“QE Infinity turned your savings account into your checking account, the bond market into your savings account, the equity market into the bond market, the venture market into the equity market, while given rise to the crypto market as the new venture market”
On a recent podcast with Pomp we spoke about public & private markets, the current macro environment and implications for risk asset allocation. Some asked for the spark notes version of what was discussed and why it’s relevant; which is what is attempted below.
In a world post-financial crisis, we have seen a structural move lower in global rates with an estimated $17.0 trillion of negative yielding debt. The COVID-19 pandemic has only accelerated this trend due to the unprecedented global fiscal & monetary stimulus with Central Bank’s (Fed, BoJ, Swiss National Bank, BoE, ECB) balance sheet’s expanding by $5.5 trillion YTD from $16.0 trillion to $21.5 trillion (+34.0%), representing the biggest move since the depths of the GFC in 2008. The U.S. 10-Year Treasury opened the year at 1.9% and is down to 0.7% last.
If we look across Global Yields the story is the same with the “average” 10-year yield across the U.S., Canada, U.K., Germany, France, Italy, Japan, and Australia at 0.37%.
As you can see & unsparingly the global CB reaction has had implications across the yield curve. Investment firms such as BlackRock, Fidelity, Federated Hermes, and J.P. Morgan Asset Management have recently had to waive fees on the $5.0 trillion of assets held in money market funds to keep yields that investors earn from dropping below zero, with the seven-day net yield for the average money fund hitting 0.05% in July down from 1.31% at the end of 2019. The “Top Rated” tier of the high yield bond market now offers an effective yield of ~3.8%, and the effective yield on the entire junk-bond market as measured by the ICE Bank of America High Yield Index is at 5.4%. The yield on IG bonds as measured by LQD is ~2.75%, and municipal bonds as measured by MUB is ~2.0%.
Fed Chair Jerome Powell recently said the Fed was “not even thinking about thinking about raising rates.” Concurrent with the Fed’s desire to keep rates low they have also recently released a statement on the Longer-Run Goals & Monetary Policy Strategy in which they note that, “the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”
This commitment from the Fed to look to ramp inflation, coupled with lower rates puts the onus on investors to reassess portfolio allocation & search for alternative sources of return.
Why Do Yields Matter?
While QE Infinity has created a generation of dip buyers & the belief that stocks only go higher, risk matters, & riskier investments should have higher expected returns than safer investments. This should be pretty intuitive; e.g., if you were to write a check in an Angel Round for a startup you believe you can return 100x+ your money because there’s a significantly higher probability that it goes to $0, and therefore you size that investment accordingly. Alternatively, if you are going to invest in WMT stock, while there have been a number of 20–30% pullbacks over the trailing 20 years, you probably expect your investment to compound at a high single digit rate of return, and aren’t all that concerned about it going to $0 . If you were to invest in WMT bonds you might be earning ~2.5% today but view that as effectively “risk free” on par with sovereign debt.
NYU Professor Aswath Damodaran is known as the “Dean of a Valuation” and has written a series of papers on Equity Risk Premiums (“ERP”). Damodaran writes that, “the expected return on any investment can be written as the sum of the risk-free rate and a risk premium to compensate for the risk.”
In explaining why equity risk premium matters he highlights: “The equity risk premium reflects fundamental judgments we make about how much risk we see in an economy/market and what price we attach to that risk. In the process, it affects the expected return on every risky investment and the value that we estimate for that investment.” He notes implications on expected returns & discount rates.
Damodaran acknowledges those not in the midst of valuation might not care about ERP but should due to wide reaching effects including:
· The amounts set aside by both corporations and governments to meet future pension fund and health care obligations are determined by their expectations of returns from investing in equity markets, i.e., their views on the equity risk premium. Assuming that the equity risk premium is 6% will lead to far less being set aside each year to cover future obligations than assuming a premium of 4%. If the actual premium delivered by equity markets is only 2%, the fund’s assets will be insufficient to meet its liabilities, leading to fund shortfalls which have to be met by raising taxes (for governments) or reducing profits (for corporations) In some cases, the pension benefits can be put at risk, if plan administrators use unrealistically high equity risk premiums, and set aside too little each year.
