their portfolio and not relying on falling interest and capitalization rates. The chart below shows how significant the loss of property would be if capitalization rates increased from 4% to 8%.
3. Oil and Gold
Gold historically has a no real relationship to interest rates. Instead, the two commodities have a strong reverse correlation to the US Dollar. In a scenario that the US interest rates are increasing, there is more demand for US treasuries which enhances the value of the dollar. Higher interest rates should then lower the prices of oil and gold in USD.
4. Stock Market
The future value of a stock is derived by two main factors: first, the growth in earnings year over year and second, the Price/Earnings multiple that the profits command. Falling interest rates typically increase companies’ profits as it reduces their interest costs; the opposite is true for rising interest rates. One factor that can be seen very clearly historically is that P/E ratios have an inverse correlation to interest rates. For example, in the table below, I have shown the average PE ratio of the US stock market during two periods. The first period was a century high in interest rates and the second time frame was the century low in interest rates. Notice that during the hundred years’ peak period, the average PE ratio was 8.01 and during the second term, it was 19.35. It is also interesting to note that today on December 1st, 2016, the PE Ratio is 25.21. The conclusion from this is that if interest rates increase, it could lower earnings of companies and their PE multiple could also decrease, resulting in much lower stock market levels.
In summary, I believe that we are going to experience a once-in-a-lifetime valuation correction. Like everyone else, I am not sure when it will happen, but I’m confident that it will start sooner than we may expect. I think that one should consider the present risk profiles of public bonds, stocks, and passive real estate and consider alternative solutions. For myself, I am very intrigued with asset-backed private debt and alpha–driven, non-leveraged real estate opportunities.
"I think that one should consider the present risk profiles of public bonds, stocks, and passive real estate and consider alternative solutions"
William McNarland, CFA is a corporate finance expert specializing in the structuring, analysis, and capital raising of private debt and equity. Bringing over 20 years of industry experience, William was the founder of ExemptAnalyst and formerly was Managing Director of Pinnacle Wealth Brokers. Currently William is the co-founder and Managing Director of Eiffel Peak Capital, and a director of Rethink and Diversify Securities.