Preparing for the next paradigm in markets

We need to talk about rates.

Bloomberg recently put out an interesting article on negative yields, one that’s reflective of the surprise, dismay and downright disillusionment of clients we’ve been seeing over the past few weeks. Then, on Wednesday, the Fed stuck to the script and cut rates for the first time since the financial crisis. It labelled the move a “mid-cycle adjustment to policy” rather than the start of a more aggressive cycle of monetary easing.

Of course, an ever increasing amount of debt is now yielding zero or less ($13 trillion by one estimate). But what’s amazing (and scary) is how far down the credit curve this has penetrated. Some European high yield issues are trading at negative yields, most BBB rated corporates are negative out to 6 years, and the 10y EUR mid-swap currently sits at 1bp and is heading south fast, having been at around 4% in early 2009. We live in remarkable times.

Ray Dalio’s thoughts on paradigms are instructive here. He reckons a paradigm shift is coming to markets, thanks to massive monetary easing since 2008 and the subsequent explosion of debt. Ultimately, he believes, “monetizations of debt and currency depreciations will eventually pick up, which will reduce the value of money and real returns for creditors and test how far creditors will let central banks go in providing negative real returns before moving into other assets.“ Essentially, the value of cash will decline…perhaps precipitously.

Low yields sliding even lower have certainly sparked plenty of hand wringing over the past decade. But they’ve been accompanied by commensurate asset price gains (directly in bonds and indirectly in other assets), so the market grumbled but at the end of the day, enjoyed the price appreciation. But as Dalio rightly points out, that price appreciation is essentially bringing forward the expected return to the present, so we should expect future returns of the asset to be lower. Bond yields, dividend yields and earnings yields are all falling fast, which means the sky-high valuations that these assets currently command is increasingly at risk.

What does all this mean for the future paradigm? There seems to be a consensus that in a world flush with cash, cash will perform the worst, and thus bonds are not safe but other “risky” assets are – things like stocks, real estate, private equity and alternatives. That’s essentially the world we’ve been living in since March 2009. And one half of that thesis will certainly continue to hold – it’s very dangerous in the long term to have money parked in bonds with a negative yield. However, the risk rally over the past 5+ years has pushed up valuations, not just of positive-carry assets like real estate and profitable companies, but also of speculative negative-carry assets like high-growth but cash burning startups.

This is a topic I find fascinating, having started life in fixed-income before becoming immersed in the tech and venture landscape. The relationship between low rates and increasing asset allocation towards VC/PE has always been very clear to me. Recognising this brute fact has allowed me to retain a healthy skepticism with regards to the eye-watering high private valuations we’ve seen in the tech world. For some time now, it’s been obvious that WeWork, Uber and many other companies weren’t growing their valuations from unicorn to multi-decacorn status purely on the back of “crushing it”. They were benefiting from broader macro trends. It was a case of right place, right time.

The recent wave of listings on public markets has exposed some of the froth and sadly, some of the businesses I really respect have been caught in the crossfire (such as Funding Circle, who went public at a £1.5bn valuation and are now valued at <£400m, a nearly 75% drop).

The fact that central banks are returning to an easing cycle is scary, as it reflects the inescapable fact that the global economy is slowing and perhaps even heading to recession. In a recessionary world, trying to grow one’s way toward profitability is even harder than it would be normally, and any hint of weakness in the private capital market will cause a wave of startup failures among cash-burning companies who simply run out of funding. This is a very real possibility.

In this scenario, there would be a flight to quality. For those companies that don’t have a strong moat (Uber, Lyft and others) and which are still burning cash, it is going to be challenging. But a low rate (and potentially inflationary) environment leaves institutional investors chasing returns, and I can see those startups that are free-cash-flow positive commanding even higher premiums. Companies with a monopoly position on a particular network, technology, or data-source are a scarce resource and will become highly sought after. The starter’s pistol has already been fired on this race, with the LSE bid for Refinitiv reflective of a scramble to buy scarce assets.

What does all this mean for Origin? We are doing what we always do – running our business as prudently and capital-efficiently as possible and focusing our efforts on becoming the market standard for primary fixed income issuance. We expect to be on the right side of the new paradigm, if that day should come.