· Business investments in new assets and capacity is determined by whether the businesses think they can generate higher returns on those investments than the cost that they attach to the capital in that investment. If equity risk premiums increase, the cost of equity and capital will have to increase with them, leading to less overall investment in the economy and lower economic growth.
· Regulated monopolies, such as utility companies, are often restricted in terms of the prices that they charge for their products and services. The regulatory commissions that determine “reasonable” prices base them on the assumption that these companies have to earn a fair rate of return for their equity investors. To come up with this fair rate of return, they need estimates of equity risk premiums; using higher equity risk premiums will translate into higher prices for the customers in these companies
· Judgments about how much you should save for your retirement or health care and where you should invest your savings are clearly affected by how much return you think you can make on your investments. Being over optimistic about equity risk premiums will lead you to save too little to meet future needs and to over investment in risky asset classes.
Damadoran compiled Summary Statistics for U.S. Stocks, T.Bills, and T.Bonds from 1928–2018 displayed below. While U.S. equities have delivered much higher returns than treasuries over this period, they have also been more volatile, as evidenced both by the higher standard deviation in returns and by the extremes in the distribution. Using this table, he takes a first shot at estimating a risk premium by taking the difference between the average returns on stocks and the average return on treasuries, yielding a risk premium of 7.93% for stocks over T.Bills (11.36% minus 3.43%) and 6.26% for stocks over T.Bonds (11.36% minus 5.10%).
After exploring a number of different methods he compiled historical risk premiums across Equity Markets from 1900–2017 globally.
Hypothetical Walk Through:
How do you determine the value of a stock? One of the most common valuation methods, particularly for high growth companies, is a discounted cash flow model or DCF. DCF’s attempt to determine the value of a company today based on projections of future cash flows, discounted back to the present. Below is a very basic DCF walk through for a hypothetical company named “SaaS Co.” In it we model out 10 years of unlevered FCF, discount them back and come up with a Total EV & in turn price / share.
Notably if we keep all estimates the same for that 10-year period but move the discount rate +/- 1% the theoretical fair value changes by 6–7% as outlined below. This leads to an incredibly wide range of “fair values” that differ by nearly 60%. The odds of a 10-year forecast being remotely right are close enough to 0% in it of themselves, so it’s very notable / important how much a small change in that discount rate impacts valuation.
S&P 500 Valuation Regimes Over Time
A lot of market pundits talk about markets at all time high valuations looking at it on a pure P/E basis without factoring in Equity Risk Premium. When looking at ERP the market is still in light to slightly cheap vs. historical averages.
There’s also a number of structural reasons that support higher multiples than in decades past including the fact that’s never been easier to index / diversify which inherently lowers the risk associated with any single equity position. Given the proliferation of ETF’s and globalization of mega cap businesses leading to geographic diversification, the market can support higher multiples. The composition of broad-market indices has changed with the Top 5 stocks in the S&P 500 all technology stocks for the first time; which have historically supported higher multiples as a result of growth rates / margin profiles than financials / industrials / energy / conglomerates which historically were larger percentages of the indices. Finally, technology progress more broadly has led to structurally higher margins which all else equal, increases profitability again supporting higher multiples.
At the most fundamental level, capital allocation decisions are predicated upon investable assets, expected inflows / outflows, and risk / return objectives. These core characteristics vary considerably when you’re dealing with pension plans that have a significant retiree base with an ever shrinking employee base, vs. an endowment with billions of dollars and minimal operating expenditures required (“5% spending rule”), a high net worth individual in prime earnings of their career, a middle class individual near retirement, or a recent college graduate. Regardless of what bucket an entity or individual falls within this move in rates, has a profound impact on allocation decisions.
Pension funds manage $4.5 trillion of assets so what they do has an impact on markets. Estimates for unfunded pension liabilities in the U.S. range from $1.6 to $6.0 trillion, depending on the method and assumptions used. There are three primary levers these organizations can utilize to close that gap including 1) Contribute More to the Plan 2) Cut Payouts to Beneficiaries 3) Generate Higher Returns. Since the first two have significant controversy there’s a push to increase returns. Pew showed an analysis of Average Assumes Rates of Return for Pensions, vs. the 30-year treasury and implied risk premium. Notably the assumed return has drifted from ~8.0% to 7.2% despite the 30-year going from ~8.0% to now less than 1.5%.
