Investors face their own Breaking Bad moment

This article first appeared in the AFR on 4 January 2021

Market liquidity is typically thin over the annual holiday period as investors and asset allocators seek a change of scenery for a week or two. This year, even that change of scenery will need to be virtual.  Investors reduced to taking their mental break via streaming could do worse than (re)watching the AMC series “Breaking Bad”.  Aside from being rated as one of the top TV series of all time, the series’ story arc takes viewers on a journey that could be prophetic for global investors.

Breaking Bad’s narrative innovation was to take the protagonist on a journey.  The show’s creator, Vince Gilligan, told Newsweek: “Television is historically good at keeping its characters in a self-imposed stasis so that shows can go on for years or even decades.  When I realised this, the logical next step was to think, how can I do a show in which the fundamental drive is toward change?”  The five seasons of the show tell the story of high school chemistry teacher Walter White responding to hardship by “breaking bad” and ultimately transforming from downtrodden hero into violent, hard-boiled villain.

Savers are also on a journey as they undergo a transformation from sober, cashflow- and value-focused investors towards more flamboyant, risk-taking speculators.  What has prompted this change and how far along are we?

In Breaking Bad, the transformation starts when Walter White discovers he has advanced cancer and starts taking more risks to provide for his family.  The health scare for savers was the Global Financial Crisis, when market falls gave investors a shock to their net worth.  Their efforts to rebuild their wealth by investing in assets that had traditionally provided solid returns were hampered by the arrival of the policy-led era of low interest rates, which came to be known as “lower for longer”.  Yield compression across all asset classes began to rapidly boost asset values and diminish income.  This meant that by late 2019, the only remaining lens through which equities looked like attractive value was “relative to bonds”. 

Then in early 2020, just as investors might have begun to hope that policy rates would start to rise, allowing yields to rebuild and equities to offer a better entry point, the pandemic struck.  Counterintuitively, asset values - across stocks, bonds, property and bitcoin - have taken another leg up.  Why?  Because of the most significant behavioural impact of the pandemic on financial markets: savers have gone from reluctantly edging out the risk curve, to beginning the capitulation into outright speculation. 

So where does this end? By the end of Season three, Walt is faced with the choice of bowing out of the drug trade on which he is now reliant, or murdering his erstwhile apprentice Gale.  While much less extreme, investors have also been wedged into a corner.  So long as interest rates were expected to “eventually” go up, then investors needed to be careful to not fully price low interest rates into asset valuations.  But 2020’s shift of mindset from “lower for longer” to “lower for forever” - the belief that policy rates can “never” go up - means that risk discount rates will keep coming down towards zero.  Mathematically, this means that asset values must keep going up. 

The combination of a dearth of assets offering anything above a peppercorn yield, and the prospect of asset values disconnecting from traditional cashflow-focused metrics, means that assets will now be priced on what tomorrow’s greater fool might pay for them.  Savers increasingly face Walt’s choice:  do they bow out, leaving behind the life of riches they have become accustomed to?  Or do they take the next incremental step in jettisoning their previous standards?

Obviously the analogy falls down in that (spoiler alert) Walt chooses the illegal and immoral course of action, whereas there is nothing illegal or immoral about the way investors are behaving. That difference aside, anecdotes of profligacy abound, from the customer who told a bank CEO that he was “saving” for a mortgage deposit by day trading tech stocks… to the wealthy Australians who have concluded that buying luxury property is the only way to earn a return on their capital… to index investors buying Tesla at a valuation greater than that of the entire Japanese auto industry...

We look back on the 1920s and marvel at their folly to believe that “stocks had reached a permanently higher plateau”.  As my colleague Anthony Bolton says, there’s always a story that drags markets to an extreme - and these days “lower for forever” is it.  However, Anthony also cautions that once the narrative is fully priced in it loses its power.  There comes a point where everyone who can or will buy stocks to chase the narrative has done so.  At that point, markets peak and then fall.

Currently, savers are making small decision after small decision that leads them further away from investing and closer to outright speculating.  We’re somewhere around the end of Season 3.  Time will tell if we will head towards the bloody climax seen in Season 5 or follow a new narrative.

 

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity International.

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