December 2014 Update

Equicapita December Briefing

OUTLOOK:

CHART 3: GERMAN BOND YIELDS

We continue to inhabit an unprecedented global

negative real interest rate world, even negative
nominal rates in some cases.1 A quick survey
around the globe reveals developed markets with
nominal rates at multi-century lows.

15%

10%

As investors we must always step back and

contemplate the abnormal global interest rate
environment as risk assets are bid ever higher.

5%

0%

16%
14%
12%
10%
8%
6%
4%
2%
1920

1930

1940

1950

1960

1970

1980

1990

2000

2010

Source: Federal Reserve

CHART 2: UK BOND YIELDS

15%

10%

5%

0%
1700 1720 1740 1760 1780 1800 1820 1840 1860 1880 1900 1920 1940 1960 1980 2000

Source: BOE, Church House

1860

1880

1900

1920

1940

1960

1980

2000

In our worldview, negative real interest rates are a

driver of mal-investment, capital destruction and
asset bubbles.

18%

1910

1840

Source: Global Financial Data

CHART 1: US BOND YIELDS

0%
1900

1820

In such an environment, we also believe our

predisposition to hard asset investments remains
sound. Economic laws and market forces are great
levelers and while governments may try to immunize
themselves from their operation in the end this is not
possible. To quote George Wickersham - These laws
cannot be destroyed by governments, but often in
the course of human history governments have been
destroyed by them 2
While sovereign bond yields remain low and public
equity market returns are nothing short of spectacular
our mandate is to think more broadly than next
quarter. The artifice of central bank suppressed
interest rates only supports nominal prices of
accessible risk assets in the short to medium term,
ultimately cash-flow triumphs and assets will reprice in real terms to reflect this fact. Current
policies effectively result in the capital of savers being

Equicapita December Briefing (continued)

consumed in order to provide what is believed to be

the raw material of a rebirth of growth in the form
of low interest rates. However this capital is largely
being used by the financial sector for speculative
activities hence the substantial increase in the value
of even the riskiest assets without a corresponding
recovery in the underlying real economy.
To this end, we believe that stock market prices are
not being driven by fundamentals and do not reflect a
recovering economy but rather:

Central Banks: Federal Reserves balance sheet

is driving the markets - highly correlated to stock
market price levels (see Chart 4)

CHART 5: SCHILLER CAPE E10 RATIO

50

2000

45
40
35

1929

30

1901

25

1966

25.78
!

20
15
10
5
0

1860

1880

1900

1920

1940

1960

1980

2000

2020

Buybacks: Stock buybacks are at record levels

even though stock prices are at record highs (see

Chart 6)
CHART 6: SP STOCK BUYBACKS BY QUARTER

CHART 4: FEDERAL RESERVE BALANCE

SHEET VERSUS SP

$180
Federal Reserve Balance Sheet

S&P 500 Stock Price Index

1800

$160

3300000

1600

$140

3000000

1400

$120

2700000

1200

$100

2400000

1000

$80

2100000

800

$60

1800000

600

$40

1500000

400

$20

1200000

200

$0

3600000

900000
2008

2009

2010

2011

2012

2013

Multiple Expansion: Cyclically adjusted price-

to-earnings ratio (10 year average trailing PE)

or CAPE range of approximately 12x to 16x
historically but is currently over 23x - going back
100 years, there have only been two higher
readings: first in the late 1920s, before the Black
Tuesday crash, and second in 1999, before the
dot-com crash (see Chart 5)

2008

2009

2010

2011

2012

2013

2014

Source: Capital IQ
We also believe that inflation is not subdued. The
calculation method has merely been changed so
that it now only measures a constantly declining
quality of life given substitution effects and stripping
out the costs of food and energy. One of the most
less obvious techniques to hide inflation is what we
call shrinkflation = where companies reduce the

Equicapita December Briefing (continued)

weight or size of an item without decreasing its price.

See the examples of chocolate and orange juice
containers below (1980s versus 2010s). Inflation
is currently above 10% per year with a 10-year
average above 7% pa (see Chart 7). To put this in
perspective, that represents a 95% loss of purchasing
power versus 20% loss under government numbers.
While it is true that the official unemployment rate
is moderate and dropping, we do not believe it

CHART 8: OFFICIAL UNEMPLOYMENT (U3)

VERSUS 1980S METHODOLOGY
Official (U3)

25%
20%
15%
10%
5%
0%

Year to Year Change. Through July 2014. (BLS, SGS)

SGS Alternate CPI, 1980-Based

1998

2000

2002

2004

2006

2008

2010

2012

2014

CPI-U

10%

CHART 9: REAL BOND & EQUITY RETURNS

VERSUS INFLATION RATE

5%
0%
-5%

1996

of our investment thesis is that higher real returns

and Sharpe ratios can be found in alternative asset
classes and that current market conditions do not
bode well for future public market bond and equity
returns. The idea that public equities are useful
inflation hedges is only the case in periods of deflation
or low, stable inflation. When inflation begins to trend
above 5% pa this breaks down and substantial real
losses in both public equities and bonds accumulate
(see Chart 9).

CHART 7: CPI-U VERSUS 1980S

METHODOLOGY
15%

ShadowStats

Rate of return/inflation (%)

20

1982

1986

1990

1994

1998

2002

2006

2010

2014

is dropping because the economy is recovering.

Unemployment rates are calculated using a different
methodology from 1980s if you use the 1980s
method unemployment rate in the US is over 20%
versus the posted 6% currently (see Chart 8).
If inflation is already high then it has consequences
for the real returns of various asset classes. Part

10

18

20.2
11.2

6.8

11.9

11.4
5.2

-3.5

0.5

10.8
3.4 1.9

7.0
2.8 2.9

4.5

8.0

5.2

-4.6

1.8

-12.0

-10
-20
-30

-23.2

-2.6

Low 5%

Next 15%

Next 15%

Real bond returns (%)

Next 15%

Next 15%

Real equity returns (%)

Next 15%

Next 15%

Top 5%

Inflation rate of at least (%)

Source: 2012 Credit Suisse Global Investment

Returns Yearbook

Equicapita December Briefing (continued)

Real assets, producing goods with inelastic demand

curves in sectors with leverage at or below historical
averages, where possible with un-priced inflation
hedging qualities are our preference. Over the next
decade we believe such investments we return higher
nominal and risk adjusted returns than bonds and
equities.
Ultimately central banks have a Hobsons Choice3
they can control exchange rates/purchasing power
or interest rates/asset prices but not both. Central
banks are institutionally committed to lower interest

rates and higher asset prices. The only realistic way

for sovereign borrowers to repay debts is a de-facto
default via money supply expansion that aligns with
speculative capital interests and central bank policy.
Therefore, the negative real interest rate environment is
likely to continue for the foreseeable future, and so we
continue to believe real assets with inflation hedging
qualities in the form of inelastic demand curves (an
example of an inelastic demand curves is water,
energy and food) and soft linkage to commodity prices
will generate superior returns.

ENDNOTES:
1 ECB has implemented negative 0.20% deposit rates for banks. In addition, Deutsche Skatbank has
announced that customers with over
500,000 on deposit as of November 1 will earn a negative interest rate of 0.25%.
2 Wickersham Commission - May 1929 (full name National Commission on Law Observance and
Enforcement)
3 Wikipedia: Hobsons Choice is a free choice in which only one option is offered. As a person may refuse to
take that option, the choice is therefore between taking the option or not; take it or leave it.

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