How are Pensions supposed to generate higher returns in a lower interest rate environment? They need to move out the risk curve with a higher allocation to alternatives. A recent report from Morgan Stanley highlighted that Pension funds took their allocation to alternative assets up from 7% in 1990 to 29% in 2019; with close to 40% of institutional investors planning to increase that exposure.
Endowments control more than $600 billion of assets and while smaller than Pension funds still very significant as it pertains to their capital allocation decisions. David Swensen & Yale really pioneered the Modern Endowment Model or the Yale Model. This relies on a heavy allocation to alternative assets, while simultaneously avoiding asset classes such as Fixed Income / Commodities. Per their last update Yale’s endowment returned 11.4% per annum over the 20 years ending June 30, 2019, exceeding broad market results for domestic stocks, which returned 6.4% annually, and for domestic bonds, which returned 4.9% annually. For FY20 their target portfolio allocation is below:
Endowments at large have taken their alternative asset allocation from 6% in 1990 to 53% in 2019. At present smaller endowments still have a smaller allocation to alternative assets due to the lack of liquidity, as liquidity venues for LP stakes become more prominent, as well as direct single asset exposure we would expect to see that tail continue to trend higher as well.
For Retail investors that have a 401(K) or even discretionary accounts, there’s been talks for decades about the 60/40 portfolio popularized by Jack Vogel; and for good reason as it’s had an outstanding track record over the past 50 years:
· 82% positive rolling 1-year return
· 93% positive rolling 3-year returns
· 99.4% positive rolling 5-year returns
· Fell 20% or more in a year just one time
· Gained 20% or more in a year 10 different Times
· Average Annual Return of 10.7%
Virtus Investment Partners highlights that these returns were driven not just by stocks but also by bonds, which had an average annual return of 7.5% from 1976–2019. The average 10-year yield over this time was 6.2%; today it’s 0.70%, which is why it’s impossible for forward returns to match those of the past.
There are an estimated ~$28.7 trillion in retirement assets inclusive of ~$1.5 trillion in target date funds. If you start to see a shift in that allocation (which we believe you must) that’s a significant amount of capital to be reallocated and potentially prop up risk assets.
This has resulted in significant inflows into Hedge Fund, VC Firms, and Buyout Funds over the past 45 years up 470x over that time period.
Ramifications for Asset Classes / Strategies:
What does this mean for risk assets over the next couple of years?
The U.S. bond market is in almost a four-decade bull market and for the better part of the past decade industry pundits have been calling for it to end. With the Fed not thinking about thinking about raising rates, and liquidity that needs to come out of the bond market in search of higher returns elsewhere we’d have a minimal to near-zero allocation to bonds as this time.
There should be a continued bid for U.S. Equities as a result of this backdrop. You’ll see capital inflows out of Fixed Income into Equities with lower interest rates / higher ERP’s supportive of this. Stanley Druckenmiller has noted that “liquidity is the most important driver for the market.” Besides the ramifications of monetary stimulus, you should see significant inflows out of fixed income into equities all else equal driving equity prices higher.
While Druckenmiller also commented that he believes risk / reward at current levels is maybe the worst he’s seen in his career, he also notes how quick he is to change both his mind and his portfolio. For those with a longer term time horizon +10 years willing to dollar cost average & be patient now is as good a time as any to start / continue deploying in public markets.
Chamath Palihapitiya had a good tweet thread on this recently highlighting the importance interest rates play in equity valuation.
Not all equities are created equal with the market bifurcating between Small Cap, Mid-Cap, and Large-Cap across Value, Core/Blend, and Growth (while the team at Ark argues that Innovation Deserves a Strategic Allocation).
Historical studies demonstrate that Value has outperformed Growth over long-time periods. The team at Touchstone Investments has noted that historically style leadership changes have occurred near the end of an economic cycle; which did not occur in the COVID-driven downturn & their expectations that this reverses as the market rebounds.
The outperformance of growth stocks YTD is most evident when looking at Bessemer’s Emerging Cloud Index. Now perhaps this sub-sector of growth is not representative of the entire market given the specific macro tailwinds associated with many of the companies as result of the enhanced rate of digitization.
