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Time to prepare for the new lost decade (where private equity won’t help)
“A lot of investors are talking about the pendulum swinging from growth to value, but I believe the pendulum swing is more from quantitative easing (QE) to quantitative tightening (QT),” Bhansali says. “It’s a regime change – and the implications of that regime change are that in a QE world, risk taking was rewarded; in a QT world, risk taking will be penalised.”
“That has significant implications for repositioning portfolios. What worked in the last decade is unlikely to work in the next decade – if anything, quite the opposite.”
Whether it’s junk bonds or junk equities (defined by four “Ls”: loss-making, leveraged, ludicrous expectations, lofty valuations), markets are now smoking out the risk. And the odds of things getting a whole lot worse are far greater than the odds of things getting a whole lot better, Bhansali says. On the margins, the things that are getting better are supply chain disruptions. But the abrupt withdrawal of monetary and fiscal stimulus is going to create a growth challenge “and a lot of air pockets for the real economy”.
“Markets don’t do well with this kind of uncertainty; it was an upward trending market, it’s likely to be a choppy market, and in choppy markets passive investing, which has been the dominant form of investing in the last decade, and I would argue momentum investing, because passive and momentum have become almost equivalent, and let’s throw in growth there, all wrapped up in one (are going to suffer),” Bhansali says. “The notion of just buying cheap for cheap’s sake is going to unravel.”
Investors have grown complacent, Bhansali says; dip-buying is a crutch. And the US stock market’s combination of high levels of margin, high valuations, and high debt, along with a strong currency, will conspire to create a “lost decade in the US stock market” – that is, a decade where markets end lower than where they started. It’s happened before; most people remember the lost decade of 2001-2010, but it also occurred in the US between 1969 and 1978.
“The last time a country got to 60 per cent of its benchmark (the US is currently 60 per cent of the ACWI benchmark) was Japan, in 1989,” Bhansali says. “And we all know what those sorts of thresholds can mean. For the next two decades, Japan did nothing but de-rate. I know it’s hard to imagine that about the US stock market, given the juggernaut it has been. But that is exactly how markets behave.”
“Nobody expected the Japanese stock market to correct for 20 plus years, but it did… the whole notion of passive, set and forget, buy the dip – all those precepts that we’ve learned in the last decade, we’re going to have to start unlearning. It is time to become more agile, it is time to focus on fundamentals and valuation.
“Easy money is behind us, and I think that plays into the hands of active stock pickers, fundamental stockpickers, hedge funds who can short, dividend paying companies. There’s a lot of ways to make money – but it does require a rethink.”
But the “canary in the coal mine” – the one asset class that “nobody is thinking of as a real source of risk” – is private equity, which Bhansali believes will be the one to unravel the most for many institutional investors. It’s really a grotesque combination of junk bonds and junk equities, Bhansali says, one that’s been turbocharged by the QE world of leverage and rising valuations. And that could create a situation similar to the 2007 housing market downturn, when allegedly AAA-rated paper turned out to be anything but.
“Private equity firms are on the record saying they consummate transactions at a net debt EBIDTA multiple of 5-7x,” Bhansali says. “… If you look at Moody’s and the ratings agencies typically, when they rate bonds, whether they’re investment grade or junk, the dividing line is 3-3.5x net EBIDTA. The moment you go above that number, you start getting into junk.”
“Five to seven times is squarely in the junkiest of junk. That is a kind of bond exposure that a private equity portfolio has, but very few people think of it as being extremely long junk bonds.”
