It is likely economists in the future will say today’s central bankers made a bigger mistake with inflation than those working in the 1970s, according to Orbis’s Alec Cutler.
Cutler, manager of the Orbis Global Balanced fund, said there is a trend among modern-day central bankers to criticise the actions of their forerunners working in the 1970s, when the consumer price index (CPI) reached 13.5%.
Yet while today’s economists say they now know what tools to use to keep inflation under control, Cutler said their reluctance to take difficult decisions could see history treat them even more harshly than those they are disparaging.
“If you study economics in the 1970s, you'll find PhD papers from the 1990s written by the people now running the Fed, and they think they know what they're doing,” he said.
“But if you compare how closely the inflation rate has tracked T-bill yields, today it is the biggest gap since 1970.
“What are the odds that five to 10 years from now, people will look back at this period and say, ‘these guys really got it wrong’? It feels to me the risk is actually higher now than it was back in the 1970s.”
While interest rates in the US stand at just 1.5%, around 7 percentage points below CPI, they have already been raised three times by the Federal Reserve this year – most recently last week. Along with the threat of further hikes, this has led to a 7.2% fall in the ICE BofA 1-10 Year US Treasury index so far in 2022.
Performance of index in 2022
Source: FE Analytics
Cutler said the popular media narrative suggested the crash in what is supposedly a safe haven asset class was “striking, exceptional or outrageous”, but what was more outrageous to him was that it was able to make more than 5% in 2019 and 2022.
“When you have nearly 20% of all bonds in the world, government and corporate, yielding less than zero, they make absolutely no sense from a risk/reward standpoint – to the point where we started referring to them as reward-free risk,” he continued.
“It’s the same with gilts. If you bought a gilt in July 2021, you would have received an interest rate of just over 0.5%. With an increase in the yield on the bond to 2% and a nine-year duration, you’ve got an 18% capital loss over nine to 10 months. But you did get 75% of 50bps for that – you got 37bps in return for the risk that got actualised and cost you almost 20%.”
With interest rates set to climb further, Cutler warned there was further pain to come – and not just for investors who hold bonds.
Because valuing growth stocks involves discounting future earnings, a higher risk-free rate means these are worth less. While there has already been a noticeable shift in sentiment in the press, with commentators no longer urging investors to ‘buy the dip’, Cutler said growth investors look completely unprepared for the scale of losses coming their way, with all the signs suggesting the bear market may just be getting started.
For example, while the NASDAQ just had its 20th worst week on record, this is the first entrance by the current bear market in the top 20. In contrast, the dotcom bubble accounted for 11 of the index’s worst weeks.
“If you add up all the weekly falls [after the bursting of the dotcom bubble], you would say, ‘that's impossible. How can you have -25%, -15% and -12%? You’ll get down to a ridiculously low level.’ Yeah, you were down 90%,” added Cutler.
“But if your margin crashed 50% and your multiple crashed 30%, then that seems a lot more reasonable. That's what's happening now.”
Cutler said that back in the early 2000s, he thought he would never again see an environment where the difference in price between value and growth stocks became so extreme.
Yet he said the difference in expected returns of the top and bottom halves of the FTSE World index by duration shows that despite the recent crash in growth stocks, they need to fall another 50% just to get back to par.
“This is a decent way of explaining why we are rotating out of growth shares and into things like BP, Shell, Smurfit Kappa and Bank of Ireland,” he added.
“It was because we had blown through the prior peak of complete weirdness in the market and we felt it was time to rotate into these names that were already extremely cheap.
“You could say we’re almost halfway there. But it's nothing compared with the amplitude needed just to get back to the extremes of 2000, much less to get back to some kind of par. We're nowhere near a period when value is popular. Growth is still actually quite popular. We have a long runway to go.”