In our view you will continue to see Growth outperform Value as investors are discounting future cash flows at lower interest rates, while going out the risk curve even within the equity asset class itself chasing returns. We think tech stocks particularly those with high recurring revenue will continue to do well (look no further than the AAPL or ADBE re-rating when recurring revenue increased).
With elevated public market valuations buyout math becomes trickier as PE firms have to acquire companies at higher entry multiples. That said with a boom in Assets Under Management as well as annual investment, you haven’t seen a slowdown in deal activity and the median EV/EBITDA multiple has generally followed the S&P higher as PE firms have the expectation they’ll be able to sell for an even higher multiple down the road (with the lone exception being the last tech bubble).
Given the cost of debt and elevated multiples it wouldn’t surprise as to see even greater leverage applied to companies as a means to try to improve MOIC / IRR. This is where a softer economic backdrop can cause potential problems if there’s a material (or in some cases even a modest) slowdown in these highly levered businesses.
Given the economic damage caused by the COVID-19 crisis we think some of the smaller buyout firms focused on the lower-middle market will perform incredibly well over the next couple of years due to the entry multiples at businesses that today are going concerns.
We’re seeing a blurring of the lines of public & private markets with an ever increasing number of cross over funds. Initially this was largely relegated to hedge funds (predominantly TMT) but now long only asset managers such as T Rowe Price, Fidelity, Wellington, Franklin Templeton, etc… are frequent participants in late stage venture.
Not only are we seeing new entrants into late stage venture but we’re also seeing the proliferation of what some are calling SPAC’s 3.0 looking to take its place; with people like Chamath, Reid Hoffman & Marc Pincus, and Micky Malka all coming to market with SPAC’s. In the $690M Reinvent Technology Partners SPAC that Hoffman / Pincus are looking to bring to market they highlight that they are “excited to be a new kind of VC partner at the table for one of the many tech companies set to go public over the next few years & to help it maintain a growth mindset, be bold, and go for it in the face of pressure to deliver quarterly results.”
In our opinion the $3.3B KCAC deal for QuantumScape will be looked at as the poster child for this trend. Despite the fact that QuantumScape isn’t projecting any revenue until 2024 they were able to raise $700M as part of the deal ($230M of cash held in a Trust +$500M of a PIPE). They had a who’s who of backers venture funding from Kleiner, Lightspeed, Bill Gates, Khosla and strategic backing from Volkswagen; with John Doerr & Vinod Khosla on the Board. They could have remained private and given the revenue trajectory was probably more appropriate to do so. But given the market appetite for EV companies, and QS’s position in the market as the only lithium-metal solid-state battery with automotive OEM validation they were able to build a fortress balance sheet and raise more capital than they otherwise would have been able to privately or in an IPO.
As late stage valuations get bid up due to new competition, and larger fund sizes we think returns will disappoint in the near term.
This however leads to an opportunity in the early stage part of the market due this capital chasing late stage deal and perhaps earlier exits such as those that occurred pre-tech bubble. One of the most attractive parts of Seed-Series A venture is regardless of macro environment they can only be bid up so much (Pitchbook charts below); and if a company goes on to IPO or sell in a meaningful way those differences are negligible.
In our piece entitled Bitcoin & the Macro Environment we highlighted growth in the Fed’s balance sheet, M2, and savings rate as ripe conditions for BTC. Bitcoin has a plethora of both macro & micro catalysts that are relevant in this 0% interest rate world many of which Paul Tudor Jones discussed in his May letter entitled The Great Monetary Inflation where he outlined assets to own as inflation hedges in which, he identified Gold, The Yield Curve, NASDAQ 100, and Bitcoin as some of the assets most likely to outperform
We think this macro backdrop leads to the “Financialization of Everything.” While we wrote about the various potential areas of growth at detail (Sports Teams, Memorabilia, Diamonds, HELOC’s, Income Sharing Agreements, etc…) we’re most excited about companies like Pipe that are creating an entirely new asset class out of subscription revenue isolating the contracts from the equity / debt themselves.
While the Fed, inflation, and target yields may seem to be an afterthought for growth VC’s the financial markets are one interconnected web; growing more so by the day.
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