“Reality” is a relative term. Things that appear solid and permanent – all the material objects in the world around us – are mostly empty spaces when viewed at sub-atomic levels. If an atom – consisting of a nucleus of protons and neutrons at its core and electrons orbiting in space around the nucleus – were the size of a football stadium then the nucleus itself (containing over 99% of the atom’s mass) would be the size of a grain of rice. Our very ability to perceive the world around us is determined by the specific way the human visual cortex processes images of reflected light, and thus our “reality” looks vastly different from that of a frog, a dolphin or a fruit fly. And we won’t even begin to get into how weird reality becomes when we contemplate the quantum world, or how quantum mechanics supplies evidence for possibilities like the existence of multiple universes. Things that were once the province of fanciful science fiction are turning out to be entirely plausible theories of “reality” in complete accordance with the laws of physics. Brian Greene’s is one of the latest books to come out over the last couple years addressing these various theories (Steven Hawking, among others, is a recent contributor to the literature). These are as fascinating as they are unsettling (and well worth a read). This brief tour d’horizon of recent scientific theories may seem far removed from the world of investment markets, but we think the metaphysical question “what is reality?” is actually a fairly good segue into the strange landscape of markets and assets at the dawn of 2011. We operate on a daily basis by calling up our memories, which are repositories of ideas and associations accumulated from empirical evidence gained over time. “Stocks always go up in the long term.” “US government bonds are the ultimate risk-free investment.” “Perfectly rational behavior is the best assumption for models that make valuation calculations for investments”.
These images and associations help us establish a framework by which we can explain the world and our place in it. When confronted with new evidence that conflicts with these stored perceptions our natural instinct is to resist it. It can take a long time for old perceptions to catch up with new realities. For creatures that exist in a world of constant change, who in fact ourselves have successfully evolved over millions of years by constantly adapting to change – for all that, we humans are not particularly fond of change.
Which brings us to the weird reality of capital markets at the beginning of 2011. If there is one image that perhaps more than any other expresses the reality to which we have grown accustomed in the market over the last thirty years it is that of declining interest rates. This long-term decline, as illustrated by the US 10-year Treasury note in the chart above, is arguably the most important context in which all other investment trends over this period have played out. Not only has it been a good thirty years to be a bond investor, but an environment of declining interest rates helps other asset classes as well. They stimulate the creation of credit, which results in capital investment by businesses and more purchasing power for consumers. Think of how much easier it became over this period to obtain financing to buy a house, a car or a major home appliance. Think of how many more businesses, even those without sterling credit ratings, could obtain debt financing by tapping the high yield bond market. Credit creation stimulates economic activity, which in turn improves the prospects for businesses and thus makes investing in their common stock desirable – hence the longest bull market in history from 1982-2000.
This observed reality of structurally low interest rates is really the touchstone of this report – because we believe that this period is coming to an end, probably sooner rather than later and for a variety of sometimes unrelated reasons. When we speak of a “new reality” we mean that we expect credit markets over the coming years to look quite a bit different from what we are used to. That may at times be good news for other assets, and at times it may be challenging. As we will discuss in a later section of this report, we think that the particularly strong performance of the bond market over the last decade relative to stocks and other risk assets is likely to reverse in the coming year and perhaps farther ahead.
But there are inherent risks as well. Periods when interest rates rise over a multi-year period are typically not good for investment markets in general – witness the stagnant environment of the 1970s. We cannot predict how the credit markets of the new reality are going to look. Are we going to see a steady rise in interest rates over a multi-year period even as long as ten or more years? What are the implications for the broader market of further declines in the credit quality of leading developed sovereign nations, including the US but almost certainly the Eurozone and Japan? With structural weakness in both the dollar and the euro, and trillions of dollars of stimulus money flowing through the credit markets, is runaway inflation a major near-term threat? What is to become of the Eurozone and the US municipal markets? The answers to these questions will likely have a major impact on markets over the coming years. All we can do now is be mindful of their potential influence and diligent in our analysis of what threats and opportunities are manifesting at any given time.
Things may be here, they may be there, and they may confound the limits of human abilities to reason and make logical, fact-based decisions. The wheels are already in motion for this new reality. There are tremendous opportunities, we believe, but at the same time no shortage of potential risks to be encountered in navigating the new terrain. Welcome to 2011.